This is how to tell whether China is really heading in the right direction

Economist Michael Pettis, a superstar of China analysis, wrote a must-read (but massive) blog post on the state of the Chinese economy, and whether planned reforms are likely to work.

There are a lot of uncertainties in terms of timing and policy implementation, he said.

What Pettis does know for sure, is how the world will know China’s serious problems with debt and over capacity are being dealt with.

From his blog post:

It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted.

China’s economy is going through a transition from a system based by investment, to one based on consumer consumption. During those investment years, China’s massive state-owned enterprises racked up a ton of debt, and now it’s making them unproductive.

When companies are paying off debt, they’re not reinvesting and expanding. They’re not hiring people. They may have to lay off workers. Worse, down the line, they may not be able to pay their creditors.

You see how this is a problem.

And it’s only getting worse

China is still working on figuring out how to restructure this debt. In the meantime, the debt keeps mounting in the form of credit extended to companies in order to keep them running.

The thing is, the longer this goes on, the less impact credit actually has.

According to Bloomberg, every dollar of new credit added to China’s economy adds 27 cents to GDP. Back in 2011 it generated 59 cents.

This is what famed China bear and short seller, hedge fund manager Jim Chanos calls “China’s treadmill to hell.”

In short, when China’s corporate sector doesn’t have to live on credit anymore, we’ll know reforms are doing their work and the economy is finally running to somewhere.

Of course it’s how the government gets there that’s so painful and complicated.

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