Rebalancing, Wealth Transfers, And The Growth Of Chinese Debt

For the past ten years much of what I have written about debt in China was aimed mainly at trying to convince analysts and policymakers that the Chinese economy was structurally dependent on an unsustainable increase in debt in order to generate GDP growth rates above some level. This level might have been around 5-6% ten years ago but it has steadily declined with the rising debt burden and is currently probably not much above 2-3%.

Today it no longer seems necessary to explain that Chinese debt levels are far too high. On May 9 thePeople’s Daily published a major front-page interview with an “authoritative figure”, thought to be very close to Xi Jinping, warning that the Chinese economy was in much worse shape than many believed largely because debt had risen far too quickly. Here is the South China Morning Post:

A People’s Daily article published yesterday showed that China’s leadership is trying to make a grand shift in the nation’s economic policies in a bid to say goodbye to debt fuelled growth. In a sign of distaste for the credit-pumped growth in the past couple of months, the Communist Party mouthpiece cited an unidentified “authoritative” figure as saying that boosting growth by increasing leverage was like “growing a tree in the air” and that a high leverage ratio could lead to a financial crisis.

“The whole world”, according to the China Daily the next day, “seems to be talking about the People’s Dailyinterview on May 9.” It went on to say:

The People’s Daily article is good for all local officials to study and to follow. The message cannot be clearer. If it is from the top leadership, as some readers speculated, then what it represents is a requirement on the policy level – cut the debt level, by whatever means. Deleveraging, or cutting down indebtedness, is in fact listed as one of the five tasks of China’s supply-side reform for 2016. Now that half a year already has passed, at least some action should be taken during the remainder of the year, as the interview suggests.

Probably the real indication that the argument over whether or not China has a debt problem has been resolved is a May 7 article in the Economist. For years I had been extremely frustrated by the magazine’s coverage of the Chinese economy as being far too credulous and altogether too willing to assume away problems that other countries in similar circumstances had been unable to resolve.

Not all periodicals were so frustratingly cheerful. The Financial Times had long been writing about China’s balance sheet risks, with the FT Alphaville blog in particular zooming in on the key monetary and balance sheet vulnerabilities that by now have become so familiar to everyone else. Every time new evidence came out that suggested debt levels in China were becoming worrisome and needed to be addressed, however, the Economist responded by dismissing concerns over the debt as overblown. It consistently seemed to argue that China could easily manage it rising debt burden.

Last month, however, in a much-commented departure, the Economist suddenly reversed positions, warning that debt levels had become so extreme that “it is a question of when, not if, real trouble will hit in China.” In an alarming, but not alarmist, piece, the magazine acknowledged how serious China’s balance sheet distortions had become:

China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.

The article ended with what all of us should have been saying for nearly a decade: China’s debt burden would have been relatively easy to manage had Beijing started doing so much earlier, under Hu Jintao’s presidency. It is no longer easy to manage, but the longer Beijing waits to begin the deleveraging, the more difficult it will be:

One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.

Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.

Finally there is consensus

This, I think, is really the key point. There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.

Not that most analysts understand how important it is to constrain credit growth, the task is to explain exactly why debt is a problem, how it will undermine growth, and why many of the “solutions” that economists propose are simply not solutions at all. These “solutions” include a number of especially treacherous ideas: China’s rising debt can be managed for quite a long time before it becomes a serious constraint, countries have near-infinite capacity for domestic debt when it is “backed” by even greater amounts of savings (this is an especially foolish conceit), China can easily monetize the debt at no significant cost, or the right solution is to improve productivity to the point at which economic growth can outpace credit growth (it is nearly impossible to find a trained economists who doesn’t think this last is self-evidently the only way to approach the problem of debt management).

A little over a year ago in the newsletter I send out to my clients I tried to explain how debt constrains growth. In that issue of the newsletter I discussed debt generally, as it affects any kind of macroeconomic balance sheet, but of course the focus was on China. In the newsletter I posited a number of rebalancing scenarios in order to try to work out the implications fro debt. I have made some small adaptations to these scenarios but most of the rest of this blog entry is taken from that newsletter. One obvious consequence or revisiting this one-year-old exercise is to make clear just how optimistic were the assumptions I made in designing the various scenarios.

Economists are trained with models in which the structure of the balance is barely relevant to growth except to the extent that fear of a debt crisis undermines confidence. Of course this completely circular reasoning cannot be true except if we assume that the fear of a debt crisis is totally irrational – as it must be if growth is not otherwise affected by the structure of the balance sheet. Still, the implications of these totally unrealistic models seem to dominate the kinds of reforms that policy-making advisors have proposed even since Xi Jinping has come to office, and if my suspicions are right, and Xi and those closest to him have become intensely frustrated by the advice both Chinese and foreign advisors have proffered, we may be in for a much needed change.

The first implication of the balance sheet approach to reforms is that given extremely high debt levels there really is no easy way to rebalance the Chinese economy. It is foolish to think that China’s adjustment will be anything other than extremely difficult, and it is in the best interest of China that the challenges facing the Xi administration are not minimized.

Examining China’s debt scenarios

To show why, I thought it might be helpful to summarize the various scenarios for rebalancing and non-rebalancing that I presented to my clients over a year ago. In the table below I look at three possible scenarios in which China is able to maintain current GDP growth rates of 6-7%, with three different amounts of government transfers to the household sector expressed as a share of GDP. This is followed by three possible scenarios in which GDP growth rates drop to 3-4%, with the same three different amounts of government transfers to the household sector expressed as a share of GDP.

I divide each of these scenarios into two time frames. The first is the next three years under President Xi Jinping, and the second is the last three years of his administration (assuming, of course, that Xi, like his predecessors, serves two five year terms).

These scenarios are very rough, and I have tried to select the most optimistic and least disruptive conditions and assumptions. I assume that debt is easily refinanced, that rising debt imposes no financial distress costs, that the amount of unrecognized NPLs is too small for their refinancing to have a significant impact on the growth in credit, and that the growth in household income is not highly correlated with investment growth. I think these assumptions are very optimistic, to the point of seriously underestimating the difficulty of the rebalancing, but they nonetheless help us frame the set of possible outcomes by pretending that all those costs that are hard to quantify are negligible, even zero.

In the first of these three scenarios I will assume that it is politically very difficult for the Xi administration to transfer significant amounts of wealth from the state sector to the household sector – either directly, in the form of transfers of assets to household or to the social safety net, or indirectly in the form of houkou reform, the sale of assets to pay down debt, and so on. In this scenario in other words I assume total transfers are negligible.

Growth remains at 6-7%

No government transfers

2016-2019

Debt growth is steady at 12-14%
Investment growth is steady at current levels
Consumption growth is steady at current levels
Growth in household income is steady and household share of GDP is unchanged
No rebalancing

2020-2023

Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP
Debt growth rises to 15-18%
Investment growth is steady at current levels
Consumption growth is steady at current levels
Growth in household income is steady and household share of GDP is unchanged
No rebalancing

This scenario posits no consequent changes in any of the main variables. Investment and consumption continue growing at current rates, with no change in overall GDP growth (I am ignoring possible changes in the current account). For this to happen, debt must continue growing at current levels of roughly 12-14% annually. I have argued many times before that China is now in a stage – similar to that of the late stages of every other country that has experienced a growth “miracle” – in which so much bad debt remains unrecognized within the banking system that credit growth must accelerate simply to maintain current levels of debt financing for economic activity.

This means that even maintaining current levels of investment, consumption and GDP growth implies accelerating credit growth. Since I sent out the newsletter last year I have already been proven vastly optimistic on this assumption because the latest data just one year later suggest that debt has been growing by 15-17% to maintain 6-7% GDP growth. I suspect that within another year debt will be growing by much closer to 20%.

But I want to be extremely conservative so as to give the optimists every chance for the arithmetic they implicitly use (but don’t seem explicitly to recognize) to work. I will assume, then, that there is no need to accelerate credit growth from levels at the beginning of last year and I will assume that the acceleration we have already seen this year was somehow an aberration that can be reversed (I assume this fir the sake of conservatism. Of course, and not because I think it is remotely likely). I also ignore the financial distress effects I discuss above, even though there is an overwhelming amount of evidence that suggests that as debt levels grow and create increasing uncertainty about their resolution, economic growth slows fairly automatically and rapidly.

The key point about this scenario is that if we maintain current levels of consumption, investment and GDP growth, at the end of three years even conservative assumptions imply that China’s already high debt levels rise, as the table shows, by at least a quarter (i.e. if debt is currently equal to 200-240% of GDP, it rises to 250-300% in 3 years). I don’t show in the table that at the end of six year, debt would rise again by at least one-third, so that it would amount to perhaps 330-400% of GDP.

Debt probably already amounts to more than the 200% of GDP recorded in the June 2015 release of the World Bank’s China Economic Update (pp. 23), with many claiming that it is closer to 250%. Whatever the actual debt ratio, it is hard to imagine that the growth in Chinese debt, already among the fastest ever recorded in the developed or the developing worlds, can be maintained at anywhere near current levels for more than two or three years. The same World Bank report suggests (pp. 6) that there may already be strains in Beijing’s ability to maintain credit growth:

Policy interventions are increasingly focused on unlocking new funding sources. Besides promoting public–private partnerships (PPPs) as a new funding model for infrastructure funding, there have been efforts to intensify use of policy banks. Further, in April the State Council expanded the use of the Social Security Fund to buy local government bonds and other financial instruments. The new rules allow it to invest up to 20 percent of its portfolio in local government debt and corporate bonds.

It may very well be that Beijing’s credibility is so strong that even substantially higher debt levels won’t matter, but I would argue that it will not be easy to manage another three years of debt rising much faster than debt servicing capacity, let alone six, and if this happens it must undermine confidence, even without more credibility setbacks, like the stock market panic earlier this month.

The new normal with government transfers

The “muddle through” scenario, in other words, in which current investment and consumption growth rates are maintained, and with them current GDP growth rates, is an extremely risky one and, in my opinion, makes the possibility of a hard landing as China runs into debt capacity limits very high. Debt capacity limits are reached, as I have long maintained, when debt cannot grow fast enough to cover its two main functions: First, it must grow at a geometric rate to roll over old bad debt as well as new bad investments whose principle and interest cannot be met by increases in productivity, and second, it must grow at a linear rate to invest into new projects that generate the targeted growth in economic activity. This will be made worse if rising debt uncertainty causes wealthy Chinese residents to disinvest locally and send money abroad at even faster paces than they have in the past, but as I point out above, I am ignoring this possibility so as to present the most optimistic scenario.

But Beijing can tray another strategy. Instead of simply muddling through, Beijing might try to maintain current growth rates while transferring wealth to the household sector to force up consumption growth. I posit two scenarios, one in which Beijing is able to transfer 1-2% of GDP every year, and a second in which Beijing is able to transfer 3-4% of GDP every year. The first scenario will be hard enough to pull off politically, and the second extremely implausible, but I include both to give a sense of the range of outcomes.

In the two transfer scenarios I assume that the decline in investment has no adverse impact on household income because its impact on employment is more than counterbalanced by the rise in consumption. With household income at a little more than half of GDP, the transfers would cause household income growth to rise by 2-3 and 6-7 percentage points respectively, and I assume that this translates directly into equivalent increases in the consumption growth rate (i.e. I assume, perhaps very optimistically, that rising debt does not create enough economic uncertainty in the minds of Chinese households to cause them to raise their savings rate).

Growth remains at 6-7%

Annual government transfers of 1-2% of GDP

2016-2019

Debt growth drops to 9-10%
Investment growth declines by 2-3 percentage points
Consumption growth rises by 2-3 percentage points
Growth in household income rises by 2-3 percentage points and household share of GDP rises slightly
Minimal rebalancing

2020-2023

Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth
Debt growth rises to 11-13%
Investment growth declines by another percentage point
Consumption growth is steady
Growth in household income is steady and household share of GDP rises
Gradual rebalancing

The key point to which I would want to draw attention is the impact on the country’s balance sheet. In both cases the surge in household income would allow Beijing to bring down investment growth much more aggressively and so to rein in debt growth.

Growth remains at 6-7%

Annual government transfers of 3-4% of GDP

2016-2019

Debt growth drops to 8-10%
Investment growth declines by 6-7 percentage points
Consumption growth rises by 6-7 percentage points
Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher
Material rebalancing

2020-2023

Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth
Debt growth rises to 6-8%
Consumption growth declines by 1-2 percentage points
Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher
Material rebalancing

In both scenarios debt continues to grow, but in the second scenario it is now almost in line with the growth in GDP, which we are assuming is no higher than the growth in debt servicing capacity. While the first scenario implies that the debt-to-GDP ratio has increased by 10-15% (or, if debt is currently equal to 200-250% of GDP, it will rise to 220-290% of GDP in three years and 260-340% in six years), the second scenario implies a gradual rise in the debt-to-GDP ratio. The lower end of the estimate, I think, might be sustainable, although no developing country has managed to sustain such high levels of debt as the higher end, and it requires an implausibly high annual transfer of wealth from governments to households of 3-4% of GDP.

Adjustment with slower growth

What happens if Beijing reins in credit growth and forces down the investment rate much more aggressively, so that GDP growth rates drop to 3-4%? The decline in investment growth will cause growth in consumption to decline too, but not by as much, given that the decline in investment would affect the more capital-intensive public sector. I will assume that there is no significant rise in unemployment because Beijing will allow debt to rise to keep unemployment down while it manages the transition to a more consumption-driven economy, in which demand tends to be more labor-intensive.

Again I will consider three scenarios, the first of which involves no transfers of wealth from the government sector to the household sector. The second two will include a manageable transfer of 1-2% of GDP annually and a highly implausible transfer of 3-4% of GDP annually.

Growth remains at 3-4%

No government transfers

2016-2019

Debt growth drops to 6-8%
Investment growth declines by 4-6 percentage points
Consumption growth declines by 2-4 percentage points
Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher
Material rebalancing

2020-2023

Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth
Debt growth is steady at 6-8%
Investment growth is steady at current levels
Consumption growth is steady at current levels
Growth in household income is steady at current levels and household share of GDP is materially higher
Material rebalancing

As in the first three scenarios I would argue that the key point is what happens to debt, as this, more than anything else, determines the sustainability of the growth model and how much time Beijing has to manage the rebalancing. In this scenario the debt burden continues to rise, but after three years the debt-to-GDP ratio is likely to be only 10-15% higher than it is today.

Growth remains at 3-4%

Annual government transfers of 1-2% of GDP

2016-2019

Debt growth drops to 5-6%
Investment growth declines by 7-9 percentage points
Consumption growth is flat
Growth in household income is flat and household share of GDP is higher
Material rebalancing

2020-2023

Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth
Debt growth is steady at 5-6%
Investment growth is steady at current levels
Consumption growth is steady at current levels
Growth in household income is steady at current levels and household share of GDP is materially higher
Material rebalancing

If Beijing is able to combine lower growth with government transfers equal to 1-2% of GDP annually, the growth in debt will barely exceed GDP growth (under admittedly optimistic assumptions), and finally, if Beijing transfers 3-4% of GDP annually, the debt-to-GDP ratio begins to fall almost immediately.

Growth remains at 3-4%

Annual government transfers of 3-4% of GDP

2016-2019

Debt growth drops to close to zero
Investment growth is zero
Consumption growth rises from current levels
Growth in household income rises from current levels and household share of GDP is materially higher
Substantial rebalancing

2020-2023

Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth
Debt growth drops to well below GDP growth
Investment growth is steady at current levels
Consumption growth is steady at current levels
Growth in household income is steady at current levels and household share of GDP is substantially higher
Substantial rebalancing

Clearly the more wealth is transferred to the household sector, or the more Beijing is willing to allow the economy to slow, the more stable is China’s economic adjustment and the less painful economically over the long term. Greater transfers and slower growth, however, both come at the expense of the vested interests who oppose the reforms, and so it is politics, more than economic logic, that will determine the success of China’s rebalancing strategy.

I should note that there are so many moving parts to this analysis and so many simplifying assumptions, that the scenarios listed above should not be taken as predictions. There are important points, however, that I think emerge from this scenario analysis.

First, even after overwhelming the analysis with implausibly optimistic assumptions – discounting the disruptions caused by shifting strategies, for example, assuming financial distress costs are close to zero, and ignoring the impact on debt sustainability that results from rolling over a significant share of total loans that cannot be repaid – it is pretty clear that without a major change in policy or a tolerance for slower GDP growth it will be hard to prevent debt from becoming unsustainable. At some point, and my guess is that this would occur within the next two to three years at current growth rates, China runs the risk of a very disruptive adjustment as it reaches debt capacity limits, perhaps even the risk of negative GDP growth rates.

Second, any analysis of future growth that doesn’t tie changes in the growth rates of investment, consumption and government transfers to changes in debt levels misses out on perhaps the most important constraining factor. I think failure to understand this point explains, by the way, why over the past few years very few economists had expected GDP growth to slow as sharply as it has, and debt to rise as quickly, or allowed for either in their projections.

My guess is that the same economists will continue to make the same mistakes. To avoid doing so, as we continue to make projections about growth in GDP or in any of the drivers of GDP, we must estimate their impact on debt and how this further constrains our assumptions about growth in GDP or in its drivers. This requires a deeper understanding of how balance sheets affect growth.

What is inevitable and what is possible

Unfortunately, much of the analysis we have seen on China in the past two decades almost completely ignores the balance sheet. Four years ago one of my clients sent me a research report by Standard Chartered in which their China analyst warned that while Chinese debt levels were still easily manageabble, there was a chance, no longer insignificant, that credit growth could speed up sharply and debt eventually become a significant constraint for policymakers. Things were fine for now, the analyst seemed to suggest, but it was possible that Beijing could mismanage its way into a debt problem.

The overwhelming consensus at the time was that China’s growth model was healthy and sustainable, and would generate GDP growth rates for the rest of the decade that were not much lower than the roughly 10% we had seen during the previous three decades. My client sent me the report along with the comment that the sell-side was finally recognizing that the Chinese economy was at risk. A leading analyst who had long been part of that consensus was, he said, finally beginning to understand the Chinese economy and the problems it faced.

I wasn’t so sure. It seemed to me that those who understood the Chinese growth model would have also understood that its overreliance on investment to fuel growth, combined with the structure of its credit markets, extremely low interest rates, and wide-spread moral hazard, made soaring debt almost inevitable and that debt was already constraining policymaking.

To suggest that this might happen only if the new administration – that of Xi Jinping – mismanaged the process suggested to me that the analyst did not really understand the self-reinforcing relationship between rising debt and slowing growth and was underestimating how difficult it would be for the new administration to break out of this process. There is in other words a very big difference between acknowledging that China has a lot of debt and understanding how debt and debt creation are embedded within the financial system.

I think this was exemplified last year when the NBR’s journal for Asian economic research, Asia Policy, put together a roundtable to review Nicholas Lardy’s very detailed and carefully argued book, Markets over Mao. I was one of the five analysts who were asked to participate in the reviews. Lardy is one of the best informed and most knowledgeable of the economists covering China and so I was honored to be invited to review the book. In my review I praised his book for the quality of its analysis, and it well deserves that praise.

But there was a fundamental disagreement in how he and I interpreted the data. Lardy believes China is in good shape economically and concludes with very optimistic growth forecasts. Based on the same data and absorbing much of his analysis and interpretation of that data (I have been reading Lardy for many years) I expect growth to slow sharply. The current consensus for China’s long-term growth at the time, I think, was around 6-7%. Lardy thinks this is a low number, and has said that with the right reforms “China could grow at roughly 8% a year for another 5 or 10 years.”

I believe, however, that he is wrong. The reforms he means consists largely of productivity- or efficiency-enhancing reforms aimed at boosting growth by implementing what I refer to as “asset-side management”. But to me these asset-side reforms are barely relevant at this stage, although had they been implemented a decade ago China might not be in the difficult balance-sheet position it is in today. I have argued instead that without a massive and fairly unlikely transfer of wealth from the state sector to the household sector, the average Chinese GDP growth rate under Xi Jinping cannot exceed 3-4%, no matter how aggressively Beijing implements the standard grab-bag of orthodox reforms offered by orthodox economists.

These are the same reforms offered not just in the case of China today but during nearly every debt crisis in modern history, including to policymakers in peripheral Europe following the 2009 crisis. As far as I can tell there is not a single case in modern history in which the reforming country was able to grow its way out of its debt burden. Instead the debt burden has always increased until the country either engineers or is forced into explicit or implicit debt forgiveness.

That is why we disagree so strongly in our forecasts even though I largely accept his analysis of the Chinese economy. We disagree for the same reason I disagreed with the Standard Chartered China strategist who saw an unsustainable debt burden simply as an unlikely but possible result of policy mismanagement rather than an inevitable consequence of a structural dependence on debt. We disagree, in other words, not on the fundamental data but rather in our understanding of debt dynamics and the constraints the balance sheet can place on an economy’s “fundamental” operations.

As I see it there are at least two important disagreements here. The first is about the impact of balance sheet structures on exacerbating volatility. Neither Lardy nor the Standard Chartered analyst seem to recognize how the balance sheet might affect growth in the future and how it affected growth in the past. For me, however, this has been and continues to be a key component of the Chinese economic “miracle”, and indeed also of every previous growth miracle. As I said in my review: