China achieved its 2025 GDP growth target of 5 percent with astonishing precision, as it has in the past. Even though growth slowed rapidly during the same period—from 5.4 percent in the first quarter to 5.2 percent, 4.8 percent, and 4.5 percent over the next three quarters—Beijing set a new target for 2026 of 4.5 to 5 percent, reviving an old claim that Beijing is lying about its GDP growth rate, and that China is in fact growing much slower than the official data suggest.

But this frames the issue incorrectly. China’s GDP target is a target, not a prediction. As I explain elsewhere, as long as China is able to engage in non-productive investment without recognizing the costs—which also means as long as it is able and willing to tolerate an accelerating debt burden—China can achieve more or less whatever GDP growth target Beijing sets.

This is not because China is falsifying GDP data but rather because—much like Japan in the 1980s—it is using a measure of GDP designed for a very different kind of economy, one that operates under what economists call hard budget constraints. Because a large and rising share of the Chinese economy instead operates under soft budget constraints, the relationship between reported GDP and the underlying economy can differ significantly compared to other large economies.

What is a hard budget constraint? It is a disciplinary mechanism within capitalist economies that effectively prevents economic entities from consistently misusing resources. Economic entities operate under hard budget constraints when they must stay within strict loss parameters. They can only spend what they earn, or borrow credibly, and if losses cannot be financed, they eventually go bankrupt.

In China, however, where a large and rising share of the economy operates under soft budget constraints, many domestic economic entities can expect continued access to credit no matter what the condition of their balance sheets and profit expectations. This is because lenders assume they will be bailed out if borrowers lose money or destroy economic value. In that case, the only limit to misuse of resources is the creditworthiness of the entity—usually local governments or Beijing itself—that implicitly or explicitly guarantees the borrowing.

This matters for GDP because if an entity consistently misallocates investment into non-productive projects, and if the associated losses are not formally recognized, GDP figures in soft-budget economies are not comparable to those in hard-budget economies. What is recognized as a loss—and deducted from GDP—in the latter may not be recognized at all in the former.

How is GDP Calculated?

To understand why GDP measures different things under soft versus hard budget constraints, we have to recall what GDP is supposed to measure and how it behaves in a market economy. Measuring real value creation in any economy is notoriously difficult, and the GDP calculation tries to do this by measuring the total monetary value of goods and services produced within an economic entity during a specific period.

It can be calculated in three ways:

• Expenditure approach: consumption + investment + government spending + net exports – imports
• Income approach: wages, rent, interest, profits, and taxes
• Value-added approach: value added at each stage of production

In theory, all three approaches should yield the same number because they measure the same underlying activity.

A problem can arise when a substantial amount of investment is not economically productive and not correctly accounted for. Nonproductive investment, in this case, means investment in a project that produces less in economic value than the economic value of the resources absorbed by that project. In market economies nonproductive investment usually comes in the form of building production facilities that produce goods that cannot be sold at a profit, but in high-investment economies it often comes in the form of excess spending on infrastructure, like Japan’s famous “bridges to nowhere” in the 1980s.

Nonproductive investment reduces, rather than increases, the real wealth of an economy and so should also reduce reported GDP. Whether it does so in the current period depends on whether the loss is recognized. 

Recognizing Versus Not Recognizing Bad Investment

But now consider two countries that are identical except in the ways in which they recognize investment losses. In each country there is an entity—perhaps a government entity—that makes a bad investment, with each investing $100 in resources and producing only $80 in total economic value.

In the first country, assume that the entity is required to carry the asset on its balance sheet at its real economic value ($80), which means recognizing the $20 loss immediately in the form of a $20 reduction in profit, a $20 reduction in net asset creation, and a $20 reduction in its value-added contribution to the economy.

Notice that the $20 reduction in profit reduces the income-side calculation of GDP; the $20 reduction in net asset creation reduces the expenditure-side calculation of GDP; and the $20 reduction in its value-added contribution reduces the value-added calculation of GDP. As we would expect, a $20 loss reduces reported GDP by $20, no matter which calculation method we use.

In the second country, assume that the entity has no need to write down the value of the asset on its balance sheet. Instead, it is able to carry it at the original cost ($100), which means it does not have to recognize either the reduction in profits, the reduction in net asset value, or the reduction in its value-added contribution. This is especially easy to do with infrastructure projects—bridges, damns, airports, high-speed rail networks—whose value consists mostly of economic externalities and so is hard to value.¹

Yet there is a difference in the way the second country reports GDP compared to the first country. For the first country, under the current period, it recognizes lower asset values, lower profits, and lower value-added, while in the second it doesn’t. As a result, the first country will report $20 lower GDP growth than the second country, even though the two are economically identical. It is only when the loss is finally recognized and allocated in the second country, perhaps many years or even decades later, that the two GDP measures will again converge. 

That’s why the extent to which an economy operates under soft rather than hard budget constraints matters to the value of the GDP calculation. In capitalist economies, most economic agents operate under hard budget constraints. This means that every investment or business venture is ultimately disciplined by financial viability. If an enterprise invests in an unproductive project, the resulting losses show up in its financial accounts.² These in turn affect the reported GDP calculation.

But in a case like that of China’s, where much of the economy operates under soft budgets, and where investment in infrastructure (and, increasingly, in manufacturing capacity) plays an outsized role in driving economic activity, there isn’t always a disciplinary mechanism that forces recognition of the loss, especially when it comes to local governments or SOEs. These entities can carry an investment at cost for many years, even decades. In that case, to bridge the persistent gap between the return on investment and the cost of debt servicing, we should see the debt used to fund investment (which is most debt in China) rise faster than GDP.

Capitalizing an Expense

Accountants will recognize this process as the equivalent of “capitalizing” an expense, something businesses are not supposed to do. In standard accounting practice, losses are expensed—that is, when a business loses money, this shows up on the income statement as a reduction in net profits, and on the balance sheet as a decline in net asset values. But sometimes—for example, in the case of fraud—the losses are not expensed but are instead recorded on the asset-side of the balance sheet in the form of an overvalued asset. This allows the business to show higher net profits and higher net assets than it otherwise could.³

To put it in accounting terms, hard budgets force an economic entity to recognize investment losses as expenses within a reasonably short time period, no matter how eager it may be not to do so. Soft budgets, however, allow it to capitalize those losses rather than expense them—especially when the bulk of investment is in hard-to-value projects, like infrastructure—which also allow it to mark the value of assets above their real economic values. In this case it records profits and asset values that are higher than they should be. These, in turn, feed into higher reported GDP.

This game can go on as long as the financial system can roll over the capitalized losses in the form of rising debt, because the fact that the economic entity’s assets are not generating enough to service its debt can be hidden by “servicing” part of the old debt with new debt. 

This of course requires an acceleration in debt growth, and that’s the problem: Once an economy that operates under soft-budget constraints can no longer grow debt at increasing rates, or decides to rein in the growth of debt, the process must stop. It is no longer able to use additional debt to bridge the gap between the real economic cost of servicing the debt and the real economic returns generated by the asset. The difference can no longer be monetized. It must be recognized, and more importantly, paid for through implicit or explicit transfers from some sector of the economy.

In that case all those previously capitalized losses that had exaggerated the value of GDP will reduce current and future GDP growth by that amount. While the losses can be recognized quickly, in the form of a crisis, as happened with the United States in the early 1930s or Brazil in the early 1980s, or slowly, in the form of much slower growth, as happened with Japan in the 1990s and 2000s, they must eventually be recognized.

When GDP Isn’t Comparable

Some might argue that the distinction between faking GDP and using an inappropriate measure of GDP is too minor to matter, but they represent two very different ways of thinking about the Chinese economy. China’s GDP calculations may be “correct” in the sense that they reflect best practice in market economies, where the ability to overinvest is limited by hard budgets, but because much of the Chinese economy operates under soft budget constraints, it lacks a correction mechanism that is typical of market economies.

It is in that sense that the GDP measure for China is not comparable with the GDP measure for economies that must write down nonproductive investments more rigorously. The problem is conceptual misalignment, not statistical dishonesty. GDP measures the flow of spending, not the creation of wealth. In an economy in which bad investment isn’t recognized, the GDP measure can diverge substantially from one in which it is, especially when hard-to-value projects like infrastructure spending play such a disproportionate role in generating economic activity, and the more debt is used to conceal that divergence, the less comparable the GDP numbers become.

This is not a new story. We saw it in the USSR in the 1960s, Brazil in the 1970s, Japan in the 1980s—and even to some extent in Iceland, Ireland, Spain, and the U.S. in the 2000s, when very aggressive mortgage markets allowed the recognition of bad property investment to be postponed for many years. In every case, until soft budgets were hardened—that is, until the bad investments on the country’s collective balance sheets are cleaned up—reported GDP growth was exaggerated, and only revised later during difficult adjustment periods. 

Nearly 160 years ago, John Mill explained that “panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” Hard budget constraints are the main way capitalist economies limit “hopelessly unproductive works.”

For this reason, China’s reported GDP growth should be understood not as a measure of the value of current output, but as a joint function of output, credit expansion, and the deferral of loss recognition. As long as the system permits losses to be capitalized and rolled forward through rising debt, reported growth can remain stable even as underlying returns deteriorate. But the longer this divergence persists, the larger the eventual adjustment must be—whether through slower growth, financial stress, or explicit transfers to absorb the accumulated losses. In that sense, the GDP growth target in a soft-budget system can tell us more about the sustainability of the financial structure than it does about the creation of real economic value.