In an article in Wednesday’s Financial Times, Gabriel Wildau, Yuan Yang, and Tom Mitchell set out a range of economic outcomes for China. They propose three scenarios that they think—and I agree—are the most plausible ones. Their approach is useful, in my opinion, because by setting out the various possible paths China can follow we can compare them and logically work out the conditions that are required for each. This allows us to identify the conditions we should be looking for to help us decide the direction we think the economy is following.

The article starts with an important warning about the relationship between debt and growth that is still too poorly understood. The authors note that at the beginning of 2016, concerns about the Chinese economy had risen so dramatically that there was a growing chorus calling for financial and economic collapse. I have long argued that the Chinese economy is in far worse shape than most of us realize, and its debt burden far heavier, but I’ve always thought that a financial crisis was pretty unlikely (although I think the probability of crisis might rise sharply over the next two to three years). Most analysts seem to find it hard to reconcile these two views, but excessive debt does not have to lead to a financial crisis. In fact it usually doesn’t. A financial crisis is simply one of the two ways—usually the more efficient of the two—in which excess debt is resolved, the other being a long, drawn-out grinding away of debt, with growth slowly dropping to very low levels.

The collapse many expected in 2016 never came, but as the article points out that didn’t mean all was good:

Few think that China’s fundamental economic challenges have been addressed. The relatively strong growth performance came at the cost of adding further leverage to the economy and falling back on smokestack industries to drive growth. Many economists believe that by pursuing overly ambitious short­-term growth targets while delaying necessary but painful reforms, policymakers are only storing up trouble.

“The basic problem is they’ve got a growth target that’s unrealistic,” says Jonathan Anderson, principal at Emerging Advisors Group in Shanghai and a former China head for the International Monetary Fund. “They [the leadership] are talking about, ‘Instead of 6.5 per cent, let’s go for maybe 6.2 or 6.1 per cent’. Well, that’s nice, but you have to go from 6.5 to 3 per cent to knock this back,” he adds, predicting that China will eventually suffer a financial crisis if leverage keeps rising at the current pace.

Over the rest of this essay I will list the three scenarios described in the article along with the conditions I think are required for each. As an aside, I was pleased to see that Jonathan Anderson, whose work I used to read when he was a bank analyst, seems to think that growth has to be knocked back to 3 percent for it to be sustainable and for the debt burden to stop growing. Back in 2010–2011, I argued that without implausibly large wealth transfers from the state sector to households, I could not figure out arithmetically any way of maintaining GDP growth above 3–4 percent without accelerating growth in an already unsustainable debt trajectory. Although most analysts at the time considered my forecasts to be shockingly low and wholly implausible, and thought so even two to three years ago, I have always said that before the end of the decade it will have become the consensus. It isn’t the consensus yet, and indeed is far from it, but it is no longer considered shocking.

A gradual decline in GDP growth to below 3 percent by the end of this decade, or shortly thereafter, is in my opinion the most likely scenario for China, and is broadly in line with what the Financial Times article would characterize as the second scenario. I will discuss this scenario and the following one, and my comments will be brief because I think both scenarios are quite easy to understand, but I do plan to discuss the first scenario quite extensively because I think it is extremely unlikely, and I want to explain why it requires certain conditions—mainly an implausibly large wealth transfer—that will be hard to implement.

Scenario 1: The “New Economy” Will Drive Growth

In the first scenario proposed by the Financial Times—clearly the best-case scenario—the focus is on growth in consumption-related and “new economy” sectors in China. If these sectors continue growing at current rates, according to those who expect this to be the most likely outcome, they can soon replace the old, contracting sectors of the economy as the main source of demand that drives economic activity and keep growth rates high.

Jeffrey Towson, a business professor at Peking University and a former investment executive at the Saudi Arabia-based Kingdom Holding Company, argues that it is easy to be “too pessimistic” about the Chinese economy. “Looking at macro stuff in China does that to people,” he says. “Things are much more optimistic at a micro level.”

Mr Towson points to “unlimited demand” for everything from entertainment to healthcare, which are growing at double ­digit rates and will continue to do so for the foreseeable future.

While there are certainly good things happening at the micro level in the Chinese economy, we cannot ignore the macro if these create growth constraints, which, as I will explain, they do. To expect that the “new economy” sectors can resolve these constraints fails, I think, to recognize the structural nature of these constraints. The constraints to growth are created by the demand imbalance, I would argue, and unless it is resolved this demand imbalance invalidates nearly every forecast in which China maintains medium- or long-term growth rates of 6–7 percent, or even of 5 percent.

By now most analysts acknowledge that China’s rapid growth in investment must be reversed because a large and growing portion of this investment is not productive enough to justify the spending, the result of which is that the value created by the investment is less than the cost of the investment. But with investment being such a large share of China’s GDP, and with the growth in investment having pulled GDP growth behind it for most of the past three decades, consumption growth must accelerate and ultimately drive GDP growth if the role of investment is to be reduced without causing GDP growth to stall.

If investment growth is reduced, in other words, there are only two possible outcomes. Either GDP growth declines, especially if slowing GDP growth also results in slowing consumption growth. Or consumption growth must pick up substantially in order to replace the reduction in investment growth. I want to stress that so far this is only logic. Anyone who believes Beijing is serious about reducing investment growth, and who expects GDP growth to be maintained at or near current levels, must also believe that consumption growth will accelerate (technically a surging current account surplus could replace surging consumption, but simple arithmetic shows this to be unrealistic).

There are logically only two ways for consumption growth to accelerate. Either the growth in household income must accelerate (and in household income I include consumption expenditures made by the state sector on behalf of households), or household savings rates must drop rapidly as households consume rising shares of their income.

How can the growth in household income accelerate even as investment growth decelerates? Clearly the “natural” consequence of a deceleration in investment growth is a deceleration in the growth of household income, so that anyone who expects household income growth to accelerate must specify a mechanism by which this will happen. Without such a mechanism, the only way current GDP growth rates can be maintained over the medium and long term while investment growth decelerates is by a sharp reduction in household savings rates.

Many analysts seem implicitly to think that this is exactly what will happen. In December, for example, I was asked to participate at a BIS conference in Hong Kong where I heard a presentation on China by Jan Dehn, who I believe runs a China fund at Ashmore. It was difficult for me to find anything with which I agreed in his presentation, in which he argued among other things that Chinese debt levels are not worryingly high because China has a high savings rate, or as he put it in a blog affiliated with Barron’s:

China has a relatively large stock of debt, because the domestic savings rate is so high. In fact, China has the world’s highest rate of savings at 48% of GDP.

In practice, this means that the average Chinese worker stick roughly half of his or her pay check into a bank account every month. 

I do not understand his logic at all. By definition any country with both high investment and a current account surplus must have a high savings rate, but I don’t understand why having high savings explains China’s high debt levels. More importantly it isn’t at all clear why Dehn thinks that China’s high savings levels mitigate its high debt levels. Nearly every country in modern history that I can think of that has had very high debt levels, and has also had high savings rates (in most cases substantially exceeding investment), has subsequently had a very difficult debt-constrained economic adjustment in which GDP growth has dropped to close to zero, or even gone negative, as the country struggled to get its debt under control.

Scenario 1: The Consumption Constraint

But that’s a minor disagreement. Where I really disagree is with Dehn’s characterization of savings. He seems to have confused China’s total savings with the personal savings of Chinese households, a common mistake even among economists, but a mistake nonetheless and especially egregious in the case of China. He seems to think that China saves nearly half its GDP because Chinese workers save nearly half their paycheck, and that because it is relatively easy to induce workers to cut back on their savings, the country can easily rebalance demand toward consumption.

Leaving aside that as uncertainty rises we should expect the household savings rate in China to rise, as it has been doing, and not fall, this characterization of savings fails to understand that changes in household savings preferences almost don’t matter. Contrary to what Dehn claims, it is not at all the case that at roughly 50 percent of GDP, China has the highest savings rate in the world—and the lowest consumption rate, which is the same thing—because when the average Chinese worker receives his RMB 100 paycheck he immediately puts half of it into his bank account. The average worker of course puts in a lot less than that, and more importantly, it isn’t the average worker that drives China’s high savings rate. The reason China has the highest savings rate in the world is because when the average Chinese worker produces RMB 100 of goods and services, he only gets a paycheck of roughly RMB 50, of which roughly RMB 15 is put into his bank account. The rest of the roughly RMB 35 in savings has nothing to do with household saving and instead comes from businesses and government entities.

Chinese households are not able to consume a substantial portion of what they produce, in other words, simply because they are paid too low a share of what they produce. The constraint on consumption growth is not the savings preferences of the Chinese household. It is the very low share of GDP Chinese households retain.

This is why a surging “new economy” cannot generate enough growth over the medium and long term without some mechanism that drives up household income growth, any more than will improvements in supply-side efficiency. GDP growth cannot be maintained while investment growth decelerates unless consumption growth accelerates, and consumption growth cannot accelerate to anywhere near the extent that it must unless the growth in household income accelerates.

I will explain how this can happen in the next section, but before doing so I should point out that much of the extraordinary growth in internet retail, the most vibrant part of the “new economy,” does not represent independent new demand but rather involves a shift in demand from brick-and-mortar retail. While it may seem that demand in the new economy is growing “at double-digit rates and will continue to do so for the foreseeable future,” as Towson suggests, this will only be true while it is able to grow at the expense of brick-and-mortar demand. Growth in the two sectors together, however, is still constrained by the growth in household consumption.

Scenario 1: What Will Drive Household Income Growth?

China can only grow sustainably at 5 or 6 percent for many years while investment decelerates if the growth in household income is high enough to boost consumption growth. Because the “natural” consequence of a deceleration in investment growth is a deceleration in the growth of household income, however, if household income growth is to accelerate we must be able to specify a mechanism by which this will happen.

It turns out that there is at least one such a mechanism: explicit or implicit wealth transfers from the state sector, most likely from local governments. If Beijing can engineer wealth transfers to ordinary Chinese households, their increased wealth will encourage them to increase their spending on consumer goods and services even as investment decelerates, and with the production of consumer goods and services likely to be more labor-intensive than investment, China can keep unemployment from rising even with lower GDP growth rates. To summarize, there are only two ways in which current growth rates can be maintained. These are:

  1. If Chinese investment is on the whole productive, and the value of assets is growing as fast as the value of debt, then we can assume that current growth rates are not driven mainly by excessive debt and that Chinese growth is sustainable without the need to bring down investment growth. Of course, with debt in 2016 rising by roughly 40–45 percentage points of GDP while nominal GDP grew by less than 8 percent, it isn’t easy to explain how the real value of assets in China grew by roughly 40–45 percentage points of GDP, nor why it is proving so difficult to rein in credit growth without a sharp slowdown in GDP growth.
  2. If, however, Beijing does need to bring down investment growth, then if Beijing can engineer a transfer of wealth from local governments of roughly 3–4 percentage points of GDP every year, household income growth will speed up by enough to keep GDP growing at 5 percent or more even as investment growth is allowed to drop sharply. The problem is that Beijing has so far found even much smaller transfers incredibly difficult, and while in theory transfers of that magnitude are not impossible, I think they are extremely implausible for obvious political reasons. This is especially the case when one considers that the larger the transfer program, the greater the “wastage” likely in order to buy off political opposition, which means that for each unit of wealth actually transferred to households, the value of assets liquidated must be higher.

I have gone into this scenario into some detail because I think it is extremely unlikely that China can maintain current growth rates except under very implausible assumptions. In fact I think 5–6 percent average growth rates in the 2013–2023 period are all but impossible, and even half that level will be tough to pull off. Within three years I expect this level of GDP growth to be considered by most economists as wholly unrealistic.

Scenario 2: Stagnation

This is the scenario that I have always argued is the most likely. Under this scenario, growth drops steadily during the economic adjustment period, but in an orderly way for over a decade or more as Beijing slowly gets credit growth under control. This scenario must also involve a wealth transfer process, but at roughly 1–2 percentage points of GDP, it is I think politically manageable.

Several years ago I argued that beginning in 2011–2012, an optimal adjustment scenario might see reported GDP growth drop by roughly 100 bps a year or more to average under President Xi (during the 2013–2023 period) no more than 3–4 percent. Both household income and consumption in this scenario will grow faster than GDP, perhaps by 4.5–5.0 percent, because of wealth transfers of roughly 1–2 percentage points of GDP annually. Although many might find a forecast of 3–4 percent GDP growth shocking, I should add that in fact I am not predicting 3–4 percent average growth. Three to four percent is the highest number that I can logically work out except by making implausible assumptions. The actual average growth could be lower.

Ultimately, and for reasons I have discussed before, the main determinants of the average growth rate during the adjustment period will be: a) the size and structure of the country’s debt burden, and b) the pace with which wealth is transferred to the household sector. The sooner Beijing gets debt under control, the less costly the adjustment will be, although there should be no question in anyone’s mind that the adjustment will be difficult and that growth will continue to slow to well under half of current levels, probably before the end of the decade.

Scenario 3: Acute Crisis

I don’t have much to add to what the Financial Times article has to say on how this scenario might occur. The authors worry about

the dangerous nexus between shadow lenders and large, systemically important commercial banks. Trusts raise funds for their loans by selling high-yielding wealth management products [WMPs] to investors. For the riskiest trust products, banks typically serve only as sales agents but bear no legal responsibility for product payouts. 

Yet investors often ignore these technicalities, assuming that state-owned banks — and by implication, the government — stand behind the products they distribute. Adding to the perception that defaults are impossible is a history of bailouts of WMPs by banks, even where no legal responsibility exists. 

I continue to think that a financial crisis in China is unlikely, but as debt levels rise, it takes smaller and smaller shocks to cause balance sheet unraveling, and so a crisis becomes increasingly likely if the debt burden continues to soar. Contrary to widespread beliefs, financial crises are not caused by insolvency. They are caused by systemic asset-liability mismatches acute enough that a collapse in liquidity make impossible to bridge. In the article this is exactly the risk that is highlighted:

Yet wealth management defaults alone would probably be insufficient to spark a crisis. They would have to coincide with a system-wide tightening of liquidity, which would magnify the effect of isolated defaults by making it more difficult for banks to fall back on interbank borrowing.

As long as the regulators are credible, however, what looks like significant asset-liability mismatches within the Chinese financial system are in fact manageable because the regulators can restructure most of the relevant liabilities. The Financial Times article focuses on two things: the ways in which credibility can break down, and the areas within the financial sector in which it is harder to restructure liabilities (for example, retail WMPs). It is right to do so. Investors who are concerned about a financial crisis should be monitoring those two areas.