On January 18, 2018, China’s National Bureau of Statistics announced that the country’s GDP grew by 6.9 percent in 2017:
According to the preliminary estimation, the gross domestic product (GDP) of China was 82,712.2 billion yuan in 2017, an increase of 6.9 percent at constant price compared with last year. Specifically, the year-on-year growth of GDP for the first quarter was 6.9 percent, 6.9 percent for the second quarter, 6.8 percent for the third quarter, and 6.8 percent for the fourth quarter.
A day earlier, the People’s Bank of China (PBoC) announced that total social financing (TSF) in 2017 had increased to 19.44 trillion renminbi. The PBoC press release stated:
According to preliminary statistics, the aggregate financing to the real economy (AFRE) . . . was RMB 19.44 trillion in 2017 . . . Specifically, RMB loans to real economy registered an increase of RMB 13.84 trillion . . . foreign currency-denominated loans (RMB equivalent) . . . recorded an increase of RMB 1.8 billion . . . entrusted loans registered an increase of RMB 777 billion . . . trust loans registered an increase of RMB 2.26 trillion . . . undiscounted bankers’ acceptances recorded an increase of RMB 536.4 billion . . . net financing of corporate bonds stood at RMB 449.5 billion . . . equity financing on the domestic stock market by non-financial enterprises registered RMB 873.4 billion . . .
For those keeping track, the table below lists the relevant GDP and TSF data for the past four years:
| Table 1. China’s GDP and TSF Figures, 2014–2017 | ||||
| 2014 | 2015 | 2016 | 2017 | |
| GDP (trillions) | 63.65 RMB | 67.67 RMB | 74.41 RMB | 87.71 RMB |
| Nominal GDP growth | – | 6.3% | 10.0% | 11.2% |
| TSF (trillions) | 16.46 RMB | 15.41 RMB | 17.80 RMB | 19.44 RMB |
| Nominal TSF growth | – | -6.4% | 15.5% | 9.2% |
| Sources: National Bureau of Statistics of China; ChinaInternetWatch.com | ||||
I was recently part of a discussion on a listserv that brings together Chinese and foreign experts to exchange views on China-related topics. What set off this discussion was a claim that the Chinese economy began to take deleveraging seriously in 2017. Everyone agreed that debt in China is still growing far too quickly relative to the country’s debt-servicing capacity, but the pace of credit growth seems to have declined in 2017, even as real GDP growth held steady and, more importantly, nominal GDP growth increased.
I was far more skeptical than some others about how to interpret this data. It is not just the quality of data collection that worries me, but, more importantly, the prevalence in China of systemic biases in the way the data is collected. Not all debt is included in TSF figures. The table above, for example, indicates a fall in TSF in 2015, but this did not occur because China’s outstanding credit declined.
It occurred rather because in 2015 there was a series of debt transactions (mainly provincial bond swaps aimed at reducing debt-servicing costs and extending maturities) that extinguished debt that had been included in the TSF category and replaced it with debt not included in TSF. The numbers are large. According to the China Daily, there were 3.2 trillion renminbi worth of bond swaps in 2015, plus an additional 600 billion renminbi of new bonds issued. If we adjust TSF by adding these back, rather than indicate a decline of 6.4 percent, we would have recorded an increase of 15.7 percent.1
Credit Growth Can Embed Systemic Biases
Most analysts were already aware of the impact of provincial bond swaps on TSF and duly adjusted their data; but this suggests a wider problem, which is what I wrote about in my first contribution to the listserv discussion. I proposed two reasons why I am not convinced that observers have seen the beginning of any meaningful deleveraging.
The first has to do with systemic biases in the way credit is structured and counted. Chinese bankers—like those in the rest of the world, no doubt—have always gamed regulatory constraints when it comes to credit creation. Like bankers everywhere, they respond to institutional incentives by altering the ways in which they structure credit creation. These changes often have been driven as much by Chinese bankers’ need to please a varied group of regulators—whose own institutional biases are exacerbated by the competition, and even hostility, that exists among them—as by economic and financial factors.2
That is why it is wise to be especially skeptical about recent evidence that Chinese banks have begun to take deleveraging seriously. Beijing has been worried about China’s growing debt burden since at least 2012. But in 2017, this issue has become almost an obsession in some quarters. Beijing has made a series of aggressive announcements in the past year testifying to this surge in concern, culminating in an October 2017 statement by PBoC Governor Zhou Xiaochuan, who warned that China could face its own “Minsky moment.”
Under these circumstances, then, it was always to be expected that banks would take greater pains than ever either to rein in credit growth or, if that was too difficult, to structure credit in ways that seemed to comply with regulatory concerns. One way of doing so is to push credit creation off balance sheets and into forms that are less likely to trigger regulatory reprisals. That Chinese bankers might be doing so is confirmed by both anecdotal and official evidence indicating faster-than-expected credit growth in categories that fall outside widely watched measures like TSF. The point is that the deceleration in credit growth implied by TSF data might indeed reflect the beginning of Chinese deleveraging, but it could also reflect the surge in regulatory concern. In the latter case, this would mean that China has experienced not the beginnings of deleveraging, but rather a continuation of the trans-leveraging observers have seen before. I will discuss some of the most obvious examples of how this may be occurring later in this essay.
GDP Growth No Proxy for Growth in Debt-Servicing Capacity
My second reason for skepticism is one I have written about elsewhere, in both a November 2017 Financial Times article and a September 2017 blog entry. When one compares credit growth to growth in debt-servicing capacity, not only is it uncertain how quickly credit is growing in China but, more importantly, it is even less certain how quickly the country’s debt-servicing capacity is growing.
The standard proxy for growth in debt-servicing capacity is GDP growth, but this is only valid in economies in which GDP growth data is a systems output that measures the underlying performance of the economy. But this is not true of China, as I explained in the Financial Times article:
Typically, analysts assume that changes in reported GDP reflect movements in living standards and productive capacity. In China, however, this is not the case. Local governments are expected to boost spending by whatever amount is needed to meet the country’s targets, whether or not it is productive. [In China] GDP growth is not the same as economic growth.
In my email, I went on to discuss why this matters so much and why it is incorrect to think of China’s GDP growth as growth in China’s underlying economy (or in its debt-servicing capacity, or its productive capacity, or however else one prefers to think of GDP). GDP growth measures the increase in economic activity, whether that activity is building bridges to Brooklyn or bridges to nowhere. It does not directly measure the increase in economic value-creation, as observers usually assume it does. It is only because in most economies there are constraints on the ability to fund nonproductive activity that observers generally ignore the difference between economic activity and value creation.
Because of these constraints, most economic activities create value, and those that do not are reversed in fairly short order. If these constraints are not in place, however, analysts can no longer ignore this difference because the economy can then engage in nonproductive activity that for many years can force up the debt burden and add to GDP. While the purpose of this activity may be to generate employment, if the activity is not productive, the GDP it creates—along with the employment it generates—will be reversed in the future once debt capacity has been reached.
Not everyone on the listserv fully understood this argument about Chinese deleveraging. Because I received a lot of responses, both negative and positive, I decided to follow up with a second email, in which I use an approach very different from any I have used before to try to show that this is just a logical argument.
I thought it might be useful if I were to reproduce on my blog the two responses that I wrote, although only after eliminating any reference to participants in the discussion (this is a private listserv), editing, and extending for clarity. Here are the two emails:
The First Email: On Credit Growth
Actually, I think the claim that credit growth has slowed is more complicated than what you suggest. The growth in TSF, plus most standard adjustments, seems indeed to have decelerated in 2017 relative to 2016, and this is especially impressive when one compares the growth in credit with rising nominal GDP growth (which is the only right way to do it). But as I see it, there are at least two problems, besides obvious timing mismatches, with treating this as a meaningful deceleration in credit growth.
First, Chinese banks and financial institutions have always been very creative in terms of extending credit in ways that get around regulatory constraints. There is no reason to assume that the enormous amount of attention paid to credit growth recently has had no impact on this kind of behavior. For example, Andrew Collier, of Orient Capital, has been particularly thorough in attempting to understand these kinds of transactions. In a January 2018 report, he discusses the recent surge in lending that has occurred under China’s public-private partnership (PPP) program. He sets the number of completed PPP projects at 3.2 trillion renminbi, with a total of over 14 trillion renminbi in projects planned or under evaluation.
Because most of these transactions are structured in ways that help banks keep them off their balance sheets, the consensus among analysts with whom I have discussed PPP is that a lot of these transactions are not showing up in TSF or in any of the other standard measures of credit creation. What is more, these PPP transactions are often structured in ways that may create additional contractual obligations to fill the cash-flow gap for user-pay ventures, and these obligations do not show up at all in the debt statistics. Already, as Reuters has reported, “China’s finance ministry . . . has grown increasingly concerned about rising hidden debt risks from potential abuses of the program.”
The recent explosion in debt securitizations, as another example, also seems to reflect mainly the need to structure loans in ways that do not appear in the main measures of credit creation. The numbers here are large too. A January 2008 Orient Capital research note reports the following:
Developers have learned how to reduce their official borrowing by offloading balance sheet debt to consumers through securitization, as a way to evade borrowing restrictions. For example, in December 2017, China Merchants Group, a state-owned firm, said it would work with China Construction Bank to issue asset-backed notes worth Rmb20 billion to be sold in the interbank market, in what would be China’s largest rental housing securitization. These notes are not included in TSF.
To take yet a third example, in 2017 at least 1 trillion renminbi of debt was converted into equity by the banks that had extended the loans. While this reduces the reported amount of outstanding debt, if the concern is the ability of borrowers to generate the returns needed to service the debt that funded these projects, converting them into equity does not reduce the riskiness of the banking system, nor does it reduce net indebtedness for the country overall. Most, if not all, of these transactions create unreported contingent liabilities even while reducing the growth rate of debt—in this case by more than five percentage points.3
These are pretty big numbers, and there are likely to be many similar examples, many of which will not be recognized for months or even years. The problem is that the banks are in a difficult position. The recent surge in regulatory demands to rein in various types of credit creation conflicts with the pressure on banks from local authorities to fund even more nonproductive economic activity. There are only four ways for the financial system to respond to these conflicting pressures, of which the recent data seems to support only the last two:
- Banks can rein in credit growth to please the regulators and anger local authorities by allowing GDP growth to decline sharply.
- Banks can maintain high GDP growth rates to please local authorities and anger regulators by allowing credit to surge.
- Banks can maintain high GDP growth rates to please local authorities but, while allowing credit to surge, they structure new credit in ways that disguise credit growth.
- Finally, banks can radically transform the ways they issue credit, so that it is possible to keep GDP growth rates high even as the real debt burden declines.
Clearly, the last of these four is the optimal response, but Beijing has been trying unsuccessfully to do this for nearly ten years, and neither the arithmetic nor the historical precedents give observers much hope that this can be done to any serious extent without a radical transformation of the country’s development model. That leaves analysts with two possibilities: either credit growth has been disguised, or there has been the necessary transformation in the capital allocation process just in time for the 19th Party Congress.4 A year ago, a very cynical professor at Peking University promised me that now that Beijing had become so concerned about debt, there would inevitably be improvement in the measures of credit creation, whether or not there were any real changes in the pace of credit growth: this seems always to be a safe prediction.
The First Email: On GDP Growth
There is a second important problem, as I see it, with treating the recent data as indicating a meaningful deceleration in credit growth. The proper way to measure the improvement in China's debt burden is to measure the relationship between credit creation and debt-servicing capacity. This requires that observers have not only an appropriate measure of new credit in each period, but also an appropriate measure of the growth in debt-servicing capacity.
In China, this is an even bigger problem than quantifying the growth in credit. For most economies, analysts typically use GDP as a proxy for debt-servicing capacity, but while this is more or less appropriate in most economies (in spite of a barrage of criticisms recently in the Financial Times and elsewhere about the usefulness of GDP), measures of GDP growth in most economies are at least systems outputs, which means that they can serve as proxies, however inexact, for activity in their respective economic systems.
In China, however, GDP growth is a systems input. This means analysts cannot treat it in the same way. An input measure cannot tell observers how a system is performing—only an output measure can.
If the authorities are willing to engage in loss-making activities to achieve the GDP growth target, there are two relevant characteristics of an economy like China’s that change the nature of the GDP measure: first, economic activity is much less affected by hard-budget constraints than it is in most other economies; and second, bad debt is much less likely to be written down. Government officials everywhere, and not just in China, would probably be happy to engage in loss-making activities to achieve higher current GDP growth rates and lower current unemployment rates, even though these benefits are only temporary and must be reversed in the future. But they can only do so within the limits of the budget and debt-capacity constraints under which they operate.
Relaxing these limits is what allows them to achieve higher GDP growth rates than what underlying economic growth would dictate. GDP is, according to one widely accepted definition, “the sum of gross value added by all resident producers in the economy,” but it is not always obvious how to determine this market value. Consider two factories that cost the same to build and operate. If the first factory produces useful goods, and the second produces unwanted ones that pile up as inventory, only the first boosts the underlying economy. While inventory piles up, however, both factories will increase GDP in exactly the same way.
In most economies, the operator of the second factory is subject to hard budget constraints and must eventually close the factory. Once this happens, the factory stops producing GDP. In addition, if the facilities are not reassigned to other productive uses, they must be written down, along with the worthless inventory. This process reverses the GDP formerly created by the second factory because it reduces the profits of the entity that owns it (or that lent money to fund it as the loan is written down). Business profits are included in the value-added component of GDP when GDP is calculated, so because of the subsequent losses, the second factory does not add to GDP except over very short periods, after which it is reversed.
This is why countries like China, whose economies are not subject to these two constraints, are able to achieve GDP growth targets that for many years exceed the underlying growth of the economy. The simplest way to think about it, I think, is that if one wants a number that means what GDP growth means in most other economies, China’s reported GDP growth is only a starting point. It must be adjusted by some other relevant systems output number. My best guess is that one should start with reported GDP growth and subtract from it your best estimate of the amount of debt in each period that should be written down to zero.
Because the amount of bad debt in each period is almost certainly a growing number, it must follow logically that the GDP growth number observers really want, rather than the one they have—that is, GDP growth as a systems output that can serve as a proxy for debt-servicing capacity—is a declining number, and perhaps even a quickly declining number.
I personally suspect that China’s actual GDP growth is less than 3 percent, although of course I cannot prove it. What I can prove, and have proved if you agree with my assumptions that Chinese economic activity is much less limited by hard-budget constraints than other economies and that debt is much less likely to be written down correctly, is that it is definitely not 6.9 percent.
The Second Email: Bookshop Targets
[In one of the responses to my first email, someone agreed that it was “short-sighted” to place too much faith in the validity of GDP.]
I would say it is even more than short-sighted to assume that because they share the same name, GDP as a systems input can be compared to GDP as a systems output. It is literally wrong. Because this seems confusing in the macroeconomic context, I thought maybe an example outside macroeconomics might be helpful.
Suppose one wanted to measure urban literacy as a function of a city’s size, or of the average income of its residents. One way to do so is to look at dozens, or perhaps hundreds, of cities in terms of population, or average income, and compare them with the number of bookshops in each city.
In that case, the number of bookshops, which is a systems output—generated organically by the size of the city, the rate of literacy, the income of residents, and other relevant factors— would serve as a proxy for literacy, while population or income would serve as proxies for whatever variable one wants to measure. Like with GDP, there are a whole set of problems with using the number of bookshops as a proxy for literacy, but it is a reasonable proxy, and perhaps in our case, it is the best measure that can be found. What is more, because one can reasonably assume that the problems with using bookshops as proxies for urban literacy are not systematically biased, these problems can be addressed and partially resolved by using a large sample base.
But now assume that the government passes a literacy law that requires that every city must have exactly one bookshop for every 10,000 residents—no more, no less—and there is a government agency whose purpose is to make sure that for every city there is the number of bookshops required by law. To that end, all bookshops become government-owned and operated, without hard budget constraints.
Clearly, the number of bookshops in each city has now become an input to the system of literacy and is no longer an output generated by the organic growth of the city and the underlying need for bookshops. This immediately renders the number of bookshops useless as a proxy for literacy, unless one can find another output measure that can be used to adjust the number of bookshops, perhaps the number of titles on offer or revenue per shop. Without some kind of adjustment, however, anyone who used the number of bookshops as a proxy for literacy would find his work widely ridiculed.
The Second Email: GDP Targets
This is effectively what happens in any system when an input variable is treated as if it were an output. It is not a perfect analogy but—except, of course, for the part in which analyses that use the number of bookshops as a proxy for literacy are widely ridiculed—it is nonetheless similar to what happens when the health of the Chinese economy is measured by the reported GDP data, or when second-order measures, such as the dependence of Chinese growth on debt, is estimated by looking at credit growth in relation to GDP growth.
By the way, while this has always been a conceptual problem with the use of GDP in China, it has not always been a practical problem. When China was severely underinvested, which was the case in the 1980s and 1990s, GDP growth could be accepted as a reasonable measure of the real growth in the underlying economy. This is because even though budgets then were no more constrained than they are now, one could assume that the distortions they introduced were quite minimal. When China was underinvested, investments were nearly always productive, and so the ability to ignore budget constraints and hide the costs of nonproductive investment in the form of rising debt had little effect on the GDP data—or, to put it differently, rising debt did not reflect a rising debt burden.
But that is no longer the case. Because debt is now rising faster than debt-servicing capacity, one can think of the gap between the two as the capitalizing of what should be an expense—nonproductive spending—the result of which is higher reported growth and higher reported wealth: GDP as input in each period has become the sum of GDP as output and the amount of expenses that have been incorrectly capitalized.
In sum, three assumptions are all that is needed to effect this transformation of GDP. First, assume that a significant share of economic growth is generated by entities that, were they subject to hard-budget constraints, would have been closed down because the economic benefits they create are less than the cost of the investment (assume all externalities are part of the revenues generated by the system). Second, assume that the bad debt generated by the system (by which I mean the excess portion of any debt used to fund projects that add less value to the economy than the cost of the project) is not written down within the reporting period in which it was extended. And third, assume that China continues to have as much debt capacity as needed in the current period to fund the amount of activity required to meet the GDP growth target.
But once those three assumptions reach their limits, as they eventually must, the excess of reported GDP growth over the GDP growth that would have been reported had these conditions not existed will be amortized in the form of a negative excess. Reported GDP in each period will still be the sum of GDP as output and the amount of expenses that have been capitalized, but now that this capitalized amount is being amortized, it will become a negative number.
When that happens, GDP growth will drop sharply and will even begin to understate the real growth in debt-servicing capacity. Until then, the conclusion that GDP in China does not mean what it is used to mean elsewhere is just a matter of logic. It is not a hypothesis or a theory.
Notes
1 According to a March 2017 South China Morning Post article, there were a total of 8 trillion renminbi in provincial debt-for-bond swaps, and an unspecified amount of additional bond issues under the program, so these numbers must be added back to TSF not just for 2015 but also for 2016 and perhaps 2017. Because the newly issued bonds tended to have longer maturities than the underlying loans, it is reasonable to assume none of them were paid down in 2016 and 2017.
2 The TSF measure itself reflects this behavior. The PBoC created the TSF measure in 2011, largely because Chinese bankers had been de-emphasizing renminbi-denominated bank loans, the main measure regulators had previously used to monitor credit expansion, in favor of other forms of credit that were not so carefully monitored. From 2002 until 2009, renminbi-denominated bank loans fell from over 90 percent of all the categories later included in TSF to just 55 percent (I am quoting from memory, so please double-check the data). Credit in TSF categories other than renminbi loans had been growing three or four times faster, in other words, than were renminbi loans. There were, no doubt, many reasons for their relatively rapid growth, but the fact that they were not being monitored to the same extent was among the most important, at least according to informal discussions with Chinese bankers.
3 It may seem willfully perverse to most analysts to suggest that a debt-equity swap does not reduce debt, but that is because most analysts do not think systemically and fail to consider the overall impact of these transactions on debt-servicing costs and on contingent liabilities of the government. Debt-equity swaps remove contractual obligations from the borrower’s balance sheet and replace them with equity in the borrower. If done correctly, with an eye not to achieving political or regulatory objectives but rather to eliminating financial distress costs, these can improve the enterprise value of the borrower; to the extent that the lender participates in the upside (and if the performances of the various equity positons emerging from these swaps are uncorrelated), the lender’s net asset position can also improve. But the banks themselves must fund their debt and equity positions with debt, mostly in the form of deposits, interbank liabilities, and bonds. Assuming that the total amount of bad debt in the banking system exceeds total bank capital—something which is almost certainly true—the conversion of debt which cannot be serviced into an equity position that is unlikely to generate much more (and in an economic downturn, which is when we are most concerned about the debt burden, we can assume that the decline in value of these equity positions will be highly correlated) leaves the net indebtedness of the banking system unchanged, and so the contingent liabilities of the government are unchanged even as reported debt in the system declines.
4 There are two very different ways of thinking about credit growth in China, and these differing perspectives determine the way an analyst is likely to approach and interpret the data. Mainstream economics has real difficulty incorporating credit growth into its models, and many analysts think that the explosive growth in credit is not fundamental to China’s rapid GDP growth. In that case, it is very possible that, with the right set of productivity-enhancing reforms, credit growth begins to decline sharply while nominal GDP growth remains constant or even rises.
The balance-sheet model that I use ties an acceleration in credit with any attempt to keep GDP growth above what I have elsewhere called, following the lead of the Deep Throat blog, “productive growth.” According to this model, a small amount of deceleration in credit growth can occur as additional credit efficiency is squeezed out of the system, but without a sharp decline in GDP growth, substantial and sustainable credit growth deceleration cannot occur except after a major transformation of China’s growth model, one condition of which is net wealth transfers from local governments to median households of at least one to two percentage points of GDP annually. As GDP growth remains high, and as there is no evidence of substantial wealth transfers, my default reaction to data that suggests a rapid deceleration of credit growth is skepticism.
Comments(31)
That would seem to be the point at which interest rates are at the lower bound and the balance sheet cannot be expanded at a SOE /household/business level assuming they are not using foreign FX to debt finance. They turn Japanese QE and government fiscal expansion to offset the balance sheet recession.
Hi Professor Pettis, very insightful as always. I have also read in other pieces on your site that you think the likeliest long term scenario will be a 'Japan-like' low growth environment, given the myriad tools the Chinese government has to control risks. I have 2 questions: 1) How does the recent announcement of plans to open up the Chinese financial economy to foreign firms change the equation of 'control' by the Chinese government 2) How do you envision the scenario where we reach maximum debt capacity and a transition into a low growth scenario? I can easily envision a crisis situation created by a bank liquidity crisis, but it's harder for me to picture a situation of transition towards a low growth one. Perhaps the transition is so slow that there is no discernable series of events?
To answer your first question, Cy, I don’t think foreign participation matters too much, partly because I don’t think foreign firms will ever play a significant role in the Chinese economy except in a few consumer areas, but mostly because they have no systematic impact on the way growth is generated. Until the distribution of income in the Chinese economy is substantially rebalanced, growth will depend excessively on public-sector investment and related private-sector investment. Your second question is, I think, more complicated because there are so many ways in which a slowdown can occur, and most of them depend on policy choices. If Beijing does nothing and allows debt to grow until we reach debt capacity limits, there are two ways we can reach these limits. One way is in the form, of a “sudden stop”, in which Chinese borrowers are suddenly unable to roll over liabilities, and so we reach debt capacity limits in the form of a financial crisis. A sudden stop can occur if at some point China becomes dependent on external debt to fund growth (which isn’t the case now, but is worth watching out for) or if credibility collapses and we see a run on the banking system (which is possible, but, in my opinion, still unlikely). The other way occurs when liabilities are rolled over and new credit is created in the form of forced savings and transfers from households. The most obvious way this would happen is if the PBoC simply monetizes the debt by creating the liquidity which the banks lend out. For a while this was a widely-proposed strategy, but I hope by now everyone understands that this merely involves buying time while making the imbalances worse. Monetizing debt creation at the expense of households worsens the imbalances and makes the economy even more dependent on public sector investment, which means that the debt burden would grow even more quickly. What I hope happens is that we never find out how China reaches debt capacity limits because Beijing reins in credit growth well before this happens. In that case GDP growth will drop sharply in line with the drop in credit growth, but if Beijing simultaneously implements wealth redistribution policies from local governments to households, ordinary China won’t feel the pain because the steep drop in GDP growth will be accompanied by a much smaller drop in household income growth. This would be the best-case scenario for China, in my opinion, but we don’t have too much time in which to implement it. I hope to see real movement in this direction in 2018, or at least 2019.
Hi Prof. Pettis, What do you think is the likelihood the government will redistribute as it reins in credit. It seems to me that this has been going on for some time now. The gov has stated it will be doing something to control credit growth several times. Have they made any progress?
Professor Pettis, As a constructive criticism, can you please accounting T account your arguments. The verbiage explains it but many reader I am assuming don't understand it and T accounting it would further illuminate your audience.
Can you explain why inflation wouldn’t be the barometer of too much unproductive capital? In theory if too much spending is wasteful, you lack enough output and get inflation.
Can you explain why inflation wouldn’t be the barometer of too much unproductive capital? In theory if too much spending is wasteful, you lack enough output and get inflation.
You are right that T-accounts would clarify much of this, FDR, but only for those who are familiar with T-accounts, and I suspect many readers are not. I don’t think I can do T-accounts in the comment section, but try this: Accounting for a $100 productive investment: $100 credit to Cash on the Balance Sheet, and $100 debit to Investment on the Balance Sheet. Because both of these are Balance Sheet accounts, there is no impact on the Income Statement. While there is a change in the composition of assets, there is no change in Total Assets, and so no change in Equity (i.e. wealth). Accounting for a $100 expense: $100 credit to Cash on the Balance Sheet, and $100 debit to Expense on the Income Statement. Net Income drops by $100 and Total Assets also drop by $100 as does Equity (and wealth). Accounting for a $100 investment that is then written down: First, $100 credit to Cash on the Balance Sheet, and $100 debit to Investment on the Balance Sheet. Then $100 credit to Investment on the Balance Sheet (writing it down to zero), and $100 debit to Expense on the Income Statement. Net Income drops by $100 and Total Assets also drop by $100 as does Equity (and wealth). The point of all of this is to show the difference between a productive investment and a non-productive investment that must be written down. Writing down a bad investment ends up being very similar to taking on an expense. This shows that if we make a non-productive investment but refuse to write it down, we are effectively capitalizing an expense (i.e. treating an expense as if it were a valuable asset). Does that help?
Inflation would be a barometer of unproductive capital to the extent it meant that the demand for goods and services exceeded their production, Mark, and this is most likely to occur under conditions of capital scarcity. Remember, however, that in China there is a problem of structurally weak demand and excessive savings. I suspect that rather than force up domestic prices, the unproductive use of capital would mostly reduce the current account surplus, i.e. it would reduce the amount of capital that China had to export to resolve the domestic savings imbalance. In fact I have always argued that I consider a moderate amount of sustained CPI inflation as a good thing, indicating that China is really rebalancing.
Thank you for posting this. Delightfully insightful and clear.
Hi Michael - a most insightful and stimulating post, as always. You may recall that in my own blog at eforum21.com, I have repeatedly explored the reasons behind the difference between “productive” and “unproductive” investment - which, as you know, formed the basis for the essential distinction in Classical Political Economy between productive and unproductive labour. The upshot of my politico-economic studies is that the difference is based on the ability or less of an economic system to gauge the level of social conflict in a given society. Given that capitalism is the generation of political control over living labour on the part of employers through its apparent “exchange” with dead labour - that is to say, through the payment of living labour in terms of its own past production (what are called wages), - given this, the fact that a capitalist system of production of social needs relies on the existence of a “formally free” labour force, it is evident that only a system that allows this formal freedom can operate over time as a capitalist system, and only such a system can therefore be said to be “productive”. You may recall that my studies establish that this is the fundamental conclusion behind the analyses of capitalism that go from Ricardo through to Marx and Weber, all the way to Keynes, Schumpeter, and of course....Hyman Minsky himself! The insight behind the Minsky Moment is all here! What happens in a command economy such as China’s is that the element of free social conflict that market capitalism contains is absolutely missing - and that therefore the Chinese economy must sooner rather than later collapse under the strain and burden of “unproductive” investment. (Of course, this is also a key tenet of the Austrian School.) It would seem to me that your invaluable studies and analyses go very far in this direction. Keep up the excellent work!
Thanks, Joseph, and I very much agree. I think we need more formally to establish the conditions under which economic activity generates productive capacity in the ways in which we implicit assume it always does. Some kinds of economic activity are clearly productive and wealth-enhancing, just as other kinds of economic activity clearly are not. It isn’t terrible helpful to treat them in the same way.
Professor, in your last paragraph you indicate that you believe wealth must be transferred from local governments to median households. I am wondering, why local governments? What liquid assets do they possess that could be sold to put spending money in Chinese households’ pockets? And who would buy those assets? Haven’t I been reading that they have been borrowing, and helping property developers borrow, money like crazy to build wasteful projects (e.g. ghost cities) in an enthusiastic effort to outdo each other in reported GDP growth? Wouldn’t that make them a poor place to look for saleable assets to jump-start a consumer-driven economy? I’m no expert, just an interested reader who has never set foot in China, but my impression is that the money in China (i.e. the capacity to absorb losses) lies with wealthy individuals and households rather than with local governments. Am I wrong?
For roughly three decades, Karen, as GDP expanded by roughly 9-10%, the household share contracted while the government share expanded, and this expansion occurred mostly at the local government level. In the past decade much of the growth in GDP was fictitious, but even then not all of it. Local governments own tons of assets in China, mainly in the form of real estate and large and small SOEs. They certainly have borrowed a lot, and in recent years the assets created by this borrowing was not worth as much as the cost of borrowing, but the net government position in China (assets minus liabilities) is still almost certainly very large. A lot of wealth has been generated in China in the past three or four decades, and the household share of that wealth is among the lowest ever recorded. The balance must be with businesses and various government bodies.
Hi Michael, glad to see you back again with these new pieces. As I've said before, I'm a fan of your analyses as they are often the most grounded in arithmetic rather than assumptive maxims. With that said, I would like to play the devil's advocate for a second vis-à-vis your arguments regarding actual GDP growth and the overall productivity of investment. A common criticism leveled at your analyses has been that you predicted, if the PRC maintained its current fiscal practices, growth would average around 3% per year over this decade. As such some would argue the suggestions here that "real" GDP growth (i.e. output-input) has dropped to around 3% is an attempt to retroactively claim your original predictions were accurate. Now, my understanding of your position is that you made that original prediction based on the belief that the PRC would be instituting reforms to deleverage aggressively and transfer wealth to the consumer (such that the incorrect prediction was more that you were overly optimistic about the PRC's willingness to head off these systematic risks) and that your current prognosis of ~3% GDP growth has an entirely separate causative element; that is to say, your previous prediction was based on the idea the PRC would be enacting reforms to ward off systematic risks, whereas your current estimation of GDP growth is instead based on the drag produced by these very systematic risks the PRC has failed to deal with. As such, I am wondering 1) How you would respond to the aforementioned criticisms, 2) How accurate my interpretation of your analyses are, and 3) If there are any specific metrics/events you would especially recommend keeping an eye on as an indicator of the validity of your postulates? Also, though I realize you cannot obviously post other contributors' writings from the listserv here, were there any particular criticisms/alternative theories you found particularly noteworthy?
What I expected, Oro, is that average growth rates during Xi’s 2012-2022 term would not exceed 3-3.5%, and that the only thing that would keep it up above those levels would be an acceleration of credit growth to unsustainable levels. I based my growth expectations on what I think were conservative estimates of consumption growth and the growth in productive investment (with which the reported data is currently consistent, although do not prove my assumptions one way or the other), but I always pointed out that as long as credit growth accelerated, the growth in non-productive investment would remain high, in which case reported GDP would also remain high for much longer. I hoped that this wouldn’t happen, because the longer reported GDP growth remained high, the worse for China’s economy over the medium to long term, but in the end the pace of adjustment was always going to be driven by political variables, not economic variables, and this made it very hard to project with much confidence. It is pretty clear to me that the growth in non-productive investment remains very high – and, with it, reported GDP growth – because there are only two other ways to reconcile credit growth that substantially exceeds GDP growth year after year for so many years. One way is to assume that the growth in credit is mostly funding consumption growth, and clearly it isn’t. The other way is to assume that it is funding investment in projects whose impact on productivity is pushed very far into the future, like investment in education. While some of this might be happening, if you look at the data you will see that almost all the growth in credit is used to fund infrastructure, real estate and manufacturing projects, in which case if the investments were productive, GDP growth would have caught up to credit growth within 3-4 years at most. Because it hasn’t, the only other way I can get reported GDP growth to reconcile with much higher credit growth is to assume that much of the investment will never result in increased productivity, and so will never cause GDP growth to pick up. This means that reported GDP growth must be overstated. At best you might argue that it is not overstated by as much as I claim, and this may be true, but given the sheer extent of credit growth, it is hard for me to believe that the amount of overstatement can be much less. In fact, I always try to remind readers that my estimate of 3-3.5% real growth is far more likely, in my opinion, to overstate reality than to understate it.
Thank you for clarifying what GDP actually measures. It can be maddening to read an article that quotes Chinese GDP numbers as if they were a real measure of long term economic growth. But I do have a question. In your response to CY, you say that China doesn’t depend on external debt to fund growth. But why has China liquidated over a trillion dollars worth of foreign reserves if not to deal with external debt? Granted, this liquidation has stopped, for now, but what was the reason in the first place, if not to raise badly needed and externally denominated funds?
Part of the decline in reserves since mid-2014 reflects the paying down of external debt, JEM, and most of the rest reflects the funding of significant amounts of capital flight. China’s high reserves were built up because of the combination of large current account surpluses since 1994 and net capital account inflows until around mid-2014. Since then, China has experienced net capital account outflows, and as these exceeded the current account surplus from mid-2014 until very early 2017, we saw reserves drop by roughly one quarter from their peak.
China is not exempt from Physics and Thermodynamics Laws. It must experience the spiral of more and more energy being required to sustain its socio-economic engine like any other energy-generating device, but Physics rule: "No device can generate energy in excess of the total energy put into constructing it".
I’ve recently lost faith in trying to understand global conditions through the lens balance of payments mechanisms. It now seems intuitive to me that BOP mechanisms point to first order national imbalance, but there seems to be great fault in scaling that to a national level. Those faults are failure to account for gross capital flows which can be destabilizing and a tendency to overstate the importance of current account imbalances. Neither of these things have been, to the best of my knowledge, contended by Mr. Pettis. I simply hope this short post can facilitate discussion, or someone could recommend point to further reading that addresses my perceived shortcomings in balance of payment analysis. To the point, the following papers were influential: Claudio Borio and Piti Disyatat 2011 Hyun Song Shin 2011 Bernake et al 2011) The Bank for International Settlements paper (Hyun Song Shin 2011) will be quoted for simplicity. “A prominent view is that an excess of saving over investment in emerging market countries, as reflected in corresponding current account surpluses, eased financial conditions in deficit countries and exerted significant downward pressure on world interest rates. In so doing, this flow of saving helped to fuel a credit boom and risk-taking in major advanced economies, particularly in the United States, thereby sowing the seeds of the global financial crisis. A focus on current accounts in the analysis of cross-border capital flows diverts attention away from the global financing patterns that are at the core of financial fragility. By construction, current accounts and net capital flows reveal little about financing. They capture changes in net claims on a country arising from trade in real goods and services and hence net resource flows. But they exclude the underlying changes in gross flows and their contributions to existing stocks, including all the transactions involving only trade in financial assets, which make up the bulk of cross-border financial activity. The excess savings view tends to conflate borrowing and lending which are financial transactions, with national income accounting concepts, which track expenditures on final goods and services. Net capital inflow focus in discussing global intermediation and financing conditions in current account deficit countries does not distinguish between (1) saving and financing and (2) gross and net capital flows across countries. Current account imbalances (1) provide a misleading picture of the global pattern of financing flows and intermediation and (2) do little to inform about potential risks to financial stability. First, gross capital flows rose from 10% of world GDP in 1998 to 30% in 2007. The bulk of the expansion reflected flows between advanced economies, despite a decline in their share of world trade. By comparison, flows between, or from, emerging economies were much smaller. It is hard to see how emerging market countries were the main drivers of global finance. Second, current accounts did not play a dominant role in determining financial flows into the United States before the crisis; the increase in net claims on the country was about three times smaller than the change in gross claims. Even if the United States had not run trade deficits, there would have been large foreign inflows in to the US financial markets. Third, Europe accounted for around half of total inflows in 2007; of this more than half came from the UK. As documented in Milesi-Ferreti (2009) and Bernake et al (2011) while total holdings of US debt services on the eve of the crisis were high in China and Japan, holdings of privately issued mortgage backed securities were concentrated in advanced economies and offshore centers. This suggests that Asia’s role in financing the US housing boom was not substantial in relative terms. Gross capital flow to the United States decreased by $1.6 trillion white net flows decreased $20 billion. Since 2000 the outstanding stock of bank’s (in eleven reporting countries in the BIS international statistics) foreign claims grew from $10 trillion to a peak of $34 trillion by end 2007.”
I apologize for the god awful formatting and writing errors.
Prof. Pettis, Thank you for the interesting and well thought post. However, I'd like to ask your opinion on a variable that you did not address: specifically, the role of rapid advances in technology on the degree of under-investment or over-investment. Not being an economist it's my impression that scholars studying developing economies usually use developed economies as a rough baseline for determining the degree of development for developing economies, and in relation the degree of over or under-investment. By that bar China has certainly met and exceeded the tipping point in the efficiency of state driven investments. However, one could also measure development of a country by comparing its state of development to a hypothetical country that is developed to the maximum degree possible by the current state of the world. Surely, this baseline changes with developments in science and technology. For example, a country that is fully developed for a industrial era nation, is not fully developed by information age standards. If we use this new baseline, then developments in S&T results in an ever shifting baseline that creates additional room for investment. During eras of rapid technological change, this baseline could move quite quickly, making it easier to get returns from state driven investments. As many seem to believe that we are now in a 4th industrial revolution, with the convergence of AI, robotics, information, advanced manufacturing, biotech rapidly changing society, could it be that China has stumbled into a fortuitous juncture where rapid technological change is creating conditions to save or at least mitigate the effects of state driven over-investment? Is there some way to measure these effects to see if that could be the case?
You should read a previous essay by Michael titled "How Much Investment is Optimal." It's a great read and offers a very different way to think about investment levels than what you outlined. Good luck in your search.
Sorry I'm a little late on the commentary here....I just was this piece...I also apologize if this is a repeat comment since I'm getting an "odd" disappearing screen once I hit the "post" button. Michael, I'm flattered that you cited my blog re: the difference between GDP and PGDP. Your distinction between GDP as an "input" vs. an "Output" and the relationship with credit formation is spot-on. I believe that "debt" might be one of the most mis-analyzed and cloudy metrics available when looking at the differences between centrally planned and market driven economies. There's an inescapable distinction between "good" (productive) debt/GDP and "bad" (unproductive) debt/GDP. Yet, so little research has been done, and so little data is available on the topic. Really well said....All the best... DeepThroatIPO
"Still, the official figures can appear to suggest otherwise. By my calculations, property prices in China have grown sixfold since 2004. But property transactions are not included in gross domestic product assessments — which helps explain why debt levels have surged while G.D.P. has not." The above is from Yukon Huang in today's NYT. What do you think?
1.) Debt has surged in local governments and SOEs. The Asia Society's China Dashboard shows local governments are currently spending about 144% of their revenues. Im not sure how the value of land plays a role in this. 2.) The problem is not total debt. The problem is debt versus debt servicing ability. Im not sure how land appreciation helps service debt, and, if it does, it seems to bring up serious maturity issues. 3.) China doesn't seem to recognize gains or losses after initial economic activity. Of course China doesn't count land appreciation in GDP, but it doesn't recognize long term losses either. Michael has an excellent piece about this. 4.) Wouldn't much of this land be a liability to some entity? 5.) Do countries normally count real estate appreciation in GDP? The greater point seems confused. A creation of value should lend itself to future economic activity that would be noticed in GDP, debt, and debt servicing. 6.) In general this point doesn't explain debt servicing or debt dynamics we see. It raises more questions than it answers.
I guess the implication from Yukon Huang is that the debt does correspond to debt servicing because financial innovation have captured the value of real estate. I’m not sure he is right but that is his point. Pettis’ point about China not adequately recognising impairments doesn’t change GDP calculations over time. It’s just an issue of accelerated depreciation. It’s a clever but ultimately minor point which I think MP understands but his fans do not.
Yukon Huang’s piece, relative to what you first wrote, has 4 points that are critical to address. 1.) China won’t succumb to a financial crisis because of its debt. 2.) Debt growth to date “went into property-related assets.” 3.) Property values have increased to match the debt growth. 4.) The problem in China is local government’s ability to finance their social expenditures. *Paragraph* Most China economic commentators aren’t forecasting a Chinese financial crisis. The second and third point is irrelevant because it only addressed current debt relative to financial crisis in the immediate future. The fourth point is not wrong. Yukon Huang’s ideas and writing has a lot of overlap with the ‘consensus’ that China’s investment led model should change. Yukon links to his Carnegie report on China’s Debt Dilemma. In his report, he writes, “reforms are needed to ensure China’s long-term financial stability and reestablish rapid but more sustainable growth. Many of the key actions lie in strengthening the fiscal system since the country’s debt problems are merely symptoms of underlying weaknesses in the way that resources are being raised and allocated. China’s leaders demonstrated that they realize change is needed in November 2013 at the Third Plenum meeting, when they laid out a comprehensive plan for reforming the economy.” The point is that China must change its growth model, not to avoid a financial crisis but to ensure future growth and future debt servicing. Money must be ‘raised and allocated’ in a different way and the Third Plenum’s language mirrors that which has been said for the past decade: not a simple feat and something the party has so far failed to do. On a side note, I hope we can format these comments better in the future!
Excellent response Peirce How lands plays in Local debt, it plays into local revenues, and local spending (debt) regarding mandated spending on developing infrastructure, which of course relates, somehow, to land development costs. Land appreciation, acts as collateral function, enabling loans out of thin air and the increase in debt. Otherwise would be found in wealth or asset to GDP ratio's, providing notions of wealth accumulation and success to development model, and thus expectations, credence effects, enabling the general dysfunction overall. The "maturity" issue you mention is noted, but it does explain debt dynamics and debt servicing problems, doesn't it? That is a reason the process continues, and the issue (servicing) arises.
Maybe someone can help me here. I'm puzzled. BEA. Section 5, Saving and Investment, Table 5.1, lines 36 and 39, -538.7 and 14.7. Notice the extreme flip flop; from hundred of billions positive to hundred of billions negative and for the govt a trillion negative to a positive. Shows something in the capital accounts. What's the explanation?
China can build bridges to nowhere, but is it really no longer possible for the country to find new ecnomically sound investment opportunities at the scale it needs? Maybe more discipline and better management would help. I also wonder about investments "abroad", ie, outside of China. Broadening the scope should hopefully make it easier to find good investment opportunities. "One belt, One road", for instance, may succeed or may fail (however we measure this), but in the least it has the potential to grow China's influence in the rest of the world. ps: thanks for all these posts, Mr. Pettis, it is a pleasure to follow you, and to read your books (just finished avoiding the fall; and the great rebalancing is on its way from Amazon!)
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