China’s debt problems have emerged so much more rapidly and severely this year than in the past that, combined with swirling rumors about the country’s leadership, a growing number of analysts believe that this may be the year that China’s economy breaks. As always, I am agnostic. There is no question that China will have a difficult adjustment, but it is likely to take the form of a long process rather than a sudden crisis. In this essay, I lay out, as methodically as I can, the dynamics that have driven the Chinese economy for over a decade.
When we consider the Chinese economy as a system, it turns out that the problems China faces are easier to understand than most analysts suggest. Like any deeply unbalanced economy or system, China’s imbalances must reverse, and one way or another, they will, but there are various paths by which this reversal can occur.
My July 2018 article in Barron’s sets out one case of how events force China to choose among these paths. If the global trade environment forces a contraction in China’s current account surplus, I argue, by definition it also forces a contraction in the gap between Chinese savings and Chinese investment. This means that either the country’s investment share of GDP must rise or the savings share must decline (or some combination of the two). There are literally only four ways that either of these outcomes can happen. Consequently, there are also only four ways that Beijing can respond, each of which would drive the economy to one of the four possible outcomes (or some combination of them):
Notice that all four paths either raise investment or reduce savings, thereby reducing the country’s excess of savings over investment. This is what is meant by a contraction in the current account surplus.
In terms of the first path, an increase in investment technically can occur in two forms. The additional investment can be productive. For that to be true, such an increase would have to result in a rise in debt-servicing capacity equal to or greater than the rise in associated debt-servicing costs. Or, to put it another way, the present value of the future increase in production generated by the investment must be equal to or greater than the cost of the investment. If that is the case, the increase in investment is sustainable and will not add to the country’s debt burden, even if it expands the country’s debt. By contrast, if the investment is not productive, it automatically increases the country’s debt burden. This means that either debt rises faster than debt-servicing capacity or that debt-servicing capacity is forced to decline, usually because productive resources were deployed nonproductively.
As an aside, if a nonproductive investment is not written down, it also results in what is effectively a capitalization of what should be an expense. In other words, an illusory increase in wealth is recorded. This is the main difference between money borrowed to fund consumption and money borrowed to fund nonproductive investment (aside from the fact that the former at least gives you temporary pleasure): neither increases wealth (that is, productive capacity) or income, but until it is correctly written down the latter allows you to report higher wealth and income that is wholly illusory. It would be as if you spent $100 on dinner and then rather than record an expense that is deducted from your total income, which would leave you $100 poorer after dinner, you instead record an asset, leaving your total wealth unaffected.
In China’s case, it is by now well agreed upon that a significant amount (and perhaps nearly all) of most public-sector investment in the past few years has been nonproductive; there has been no rise in the country’s debt-servicing capacity commensurate with the rise in debt. If Beijing were to engineer a further surge in investment, it is extremely unlikely that doing so would not result in an increase in the country’s debt burden.
Consequently, if there is a forced contraction in China’s current account surplus, Beijing’s only possible response must involve one (or some combination) of three things: an increase in unemployment, an increase in the debt burden, or wealth transfers.
Beijing wants to avoid at all costs an increase in unemployment, which it has been able to do so far by maintaining high growth in economic activity. The Chinese national government also wants to rein in the growth in debt, but so far it has been unable to do so. Moreover, Beijing will not be able to rein in debt growth if it wants to avoid unemployment at least until it has managed a sufficient transfer of wealth to ordinary Chinese.
Unfortunately, rising debt is unsustainable and, at some point, Beijing will no longer be able to increase the debt fast enough to avoid a collapse in growth. It could take several more years before this happens, of course, but once it does the result will be an automatic surge in unemployment.
Put differently, over the longer run, Beijing can only avoid a sharp rise in unemployment or stagnant wage growth to the extent that it has managed to achieve significant wealth transfers. Beijing has engineered a small increase in the household share of GDP since 2012, but this has occurred far too slowly to have prevented a destabilizing surge in debt. Beijing must speed up the transfers, but it has had trouble doing so because of political opposition from so-called vested interests.
To recap, all of the plausible policy choices available to Beijing are limited to one or some combination of the following three options: more unemployment, more debt, or more wealth transfers. This is because China (and indeed most economies) is limited to six economic paths, of which only three are plausibly available if Beijing wants to avoid surging unemployment:
These six pathways logically cover every possible option open to Beijing. If we exclude the second and sixth options as unrealistic, and if we acknowledge that the third and fifth choices both would lead to a rising debt burden, Beijing is effectively left with the same three aforementioned options as described in the Barron’s article: an increase in unemployment (option 1), an increase in the debt burden (options 3 and 5), or greater wealth transfers (option 4).
This is no coincidence. No matter what economic event China is reacting to or what Beijing’s goal may be, once we exclude the second and sixth options above, every policy Beijing could implement must lead to one or some combination of higher unemployment, higher debt, or greater wealth transfers. This is why Beijing’s only possible response to a forced contraction in the current account surplus is also limited to these options.
Eventually, however, one of these policies will no longer be available—the rising debt option. If Beijing does not rein in credit growth in time, it will be forced to do so once debt levels reach the point at which debt can no longer rise fast enough to maintain the country’s targeted economic growth rate. This adjustment can happen quickly, in the form of a debt crisis. Or (what I think is far more likely, at least for now) it can happen slowly, in the form of what is subsequently called a lost decade (or decades) of slow growth, similar to what Japan experienced after 1990.
There is little more to analyzing China’s economic options. Unless Beijing suddenly becomes able to do one of two things that it hasn’t been able to do in more than a decade, its options for preventing a fall in growth will be limited. That is to say, unless Beijing discovers and channels funding to huge new areas of productive investment (even as global conditions deteriorate), or unless China grows its trade surplus by several percentage points of GDP every year, this struggle will remain. And until Beijing manages substantial wealth transfers that shift income from low-consuming entities to high-consuming entities, the only way China can prevent growth from dropping sharply is temporary, by way of an unsustainable rise in debt. Once debt can no longer rise, unemployment will rise or wages will stagnate.
It is worthwhile to consider how the following conditions or policy proposals would fit into this framework, the result of which is likely to be higher unemployment (via a slowing economy), more debt, or greater wealth transfers:
The point of these nine examples is to show that nearly any event or policy must fit into one of the six aforementioned economic options. In China’s case, this means (practically speaking) that Beijing must continuously choose between more unemployment, more debt, or more wealth transfers to the household sector. There seems to have been a serious attempt to rein in credit growth in recent quarters, but to the extent that it has been effective (and, in many cases, it has simply pushed credit growth from monitored areas to unmonitored areas), it seems to be showing up already in a weaker economy and rising unemployment. The official data do not record any slowdown in economic growth, but there is a spreading belief that the data this year seriously overstate economic activity (having long overstated real economic growth).
For the rest of 2018, I expect that we will see different groups in Beijing try to reconcile the need for slower credit growth with greater growth in economic activity. But because these two things cannot be reconciled, one group or the other must win. So far it isn’t clear whether we will see growth in economic activity continue to slow or credit growth pick up. The PMI data released on Friday suggested a stronger-than-expected pickup in manufacturing. One data point tells us nothing, but perhaps it’s a hint.
The students in my PhD seminar have suggested that, from a policy point of view, it might be better to further subdivide some of the six economic options featured in this post. This doesn’t change the underlying framework, but it allows us to evaluate policy options more easily. Wang Xiaotong, for example, suggested that consumption should be divided into household consumption and government consumption. The students also suggested that it might make sense to divide unsustainable increases in investment into investment in rising inventory and investment in nonproductive projects. This would leave us with the following nine economic options, of which only six are plausibly available to China if it wants to avoid surging unemployment or stagnant wages:
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