It wasn’t enough that we started 2016 with one of the worst weeks in the recent history of Chinese and global markets, but the panic continued into the following weeks and wreaked a great deal of damage to confidence. A lot of the reflexive China bulls are cautioning against misinterpreting the implications of the stock market collapse, and of course they are right, but the fact that the plunging Chinese markets can easily be misinterpreted should not in any way suggest that things are fine. Two weeks ago in the FT Alphaville blog (which is the best place to read regularly about China’s vulnerabilities, in my opinion, especially in their relentless focus on the changes in the various components of the balance of payments) Peter Doyle discussed one of the standard set of responses that we’ve seen repeated regularly since 2011 and 2012. The bull refrain has been, in his words: “things really aren’t that bad or surprising, and there’s considerable willpower and ammunition left in Beijing should it be necessary.”

“This makes good copy,” Doyle suggests, and adds, more diplomatically than I might have, “but is not persuasive”. It certainly isn’t, and he discusses some of the reasons why. On the same day George Magnus published an OpEd in the Financial Times that makes a point that too many people, as he points out, are still overlooking.

China’s chief vulnerability, and the main factor driving the tendency towards the increasingly fragile balance sheets that underlie the series of interrelated financial-market disruptions that began seriously in June 2013, is the inexorable rise in debt, and any analyst that fails to come to grips with the problem of excess credit is simply wasting his time. In the article Magnus writes:

Important economic reforms to the real economy and state monopolies have stalled, or succumbed to inertia and pushback. Policies designed to develop new sectors have not been matched by those needed to tackle problems in larger ones, such as poor productivity, chronic overcapacity and now a fourth consecutive year of producer price deflation. Tellingly, China’s most serious problem — the relentless accumulation of debt — received passive attention at most.

I will return to his point about stalled reforms, but Magnus is right about the debt. China’s most serious problem is “the relentless accumulation of debt”, and economic conditions will continue to deteriorate until Beijing directly addresses the debt. In fact it doesn’t really matter if China is able to report growth rates for another year or two of 7%, or 6%, or even 8%. If the only way it can do so is by allowing debt to grow two or three times as fast, there will have been no improvement at all, the economy will not have adjusted, and China’s longer-term outlook will be worse than ever.

It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted. The astonishing ability of the China bulls, both foreign and Chinese, to celebrate every unexpected decline in growth and every new surge in debt as if they somehow justified nearly a decade’s worth of denials of the urgency of China’s rebalancing has done so much damage to China that the sooner Beijing’s leaders finally turn against the bulls, as I believe they might finally have done, the better for the Chinese people and the Chinese economy.

Beggaring thy neighbors

Before I explain why I think Beijing has decided that it has been misled in recent years, I should point out that what worried me most about the events of the past weeks was not the stock markets themselves, nor even the change in how investors and businesses inside and outside China perceive Beijing’s ability to manage the economy and the markets (I have already said many times that just as most people systematically over-rated the quality of Chinese policymaking in the past, they are likely now to be overly harsh in accusing Beijing of mismanagement). I am far more worried about how other countries might misinterpret the rapid decline in the RMB, accompanied by what seems like another surge in capital outflows.

Contrary to some of the muttering out there, I don’t think Beijing is planning competitive devaluations in order to strengthen the tradable goods sector, in the hopes that surging exports will revive growth. Certainly if the PBoC ever were to stop intervening, and to let the RMB depreciate to some imagined fundamental “equilibrium”, we would quickly see that there is no such equilibrium level. In a speculative market, the market does not tend towards some stable value, with self-dissipating movement in any one direction reducing pressure for further movement in that direction. Price movements instead are self-reinforcing, and can quickly overshoot fundamentals.

Beijing is more likely to believe that the economic slowdown was caused by been weakness in domestic real estate and infrastructure construction, and not because exports are weak, and the latest trade dataconfirms the relatively strong export performance. Although manufacturing overcapacity is certainly a problem, much of it is in areas in which global demand has simply collapsed, and isn’t coming back, and so a cheaper currency would have little impact beyond temporarily reducing excess inventory, which is not enough of a benefit to justify the many costs of a weaker currency. Production facilities would still have to be closed down.

I think the real reason for the recent RMB weakness lies elsewhere. Beijing is trying to boost domestic liquidity in the hopes that this will generate stronger domestic demand, but expanding liquidity fuels capital outflows, and these put downward pressure on the currency, while increasing PBoC concerns about the monetary impact of money leaving the economy which, as an article in last week’s FT argues, might be worse than we think. Last week’s People’s Daily reports that prominent Tsinghua professor and former member of China’s Monetary Policy Committee, Li Daokui, claimed at Davos “that at least $3 trillion foreign exchange reserves in China is required to prevent foreign debt default risk”, for reasons that elude me, but if this reflects official views, after dropping $513 billion in 2015, current PBoC reserves of $3.33 trillion might suggest that two or three more months of continued strong outflows might prompt further steps by the PBoC to limit outflows.

The biggest risk created by the weaker RMB, as I see it however, is not a Chinese risk but rather a global one. The rest of the world may view recent Chinese RMB weakness as a signal for a new round of competitive devaluations. I have already said that I expect 2016 to be another bad year for trade, and I am worried that it seems as if every major economy in the world has implicitly decided to use US demand to bail out its own faltering economy. This will very likely derail the US recovery in 2016 or 2017 unless the US, too, decides to step in and intervene in trade. If that happened, of course, the impact on Europe and China would be terrible, but it seems to me a matter purely of logic that if the hard commodity and energy exporters are nearing the limits of their absorption capacity, either the major surplus nations or the US are going to have to absorb a bigger share of the demand deficiency created in Europe, China, and Japan.

The nine-point summary

But all this is preamble. Rather than add to the mass of coverage that the recent market events in China have generated, or to continue expressing my concern about the intractable arithmetic of global demand imbalances, I plan to discuss the process of Chinese reform and adjustment in this issue of my blog. While these may at first seem unrelated, in fact financial market disruptions are tightly tied into the self-reinforcing processes of rising debt, capital flight and slowing growth that recent reforms were supposed to untangle and address – and for which they have clearly failed.

I will argue that most economists have an incoherent understanding of China’s rebalancing needs, and for this reason many if not most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant. This is going to be a long post, so for those who want the 9-point summary:

  1. China’s economic growth is not decelerating as a natural consequence of the aging of China’s growth model. It is decelerating for three reasons. The first reason is the reversal of the growth process by which China’s imbalances have reached their systemic limits.[1]
  1. The second reason is that during the phase of rapid growth, China’s balance sheets, as occurred in every similar case, evolved to become highly inverted, and just as this automatically caused growth to be higher than expected during the expansion phase, it must cause lower-than-expected growth during the contraction phase.
  1. Finally, the economy must shift, one way or another, from one of rising leverage to one of declining leverage, and with rising debt the only thing propping up growth levels, deleveraging cannot help but cause growth to drop.
  1. This means that regardless of trends in underlying productivity, growth must slow sharply, and it will, either smoothly and continuously, or in the form of higher growth early in the adjustment period and a collapse in growth later.
  1. The growth deceleration can be temporarily countered by rapid increases in debt, but ultimately this will only increase future deceleration, with a rising chance that the shift will be disruptive. Every growth miracle in history has been followed by an unexpectedly difficult adjustment, and it is unreasonable to have expected that China would be any different.
  1. The only way to minimize the costs of the adjustment is to take steps to speed up the rebalancing of demand and the repayment of debt. This must be the direction of reforms if Beijing is going to reduce the costs of adjustment and the risk of a disruption.
  1. Repaying debt simply means allocating debt-servicing costs, either directly or indirectly, to specific sectors within the economy. This will either occur in ways targeted by policymakers, or if postponed for too long, it will occur in unpredictable ways determined by circumstances. For example default allocates the costs to creditors, inflation allocates the costs to household savers, economic collapse and high unemployment allocates the costs to workers, etc.
  1. By far the most efficient ways for Beijing to minimize the adjustment costs for the economy and reduce the risk of a debt-related disruption is to allocate debt-servicing costs to local governments by forcing them to liquidate assets directly or indirectly to pay down debt, and to increase household wealth by transferring wealth directly or indirectly from local governments to the household sector. Successful reforms must be consistent with these two goals.
  1. Beijing has already tried to address its growth problems by implementing the productivity-enhancing reforms beloved of orthodox economists, but while these might be a good idea in normal times, they will have almost no effect on reducing the cost of China’s economic adjustment.

Evaluating Beijing’s policies

It might seem exceptionally contrarian to say that most of the reform proposals of the past few years, about which economists widely agree and even celebrate, are in many if not most cases largely irrelevant, but I think that senior policymakers in Beijing are beginning to agree. I say this because with the end of the Central Economic Work Conference last December, Beijing has announced with some fanfare that it plans to design and implement a new reform program consisting of what are being called “supply-side” policies.

A new reform program would seem only to be necessary if the old one has failed or is failing. It does seem to have failed. Chinese businesses and investors are very obviously increasingly concerned about both Chinese and global prospects, and so it is fitting that stock markets have been so accident prone this year. Like everyone else I have often cautioned against reading too much about China’s economic fundamentals into stock market performance. To the extent that there is informational content in the price behavior of stocks, however, we are more likely to see it expressed in the volatility of the markets than in its actual price level.

While opinion is still very split about the outlook for the Chinese economy, there is clearly a growing sense of unease about progress to date on the successful management of China’s economic adjustment, and this unease is at least part of the reason for market volatility. That is why the important news for me has been the announcement of the new reforms and the form of the announcement. Analysts are still very uncertain about what this new package of supply-side reforms that we’ve been hearing about since at least November may entail, but they way in which the reform package was announced suggests, at least too me, that the leadership is no longer satisfied that the policies Beijing has been pursuing during the past three years are having the intended effect.

I will discuss why later, and in spite of the limited information available, I also plan in this blog entry to try to place the package of reforms in some sort of useful context and to evaluate whether or not in principle these reforms are likely to be consistent with the rebalancing process. This might not be as difficult a task as it may at first seem, because rather than try to guess what Beijing will or won’t do, I will instead try to specify the conditions, albeit very abstractly, under which various policies will, individually or in the aggregate, be consistent with the rebalancing process.

It helps of course that China’s development model is not unique, and that its experiences are “different” only in the sense that with its powerful and rigid institutions (most importantly the extensive government involvement in the economy and its control of the banks) it has pushed the typical imbalances associated with its growth model often to levels that are unprecedented. There have otherwise been dozens of other countries that have experienced investment-led “miracle” growth in the past century, and their histories have been remarkably consistent.

Based on these histories we should be able to make fairly reasonable predictions about some of the problems that China faces today. Indeed we should have been able to do so a decade ago, but because very few economists seem to be familiar with the history, no matter how predictable they were each new reversal or systemic shift always seemed to come as a surprise. This is an important point to stress, especially if we want to understand what kinds of policies are likely to prove useful over the next several years. China’s extremely successful growth model was always likely to generate sustainable and rapid if unbalanced growth under certain easily-specified conditions.[2] It was also always likely to cause the financial sector and the various government and business balance sheets to evolve in a specific direction and imbed certain risks.

This is why nearly a decade ago – even if none of the economists or analysts writing about the Chinese economy understood why, with the exception of a handful, mostly Chinese academics – it was clear that the Chinese growth model would have to be reformed, and that these reforms were generally fairly easy to specify. Imbalances can persist for many years if the institutional constraints preventing adjustment are very strong, but all unbalanced systems tend towards rebalancing, and eventually the institutional sources of the imbalances are reversed, and they do.

Must everything cause a crisis?

Not everyone sees things this way. In the standard economic framework the economy is always at or close to equilibrium, and when exogenous shocks or policy distortions push it away from equilibrium it is only temporary.[3] For that reason most economists seem to assume that the longer what looks like an imbalance persists, the less likely it is really to be an imbalance that must ultimately reverse itself, when in fact the opposite is true. Imbalances can persist and get deeper year after year, but that only means that the reversal is more certain and likely to be more disruptive.

For the same reason most economists also seem to assume that if anyone thought that the Chinese economy was deeply imbalanced, and that debt was growing at an unsustainable pace, he was necessarily predicting an imminent crisis. This belief is so powerfully embedded in the standard equilibrium models most economists use that, strangely enough, even those of us who described the imbalances in one paragraph and in the very next paragraph insisted that a crisis was unlikely – in China’s case because of the government’s very high credibility and its role as financial guarantor – were automatically assumed to be predicting an imminent crisis.

Earlier this year, for example, a strategist at a Chicago-based fund by the name of Brian Singer said:

“Everyone is aware of China’s horrid debt levels and [Chinese financial markets analyst] Michael Pettis has done some great work, but he is China’s ‘Chicken Little’,” Singer said, referring to his panic-style predictions. “He discovered through his research that China has built up a lot of debt and he is right. China’s debt to gross domestic product (GDP), however, is pretty close to the United States’ and Germany’s.

“If we’re all so terribly concerned about China’s debt to GDP levels, why aren’t we equally as concerned about the US?…Even if [China’s] growth is slowed from double digits down to 4 or 5 per cent, they would still be absorbing that debt a lot faster the US could.”

I have already explained many times why comparing US and Chinese debt is nonsensical, and should be very obviously so, but to the extent that Singer, who seems an intelligent person, finds it impossible to accept that countries whose already-high debt levels are rising unsustainably (which simply means that debt is rising faster than debt-servicing capacity) do not necessarily default or collapse soon afterwards, it can only be because the economic model he implicitly uses is incoherent and that he is unfamiliar with financial history. Not only can an unsustainable rise in debt persist for many years, in some cases even decades, as Japan may one day prove, but in fact most unsustainable debt burdens are not resolved by crisis or collapse.

They are always resolved by mechanisms in which debt-servicing costs are explicitly or implicitly allocated to some sector of the economy, usually unwillingly, and while default or some form of financial crisis is one of the usually-explicit ways (the losses are assigned to creditors, obviously enough), it can often take many years before it happens, and it does not even happen in the majority of cases, as I will explain later in this entry when I discuss some of the ways in these debt costs have been allocated.

So while I have never predicted a crisis, panic-style or otherwise, I certainly have pointed out very early on that Chinese growth had become dependent on an unsustainable relationship with debt. While it was always possible that after many more years this could lead to a crisis, I always noted that a crisis was unlikely and most certainly not imminent. So why would Singer (and, to be fair, most other economists who use conventional equilibrium models) have found it impossible to see the sentences in which I said crisis was unlikely, once they read sentences in which I said imbalances were deep? It is because the two statements are incompatible in their models, which exclude ordinary balance sheet dynamics. The systemic creation and reversal of imbalances are not formally captured in these models.

My point is not simply to correct any misperceptions about what I did or didn’t say – in fact I have to confess that it hasn’t been all bad: in the past year because of similar mistaken models I have received a huge amount of credit from very generous people for correctly predicting market crises that in fact I did not predict. My point is rather about the incoherence of conventional thinking about unbalanced economies. The wide-spread inability intuitively to understand disequilibrium explains at least in part the misplaced confidence so many people have in the role Chinese reforms of the past few years would have in resolving China’s economic vulnerabilities (and those of peripheral Europe, for many of the same reasons) because it made improving productivity, rather than the rebalancing process itself, the main objective of the reforms. Refocusing on the rebalancing process will allow us to see not just why many of the old reforms simply didn’t matter, but also which of the new supply-side reforms might in principle work and which cannot.

Debt isn’t irrelevant

China’s unsustainable rise in debt is part of a self-reinforcing dynamic involving the consumption imbalance, and the important point is that because imbalances necessarily must reverse themselves eventually, any useful reform must be consistent with China’s economic rebalancing. In fact it should have been obvious years ago that Chinese policymakers only ever had two choices. They could proactively implement the reforms aimed at reversing the imbalances, however costly these reforms might be (and the longer they were postponed, the more costly they would become), or they could try to postpone the necessary reforms indefinitely – as many if not most countries in similar circumstances had done unsuccessfully in their attempts to sidestep the costs of rebalancing.

In the latter case, however, they would have almost certainly discovered, as their predecessors always discovered, that as the debt burden increased, the increasing impact of the distortions caused by the imbalances – and it is important to remember that the two are self-reinforcing – would eventually break through the institutional constraints that had prevented adjustment earlier. Rising balance sheet fragility makes an economy more sensitive to imbalances and to disruptive shocks, by which I mean that and balance sheets become increasingly fragile, their disruptive unraveling can be caused by progressively weaker random shocks – i.e. “triggers” – so that in very extreme cases it takes deceptively minor shocks to trigger major disruptions.[4] The risk in that case is that the imbalances would reverse themselves disruptively and force an unwanted resolution of the excessively high debt burden – of which the most obvious, but not only or even most likely, way would be in the form of a financial crisis of some sort.

I will give concrete examples later of how this has happened in previous cases, but put in starker terms, when for structural reasons economic growth in any country depends on an unsustainable increase in the debt burden, then simply as a matter of logic policymakers have two choices. They must either move aggressively to bring debt under control before the economy reaches its debt capacity limits, in which case they will cause growth to slow sharply over a difficult adjustment period during which balance sheets are rearranged. Or if they wait too long – usually because they mistakenly believe there is a set of efficiency-improving reforms that can cause productivity to rise faster than debt – at some point, as the debt burden continues to rise, either creditors will refuse to lend, in what economists call a “sudden stop”, or debt capacity limits will otherwise be reached, after which, in either case, growth will collapse. China must prevent its debt burden from reaching these levels.

Although it would have been much better for China if policymakers had recognized the urgent need to rebalance and implemented the necessary changes a decade earlier during the administration of Hu Jintao, it seems that Xi Jinping’s administration acknowledges the risk of continued credit expansion and wants to implement the necessary reforms before the economy is forced into a disruptive rebalancing. This, in effect, was what had been recognized during the October, 2013, Third Plenum. What is less clear to me, however, is how much time policymakers believe they have in which to force through the necessary reforms, and whether their assessment is realistic.

Right and wrong reforms

However much time they have – and in my opinion they are unlikely to have much more than 2-3 years in which to get credit growth under control, but there is no science to this so I cannot know for sure – as Beijing moves forward in its struggle to rebalance the Chinese economy, we should keep three things in mind:

  1. The rebalancing process is in fact fairly straightforward and easy to understand or describe, albeit only conceptually and at a very abstract level. Both the logic of China’s existing growth model and the almost uniform experiences of the many historical precedents reveal clearly the vulnerabilities China faces, what it must do to address them, and why the necessary reforms will be difficult.
  1. But while we should know what must happen, the specifics of the rebalancing process can be extremely complex, and depend very much on institutional conditions, at both the national level and the local level, and which include very powerful vested interests created by the development model. This is why even if it is clear in principle what must be done, choosing and implementing the actual reforms will be neither easy nor straightforward, and will involve significant experimentation and political maneuvering. However if we understand the rebalancing process in principle, we can at the very least distinguish between reform policies that are consistent with the necessary rebalancing process and policies that are not.
  1. But there is a conceptual problem. The historical precedents suggest – with ample support from Chinese experience of the past 3-4 years – that like very small whales with very large blowholes the economists advising policymakers, with the agreement of outside analysts, will offer a profusion of reform proposals which confuse two very different sets of reform programs, largely because of the mistaken model used by most economists and to which I referred earlier on the section on Singer. One set consists of what I call “asset-side” policies that are designed to improve China’s economic efficiency, and these are the only reforms that are meaningful according to most consensus economic models. The other set consists of what I might call “liability-side” policies – although these involve more than the liability side – that address the rebalancing process directly, and while finance specialists, or economists who have been influenced by the balance sheet approach of people like Hyman Minsky, easily recognize these kinds of reforms, in general they are not well understood. I have discussed before, including most recently in the September 1 entry of this blog, the difference between the two kinds of policies.

This third point is important and probably explains a feature of history about which economists seem unfamiliar. There have been dozens of cases in the past couple of centuries in which sovereign debt levels were seen as being excessive. In some of these cases the debt was subsequently repudiated, but in most cases policymakers at first sought to reassure their creditors that the country was facing a short-term liquidity shortage, and promised to design and implement a package of policies that would improve the country’s economic efficiency, increase growth, and restore confidence. In some cases these promises were perhaps never credible, but in many cases they were, and the markets were prepared to give policymakers enough time for the measures to work and for the country to begin growing its way out of its debt burden.

Efficiency versus rebalancing

But of these dozens of cases, few, if any, sovereign borrowers were in fact able actually to grow their ways out of their debt burdens until, either explicitly or implicitly, the debt was substantially written down and assigned to an unwilling sector.[5] Until policymakers take on the debt burden directly, the historical precedents seem to tell us very firmly, sovereign borrowers have never been able to implement reforms that improve efficiency enough to allow them to grow out of their debt burdens.

I have explained elsewhere some of the reasons that determine whether a country’s debt is “excessively high”, and I hope formally to list these reasons more fully in my next book, but the key is the gap that is created between projected debt-servicing costs and the projected revenues earmarked to service the debt when an economic entity suffers an unexpected surge in debt or an unexpected decline in growth. When this happens and as debt levels rise relative to debt servicing capacity, at some point the major stakeholders — including businesses, creditors, household savers, workers and so on — became uncertain enough about how this gap will be allocated that they take steps to protect themselves from this uncertainty.

As this happens investors, recognizing that stakeholder actions are likely to undermine the economy further and worsen balance sheet fragility, express their worry about the risk of default in the form of high required yields. They also make it difficult for the sovereign borrower to issue new forms of debt. Finance specialists will recognize this condition as very similar to, but more general than, the trigger that sets of financial distress costs.

For most economists this seems implicitly to be a surprising statement: excessive debt is a balance sheet problem, and not an efficiency or productivity problem (although of course inefficient or unproductive economic activity is usually, along with badly-designed balance sheets, the main cause of excessive debt). That is why, because policymakers will rely on advice from economic advisors who are unlikely to understand balance sheet dynamics and who are almost completely unfamiliar with historical precedents, it was almost inevitable that at first Beijing would prioritize the wrong set of reforms aimed at raising the equilibrium growth rate of the economy, even sometimes at the expense of further balance sheet deterioration.

And they have. This process is the typical end of the expansion phase of every investment-driven growth “miracle” in history. In each case after many years of investment misallocation, both unexpectedly high debt and unexpectedly low growth create the gap between debt servicing costs and expected revenues, with each driven by and exacerbating the other (as has clearly been the case in China today).

As the gap widens, it creates rising uncertainty about how excess debt servicing costs will ultimately be allocated, and at the point at which this uncertainty is high enough to alter materially the behavior of economic agents, and so lower the net asset value of the economic entity, the borrowing country has “excessive” debt. Once it does, the process of deleveraging, like rebalancing, is inevitable, and it too can occur in many different ways, all of which involve forms of “debt forgiveness”, usually involuntary.

Some forms of debt forgiveness are explicit. The devastating LDC debt crisis of the 1980s, which began in August 1982 when the Mexican government announced that it was unable to service its obligations to foreign banks, ended only in 1990, when these loans were exchanged for a nominal amount of Brady bonds equal to only 65% of the original notional amount of outstanding loans. In the subsequent years, one after another of the indebted LDCs obtained notional debt forgiveness of 30-50% in the subsequent Brady-bond restructurings.

Partial debt forgiveness has been a formal part of nearly every sovereign default or debt restructuring in modern history, although usually not until there has been a long and painful period of angry posturing and one or more partial restructurings. During this time we often also see informal kinds of partial debt forgiveness, for example when sovereign borrowers have repurchased their obligations in the secondary market at steep discounts, often secretly, or exchanged their obligations for other assets at a discount, for example the famous debt/equity swaps in several Latin American countries in the 1980s (see footnote 3).

The ways of debt forgiveness

Most forms of “debt forgiveness”, however, are implicit, and nearly always involuntary. German’s excessive debt burden after the Great War, for example, was “forgiven”, unwillingly, mainly by middle- and upper-middle-class households and civil servants, whose fixed income portfolios withered to nothing in the hyperinflation that began in mid 1921 and ended in early 1924. China’s huge portfolio of NPLs at the end of the 1990s (perhaps as much as 40% of total loans) was resolved by a decade of severe financial repression, so that lending rates of around 7% – in an economy in which GDP grew nominally by 18-20% and the GDP deflator usually exceed 8% – implied substantial debt forgiveness.[6]

Because these loans were funded by even cheaper deposits, debt was forgiven at the expense again of household depositors in the banking system, and of course it is no coincidence that during this period the household income and household consumption shares of GDP, which began the decade at already very low levels, plunged to levels that are historically unprecedented. There are many other ways of allocating a significant portion of the debt-servicing cost to unwilling agents in the economic equivalent of debt forgiveness: to creditors when debt is repudiated, to workers when wages are suppressed in order to increase net revenues for debt servicing, to small business owners when assets are expropriated to pay down debt, and so on.

In the current global environment this problem, by the way, is not one just limited to China. For example the same thing is happening in many European countries which – for all the urgency some, like Spain under President Rajoy, have implemented efficiency-enhancing reforms – have been unable to grow their economies faster than the growth in their outstanding debt. I would argue that so far the policy advice Beijing has been receiving has also mistakenly assumed that China’s slowdown was caused mainly by various regulatory and institutional inefficiencies and rigidities, and that as these are removed by regulatory reforms, or countered by the appropriate fiscal and monetary policy, the Chinese economy will naturally move towards a stable equilibrium with much higher productivity levels. This they think will ensure sufficiently rapid growth and will give Beijing additional time in which to resolve its debt problems.

But this is not how the adjustments have ever worked and until now it does not seem to be working in China. A rapid slowdown in growth is imbedded in the adjustment process, and will inevitably occur with or without the proper reforms. For now the only way to keep growth from dropping sharply is to allow debt to rise as rapidly as is needed to meet growth targets, currently at least two to three times as fast as the growth in China’s debt-servicing capacity, but as debt rises growth will continue to decelerate more quickly than predicted.

How never to be wrong

In fact growth in China has already slowed sharply, and by far more than was permitted in most of the standard models, but bizarrely enough the rapid deceleration in growth has not caused economists to reject their models. Instead, with great nimbleness and intellectual flexibility, and often without ever missing a beat, they have simply applied the same framework to explaining lower growth. Like Kevin Keegan famously, they always know what’s around the corner but they never know where the corner is.

A typical case might be Stephen Grenville, a former Australian central banker, whose growth forecasts are regularly and quickly undermined by reported growth data with no appreciable effect on his analysis. It may be unfair to single him out, but I have become familiar with his work mainly because several of my investment and academic friends in Australia seem to delight in sending me his articles and making witty comments about how economists can take data that confounds their forecasts and use it to confirm their analysis. He has long been an optimist on Chinese growth and a little over two years ago he assured Australian investors that Chinese government debt was quite low, and that keeping it low was easily achievable. Now he accepts that it is high and poses risks, but it was apparently never likely to be otherwise.

He even cheekily wondered at the time about economists predicting a slowdown “How wrong do you have to be before you lose your expert status?”, he asked. The question is going to prove purely hypothetical, the investor from Sydney who sent me the article assured me, given that there is no amount of slowdown and no strain in credit that will do the trick for Grenville, but he was nonetheless fairly annoyed that a former Australian government official who claimed to understand what was happening in China would have done the unforgiveable and never warned that iron prices were about to drop from over $190 to test $50, even though that turned out to be a fairly easy prediction.

Perhaps he forgot. As an aside, one of my PhD students, Hao Yang, helpfully explained to me early last year that if I ever needed to write these kinds of academic papers he could do it for me because that is precisely what PhD programs train students to do. I suspected he was being a little cynical, but certainly it has been widely noted within the investment industry that while there have been profound disagreements during the past decade about the Chinese economy, and its performance seems to have thoroughly confounded the expectations and forecasts of majority opinion, so far it is hard to find economists who haven’t been proven right, and not just among Australians. Something so extraordinary almost certainly could not happen without a great deal of highly specialized training, so perhaps Hao Yang was not being cynical at all.

The most common argument used by analysts like Grenville to justify the recurrence of “unexpectedly” low growth while maintaining the validity of the conventional equilibrium models is usually that slower growth is a natural consequence of China’s rising capital intensity. As the level of investment increases, and so becomes less scarce, the return on capital naturally must drop, and it is this drop in the marginal return on capital that explains the deceleration in growth.

This explanation however verges on the nonsensical, and it is useful to consider why:

  1. While it is true that the return on capital should decline as capital intensity rises, and that the capital intensive component of growth in China should be declining precisely because Chinese investment has surged, in fact surging investment is a three-decade-old story, whereas growth only began to decelerate rapidly over the past 3-4 years, just as China began to rebalance. This cannot just be coincidence.
  1. The deceleration in Chinese growth moreover has been far too rapid to be explained by any normal decline in marginal returns on capital as investment rises, even if capital intensity were uniform throughout China, and in fact it isn’t. Capital intensity varies tremendously from province to province, so while investment saturation might conceivably explain growth deceleration in the most advanced provinces in China, it cannot do so to anywhere near the same extent in most provinces because of the tremendous variation in capital intensity across China’s 31 provinces and provincial-level entities. In fact a mathematician looking at a map of China listing provincial per capita investment rates would immediately see that such rapid deceleration, compressed over so short a time period, would require extraordinary mathematical convolutions to support an argument based on investment saturation.
  1. Most damning of all, if growth deceleration were caused only, or mainly, by declining returns on capital as capital intensity rises, the most rapid deceleration would occur in the most advanced provinces, whereas there should be no slowdown in the least advanced. In fact across provinces the opposite is true.

Andrew Batson recently posted an interesting and related entry on his blog that is worth reading in full. Aside from investment saturation and unexplained invoking of the “middle-income trap”, I am not aware of any other plausible explanation for the sharp decline in reported GDP growth (and I ignore the very active debate about whether the real decline in economic growth is fully described by the reported decline in the GDP data) that might serve as an alternative to the model which posits sharp slowdown as the inevitable consequence of the rebalancing process.

The two important points if I am right, then, are, first, that during the adjustment a sharp slowdown in growth is inevitable, and is embedded within the rebalancing process, and second, that until the debt is specifically addressed, efficiency-improving reforms will never be enough to resolve the rebalancing process. Growth in other words will continue to decline substantially no matter what Beijing does.

By how much? I have argued since 2009 that the upper limit of average growth during the rebalancing period, which was always likely to be with the advent of the new leader, during the 2013-23 period, is likely to be 3-4% and that the longer Beijing succeeds in postponing the decline the greater the risk of disruptive “catching up” of the necessary deceleration in growth. It is not clear how quickly China has been growing in recent years because of the huge discrepancies between the reported growth data, which even Premier Li has questioned as being “for reference only”, and nearly every attempt by investment banks and independent economists to calculate growth independently. While it is hard to know what numbers to trust, most independent estimates already range from 1% to under 5%, but any higher growth rate over a longer rebalancing period is extremely unlikely and can only happen if implicit transfers from the state sector to the household sector very implausibly average more than 2-3% of GDP annually.

Do we care about the amount of economic activity?

Unfortunately the locus of the debate among those who recognize that the growth slowdown is not incidental and part of a “normal” deceleration of growth has shifted primarily to the accuracy of the published data. The Economist has typically been among those publications least convinced that China was facing a very difficult adjustment – in fact the FT’s Alphaville and the Economist have tended to bracket either side of the debate during the past few years – but in an article last week they worriedly note just how uncertain things have become:

Increases in indebtedness of that magnitude have been a forerunner of financial woes in other countries. Cracks are beginning to appear in China: capital outflows have surged, bankruptcies are occurring more frequently and bad loans in the banking sector are rising. It is all but certain that more pain lies ahead, though quite how much and how it will play out are matters for debate. 

I think the cracks may have appeared a while ago, but in the same article they make reference to the debate about how accurate are the GDP growth data:

Judging by the eerie stability of key indicators recently, China’s statisticians appear to have been doing just that. In year-on-year terms, growth over the past six quarters has been 7.2%, 7.2%, 7%, 7%, 6.9% and 6.8%. Such a tight clustering is improbable. 

I am not sure this is always as fruitful a debate as many seem to think it is. Of course it matters to anyone who wants to understand the economic cost of the adjustment, but arguments about whether the reported data are overstated, and by how much, have become part of the bull vs bear debate about whether Chinese growth is merely slowing temporarily, and not as part of a major economic reversal of the growth model. If you agree you are meant to accept the accuracy of the reported data. Otherwise you would question the data and assert that real GDP growth is substantially lower.

I don’t think this part of the discussion is especially useful. I have long argued that as long as China – or indeed any other country – has the debt capacity, it can get pretty much generate any amount of economic activity it wants. What is important is not how much growth there has been in economic activity, which is what the GDP numbers measure, but rather how much growth there has been in economic wealth, or in debt-servicing capacity, which is much the same thing, and how that compares with the growth in debt. In fact there probably hasn’t been much growth in the former, whatever the reported GDP data tell us, and there has been a lot in the latter.

Only two things matter

So what kinds of reforms are consistent with China’s rebalancing? Improvements in efficiency matter in the long term because as long as the economy does not suffer a major disruption they will tend to close the gap between the growth in economic activity and the growth in debt-servicing capacity, but they will have little effect on rebalancing. If the new set of reforms are to be truly effective, in other words, they must be designed directly to eliminate the balance sheet constraints on the economy. They must, in other words, accomplish the following:

  1. One of the two goals must be to rebalance demand. The distribution of resources must be rebalanced in a way that it can generate debt-free demand for the economy. In principle one way to do so is to reform the financial sector so that it is able to identify productive investment opportunities and channel credit in that direction. This has been one of the most regularly proposed “solutions” available to Beijing.

In practice this almost certainly cannot happen. As I have discussed elsewhere, if we understand the political and institutional constraints that drive the evolution of a country’s banking system we would see why the necessary reforms are likely to be impossible to implement, and for those who are interested, my former Columbia University colleague, Charles Calomiris has written excellently on the subject. “A country does not choose its banking system,” he and his co-author Stephen Haber point out, “rather it gets a banking system consistent with the institutions that govern its distribution of political power.”

The historical lesson here is fairly unambiguous, although as always it is disappointing that economists who do propose such a solution for China evince so little curiosity about the historical precedents. It should be no surprise that many countries in the late stages of their own investment-growth “miracles” have tried this kind of transformation, but none has ever managed so radical a change within its financial sector quickly enough, at least in part because the capital allocation decision is at the heart of distributional politics. Because China begins the process with the highest investment level in history, the extent of the transformation must exceed that of any other case, and it must occur at a time when weak Chinese demand is compounded by weak global demand, thereby reducing productive investment opportunities for the private sector.

Another source of additional debt-free demand is, in principle, the external sector. China, however, is already challenging Europe as running the highest current account surplus in history, and in a world in which demand is likely to remain weak for many years, the external sector is unlikely to provide sufficient additional demand. Of course China can generate more demand by exporting more capital to the developing world, as it proposes to do with OBOR and the New Silk Road projects. It can also exploit its technology lead in high-speed rail, as a recent People’s Daily article on potential contracts for the high-speed Moscow-Kazan, Las Vegas-Los Angeles, Malaysia-Singapore, and Tanzania-Zambia lines. The total amount of development finance or rail exports it can provide, however, is tiny compared to domestic demand requirements, and if the recipients find themselves unable to repay the debt, as history suggests could easily be the case, this becomes a worse alternative to misallocating investment at home.[7]

The only certain and politically feasible source of debt-free demand is domestic household consumption, but Chinese households suffer from the same problem Marriner Eccles identified in the US in the 1930s: those who want to spend do not have the resources, and those who have the resources do not want to spend – or in this case are not able to spend productively. The solution is as obvious as it is politically challenging: China must redistribute resources from the latter, i.e. the state sector, to the former, i.e. Chinese households.

  1. The other of the two goals must be to repair the balance sheet. Growth will not revive until the debt burden is sharply reduced. Debt can be reduced by partial debt forgiveness as part of a restructuring process following a default. It can be reduced as part of a pre-emptive restructuring. It can be reduced in the form of implicit debt forgiveness through monetization or financial repression. Or it can be paid down with funds generated from implicit or explicit taxes or from asset sales, including privatization. There are no other realistic ways to reduce debt.

Because most of China’s debt is internal debt, and directly or indirectly owed to the banks, debt restructuring with partial forgiveness is not an option at the macroeconomic level because ultimately it is a contingent liability of the government either way. But Beijing must resolve its debt burden at the national level or it risks repeating the mistakes of Japan –and Japan’s experience merely confirms what we already know: growth will not revive until the debt burden is sharply reduced.

China is also constrained from reducing the debt burden though monetization, financial repression, or taxes on households because in each case the cost is indirectly allocated to the household sector, which simply exacerbates the original imbalance. This leaves only two alternatives. First, Beijing can expropriate the wealth of small and medium enterprises directly or indirectly (in the latter case by raising taxes), although this means undermining the most productive part of the Chinese economy. Second, Beijing can liquidate government assets and use the proceeds to pay down debt. There are no other plausible options.

Multiple paths to the same outcome

One way or another China will adjust, and both of these objectives will be met. This will happen if for no other reason than because if something cannot go on forever, as Nixon’s CEA chairman Herbert Steinhelpfully reminded us, it will stop.

The logic of rebalancing is overwhelmingly corroborated, if it needed to be, by historical precedents. Every relevant country that has experienced Chinese-style growth has suffered in a similar way, and in every country the resolution has turned out to be the same, whether the resolution occurred automatically as a consequence of a financial crisis or occurred because of specific policies. But just because we can predict with total confidence that China will eventually rebalance and deleverage, it doesn’t mean that we can just as easily predict how this will occur.

There are several paths a country can follow once systemic distortions and imbalances have become deep enough. The path that China actually takes depends, of course, on the policies implemented by the government, the behavior and confidence of Chinese households, investors and businesses, and external conditions. For this reason the whole point of the reform process should be, first, to identify the distortions and imbalances that have become, or threaten to become, wealth destroying; second, to list the various plausible paths by which these distortions and imbalances will be reversed; third, to select the optimal path consistent with the country’s political, social and economic institutions; and finally, to design and implement the policies that move the economy along the least painful of the many paths.

I list what I think are only six plausible paths China can follow in Chapter 5 of my 2013 bookAvoiding the Fall, along with the associated conditions for each of these paths. Each of the various paths will take the economic system back into some kind of balance from which policymakers can expect further sustainable growth, but these various paths have very different impacts on wealth and stability.

Take rebalancing. I have already listed above some of the many ways deleveraging can take place, from default to buy backs to financial repression to the sale of assets to pay down debt, and likewise there are several ways the rebalancing of demand can take place.

Both the US in the late 1920s and Japan in the late 1980s had deeply unbalanced economies and excessively high savings rates, the consequence of which were huge current account surpluses, along with what may have been the highest and the third highest hoard of foreign currency reserves, respectively, in history (China today probably ranks second), and highly inflated domestic asset markets. The causes of their imbalances were, at least in part, high levels of income inequality and relatively low household income shares of GDP.

Both countries rebalanced in the subsequent decade, as they inevitably had to, and in both cases the savings share of GDP declined (or the consumption share increased, which is the same thing), but it declined for very different reasons. In the US, the rebalancing occurred mainly in the form of a collapse in GDP relative to household income, with the former dropping by around 35% between 1930 and 1933 and the latter dropping by “only” half that rate. This was accompanied by substantial income redistribution, much of it occurring partly because of redistributive policies under Roosevelt and mostly because of a wave of sovereign and domestic bond defaults whose losses were borne mainly by the high-saving wealthy. Japan’s rebalancing, on the other hand, occurred in the form of two decades in which GDP growth barely exceeded 0%, while the growth in household income and consumption averaged more than 1%.

The state must pay

It is worth noting, as we think about China’s options, that historically a sharp, economically disruptive rebalancing with negative consumption growth and even more negative GDP growth, as experienced by the US, and a long period of stagnation with low consumption growth and even lower GDP growth, as happened in Japan, represent the two main ways that significant savings imbalances have tended in the past to adjust. In principle you can also have moderate GDP growth and high consumption growth, but this has never happened in history, probably for obvious reasons, and the extraordinary faith many analysts have that this is the most likely outcome unless Beijing seriously mismanages the process is almost certainly wholly misplaced.

There seem to be four main mechanisms responsible for major incidences of income redistribution. The first is a politically-driven redistribution of wealth from rich to poor (sometimes disruptively, in politically unstable states, and sometimes not). The second is very high inflation or financial repression that erodes bond and bank-deposit values. The third is a wave of sovereign and domestic bond defaults. The fourth is war, although perhaps this occurs mainly because war is often inflationary.

However they occur, the many historical precedents, reinforced by logic, suggest very strongly that no reform program will be viable in China unless it is consistent with a rebalancing of demand from investment to consumption and with a reining in of credit expansion and eventual reduction in the country’s debt burden. Because the only plausible way of rebalancing demand requires that Beijing directly or indirectly redistributes resources from the state sector to the household sector, while the most efficient way to reduce the debt burden involves liquidating state assets and using the proceeds to pay down debt, it turns out that by far the most efficient and sustainable program of reform requires the wholesale liquidation of state assets to fund transfers of wealth.

And there’s the rub. While a reform program that liquidates state assets to pay down debt and to rebalance the household income share is economically the least disruptive kind of reform program, and is the one most likely to leave the economy in a position to resume rapid growth over the long term, it is unfortunately likely to be fiercely resisted by the many powerful vested interest who benefit from state ownership and control of assets. This is the big challenge faced by the Xi administration, and it has been the challenge faced by nearly every country that has undergone a similar type of growth “miracle”.

Why do we need a new program?

I have taken a very long digression before actually beginning my discussion of successful and unsuccessful reforms, among both the previous set of reform proposals and the newly proposed “supply side” reforms, because once we understand what has worked in the past, and what has never worked, it becomes much easier to evaluate the specific reforms that might work for China and those reforms that are clearly irrelevant. In fact they become almost obvious.

There are two main criteria by which to judge the usefulness of specific reforms. First, because the consumption share of GDP will rise no matter which of the rebalancing paths China takes, policies that maintain or even increase the growth rate in household consumption, mainly by maintaining or increasing the growth rate of household income, will push China along a “better” adjustment path of more rapid growth.

Second, because China will deleverage one way or the other, and because financial distress costs create a powerful inverted relationship between the size of the debt burden and the pace of economic growth, policies that reduce financial distress costs, by far the most important being those that pay down debt, will push China along a “better” adjustment path of more rapid growth. These should be the two main considerations when evaluating reform proposals, and while policies that accomplish neither may in fact benefit China’s economic efficiency in the long run, they will not protect China from a brutal and potentially disruptive adjustment.

Beijing formally promised to begin rebalancing the economy in a famous speech by Wen Jiaobao in March, 2007, although it was only in 2012 that the consumption share of GDP stopped declining and began to rise. Since then, the consumption share of GDP has expanded by perhaps one-fifth of the amount by which its GDP share would eventually have had to expand, and debt continues to rise at least twice as quickly as debt-servicing capacity, perhaps much more. Clearly Beijing plans to design and put into place what are being called “supply-side” policies mainly in response to the difficulties it has encountered so far.

I think it is safe to say that implicit in the new set of policies is the recognition that in recent years Beijing has failed to rebalance the economy by nearly as much as it should have, and that it has not made enough progress in implementing the Third Plenum reform proposals. These reforms, if implemented robustly, would have restructured the country’s economic institutions so as to consolidate the progress of the past three decades and make long-term growth sustainable, but this has turned out to be extremely difficult, largely, I suspect, because of what to many was an unexpectedly strong political opposition. And yet this opposition was very much one of the characteristic outcomes of the rebalancing process.

There are only three choices

I have explained many times before why every fiscal, monetary, or regulatory policy decision Beijing takes ultimately forces it to choose among three outcomes, and to understand the supply-side reforms, we must keep these three outcomes in mind. China faces a tradeoff in which Beijing must continually choose among these three:

  • Higher unemployment, the limit of which is largely a political issue involving social instability, with the added wrinkle that certain types of unemployment are likely to be perceived as more politically costly than others – e.g. because returning to the family farms acts as a kind of safety valve, even with a significant fall in living standards, unemployment among migrant workers is likely to be less costly politically, or because university graduates are presumably more communicative and have higher expectations, their unemployment might be more costly.
  • Higher debt, by which I really mean a higher debt burden, or an increase in debt relative to debt-servicing capacity, and this can rise until credit growth can no longer be forced up to the point where it can be used to roll over existing debt with enough margin to fund as much new economic activity that Beijing targets.
  • Higher wealth transfers, in which governments – and because the Xi administration is seeking to centralize power this is most likely to involve local governments rather than central government entities – must liquidate assets and use the proceeds directly or indirectly either to increase household wealth or to pay down debt. The main constraint on Beijing’s ability to direct this process is likely to be the tremendous political opposition of the so-called “vested interests”, for whom government control of these assets is an important source of power, patronage, and wealth.

Beijing’s range of policies, in other words, is quite limited and in every case either economically painful (higher unemployment or higher debt) or politically difficult (higher wealth transfers). This new program of “supply-side” reforms is probably expected to provide Beijing with an alternative path from which perhaps it can sidestep this difficult trio of outcomes, but it will also be limited by the fact that these are Beijing’s only options, so that the best Beijing can expect might be simply that the supply-side reforms will give it more time.

Announcing the supply side policies

A widely-read primer published last month by Xinhua, the country’s official news agency, explained what Beijing might mean by supply-side reforms. What I found to be especially interesting was its explanation of why Beijing had shifted from what it called demand-side reforms to supply-side reforms:

The Chinese economy is no longer galloping ahead on the back of investment, exports and consumption. Adjusting banking regulations and interest rates has not been very successful in boosting investment or consumption.

With growth falling below 7 percent, China’s economy is in dire need of a makeover. Instead of working on the demand side, attention has turned to stimulating business through tax cuts, entrepreneurship and innovation while phasing out excess capacity resulting from the previous stimulus. Such measures are intended to increase the supply of goods and services, consequently lowering prices and boosting consumption.

I think it is especially noteworthy that Xinhua says that the adjusting of banking regulations and interest rates liberalization, among the most important parts of the existing reform program, have not been successful, and that China is “in dire need of a makeover”. This fact alone, if true, should be a very powerful indicator of just how misguided the economic models are that implicitly underlie the optimistic consensus about the management of China’s adjustment process during the past few years. Because I have long argued that these reforms would at best reverse the process by which the imbalances were created (especially the elimination of the financial distress “tax”) if the balance sheet approach to rebalancing were the appropriate model, and are implicit in the trade-off among three outcomes I list above, they are at least consistent with what I believe is the correct analysis.

The day after the Xinhua piece, an article in the People’s Daily made the same point:

China used to rely on stimulating the demand side, including investment, consumption and exports, to support growth. However, the effectiveness of such a strategy has lessened.

The economy experienced acute volatility in the mainland equity market, disappointing economic indicators and a currency devaluation this year. The government appeared to have done everything it could, including five interest rate cuts and massive investment in infrastructure, but that was not enough to spur the slowing economy. (“That’s because it [the demand-side support policy] is no longer the remedy for the disease,” said Li Zuojun, a researcher with the State Council Development Research Center (DRC), a government think tank.

The sense that “supply-side” reforms are a response to failures in the current reform program permeates reports in the official and non-official Chinese press, to the point where it should resolve the long running argument between bulls and bears. Economists at various Chinese think-tanks have made the same point, many affiliated with government ministries, including at the independent Winbro Economic Research Institute and at China Academy of New Supply-side Economics, the latter set up by former government official, according to an article published two weeks ago in the South China Morning Post. Their goal is to explore new ways to create a better framework for reforms.

The same SCMP article provides a fairly good summary of the new thinking, and suggests more specifically the perceived failings of current policies:

Economist Teng Tai, founder of Winbro Economic Research Institute, a private think tank in Beijing, is one of the most vocal proponents of supply-side reform. The country’s previous strategies for boosting economic growth were quickly losing effectiveness.

“The effects of demand-side measures in driving economic growth are getting weaker and weaker,” said Teng, who in 2012 sparked debate with the publication of his Declaration on New Supply-side Economics. “Take fixed-asset investment for instance. The government can increase infrastructure investment for sure, but the effects can be easily offset by sluggish capital spending by property developers and manufacturers,” Teng said.

However, through “supply-side” measures, such as reducing government red-tape, cutting taxes, and freeing up the labour, land and capital markets, China could prevent economic growth from slowing even more, while creating new sources of growth, said Teng, who attended a recent advisory meeting chaired by Premier Li Keqiang.

Keeping growth high

It goes on to list similar doubts by another proponent of the supply-side measures:

“A breakthrough in economic theories is needed since the approaches found in old textbooks can no longer solve today’s problems,” said Jia Kang, a government researcher and a member of the Chinese People’s Political Consultative Conference. After retiring from his research position at the Ministry of Finance, Jia founded the China Academy of New Supply-side Economics in 2013, pulling together a group of economists from both public and private sectors to study the approach.

“The leadership’s emphasis on supply-side reform is a new approach for connecting theory with reality.”But China’s supply-side economics would be different from its Western version to reflect China’s reality. In essence, Jia said, it was a systematic summary of what the country needed to do to restart its economic engine.

The official press has also suggested that the new reform program is in response to the ineffectiveness of the existing reform program, although they appear careful not to suggest too bluntly that the policies of the past 3-4 years were not the right policies at the time. “While the effectiveness of traditional demand-side policy support lessens,” the People’s Daily tells us, “the country is now turning to the other side for new growth vitality.” Or as Li Yiping, People University professor and one of the sharper economists in China, writes in China Daily:

Since the 2008 subprime crisis in the US, China has taken a series of demand-management measures to stabilize growth, including a 4 trillion yuan ($616.8 billion) stimulus package in 2008. These measures were taken on the assumption that the government could solve microcosmic problems through macro policies.

But the government intervention distorted factor prices and created further overproduction pressure. In other words, the structural adjustment didn’t work. The marginal utility of the stimulus package declined sharply the 4-trillion-yuan investment was not enough to maintain 7 percent growth today.

While from what I can understand there are very realistic appraisals of some of the problems China faces, unfortunately rather than acknowledge that it will be impossible to maintain current growth rates for more than a few years, and that the longer they are maintained the greater the risk that China is forced into a disruptive adjustment, at least some of the policy advisors have drawn a different conclusion. China can maintain high growth rates if it switches to a new basket of “supply-side” reforms.

What are Beijing’s “supply-side” policies?

What are these reforms? Here is how the People’s Daily describes them, in an article that calls them the “top priority” of this month’s annual Central Economic Work Conference:

The supply-side reform will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system. Public service is set to be improved and new demand created to spur growth.

The country’s top leaders are likely to introduce all-round “supply-side reform” at the annual Central Economic Work Conference, which began on Friday in Beijing. “All signs are pointing in the same direction, that supply-side reform will command center stage next year,” according to a policy review of the conference by China Minsheng Bank, one of the largest non-State banks.

The article goes on to give a little more detail further along, of which perhaps the most important and encouraging comment, at least in my opinion, is the suggestion that the GDP growth target will be de-emphasized:

A Web commentary by People’s Daily called the supply-side reform “a profound change”. It will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system, it said.

In the most immediate move, the commentary said, the government will have to reduce housing inventories, and one way is to subsidize rural migrant workers so they can settle down in the cities where they work. It should also shed excessive industrial capacity, especially in industries with low technology and poor market prospects, it said.

A third thing to do is to deepen reform of the financial system, so as to build a nationwide system of financial service, taxation and multiple layers of insurance, the commentary added. Wang Yiming, vice-president of the State Council Development Research Center, said reform will definitely be the priority at the meeting.

GDP growth will be assigned secondary importance, economists said. Some suggested that next year’s GDP growth target should be lowered from “around 7 percent” this year to between 6.5 and 6.8 percent. GDP growth in the first three quarters reached 6.9 percent year-on-year, down from the 7.3 percent last year. The growth target won’t be published until the National People’s Congress in March.

In its December 22 primerXinhua explained what Beijing might mean by supply-side reforms:

Supply-side economics holds that the best way to stimulate economic growth is to lower barriers to production, particularly through tax cuts. The wealth-owners, rather than spending on direct “demand” purchases, will then be more enticed to invest in things that increase supply, such as new businesses, innovative goods and services.

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. …Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

The return of Say’s Law

My understanding of the proposed reforms is that they are only partially described by use of the phrase “supply-side”, whose overuse is already causing some off us the same confusion felt by Inigo Montoya, the vengeful swordsman from The Princess Bride: “You keep using that word. I do not think it means what you think it means.”

The phrase itself was first used in 1976 by Herbert Stein, of the University of Virginia, to discuss a body of policies that had evolved in opposition to demand-side policies, often mistakenly attributed to Keynes, that could not explain or address the stagflation of the 1970s. These policies later became more widely known as “Reagonomics”, the heart of which is usually assumed to be tax cuts as part of a strategy to reduce government involvement in the economy on the grounds that government involvement creates incentives that systematically distort economic behavior and reduce productivity.

The heart of supply-side economics is Say’s Law, sometimes summarized as “supply creates its own demand”, based on the work of Jean-Baptiste Say, a French economist who lived from 1767 to 1832 and whose main work is A Treatise on Political Economy. In that book Say claimed that “a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” Because the full value of any commodity produced is dispersed into the economy in the form of production costs, wages, and profits, insufficient demand for goods can never be a fundamental condition of any free market because the payments involved in creating the supply of goods and services also create purchasing power which will either be used for consumption or will be saved and directed to investment, creating demand that is equal to the value of those goods.

This doesn’t mean that Say and his followers deny that there can be supply and demand mismatches, of course, but that they happen only for two reasons. First, as long as perfect information is impossible, the economy will be subject to bad information, poor judgment or exogenous shocks that can cause these mismatches. These tend to be fairly small in effect and are always temporary. Second, and far more powerfully, institutional distortions can force agents into systematic misalignments of supply and demand (mainly by changing incentives for political reasons) that can get very deep and can persist for very long periods. The main source of these distortions, according to supply-siders, is the government. In that case the best way to increase productivity permanently is to remove the source of these distortions.

According to Say and his followers, policymakers should never worry about inadequate demand as the source of depressions. They should only worry about policy distortions that cause the market to create the wrong mix of goods and services. In what is perhaps the most quoted of all of Say’s passages, he says:

The encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.

But we have to be careful about how we interpret that last clause. At first glance Say and the supply-siders seem to suggest that the whole rebalancing thesis is wrong for China, and that there is no reason to worry about the low consumption share of GDP. If this were true, however we would immediately have to dismiss supply-siders because it only takes a little arithmetic to show that China’s soaring debt burden is a direct consequence of its demand imbalance, and to dismiss the consequences implies both that the country’s debt capacity must be infinite and that there will never be uncertainty about the allocation of debt-servicing costs, neither of which can possibly be true.

A more sophisticated reading, however, would recognize that China’s demand imbalance could never have existed except for very powerful political incentives that created in the past two decades deep institutional distortions. In that case the point of supply side reforms would be to eliminate these distortions so that the imbalances can reverse, and it seems to me that the only possible disagreement among supply-siders must be whether the purpose of reforms is to eliminate institutional distortions as quickly as possible or whether Beijing should take active steps to speed up wealth transfers to the household sector. Which side you support depends, clearly, on how urgent you believe it is to begin to deleverage the Chinese economy and how quickly rebalancing can occur as you eliminate distortions.

The main tenets of China’s supply-side reforms

It is pretty easy to see why this economic theory might appeal to Beijing. China produces far more than it is able to consume or demand domestically, but even with one of the highest current account surpluses in history and with explosive credit expansion to generate demand, inventories are rising and growth rates dropping sharply. Reforms during the past three years have done too little to resolve the problem, and whether China can rely on these reforms depends on how much longer Beijing can afford to allow excessive credit expansion before China runs into debt capacity limits, and on whether Beijing is strong enough to overcome domestic political opposition and speed up the pace of the rebalancing.

Is this new set of supply-side reforms the solution? At least some of the policies that are being bandied about are actually contradictory or mutually exclusive, and clearly there is not nearly enough certainty about what exactly the reforms entail nor, just as importantly, whether they can be implemented, but already analysts have been wrestling with the implications, trying to clarify the reform proposals, and providing their initial evaluations. According to last month’s Economist:

Those who first pushed supply-side reform onto China’s political agenda want a clean break with the credit-driven past. Jia Kang, an outspoken researcher in the finance ministry who co-founded the new supply-side academy, defines the term in opposition to the short-term demand management that has often characterised China’s economic policy—the boosting of consumption and investment with the help of cheap money and dollops of government spending.

Whatever the supply-side reforms imply about earlier reform proposals, I do not think we can easily declare yet either that the new policies will be successful as predicted or that they won’t – with one exception: I am very confident in saying that unless implicit wealth transfers to the household sector rise to 2-3% of GDP annually, which I recognize will be politically very difficult to manage, there is almost no chance that growth over the rest of this decade can remain at 7% or even at 6% or 5%.

Because we are still in the very early stages of this new set of policies, it is hard to discuss them except in very abstract terms, and already so much ink has been spilled describing them that contradictions and confusions have emerged. An article in China Daily seems to set the stage at least as well as any other:

China used to rely on three major forces to drive economic growth – investment, exports and consumption, which are classified as the demand side. As the effectiveness of boosting growth in the demand side wanes, the government has started to reform the supply side, or the supply and effective use of production factors, including funds, resources, skilled workers, equipment and technologies. The reform aims to accelerate economic growth by freeing up productivity and raising supply-side competitiveness. Measures will include cutting excess industrial capacity, reducing housing inventories and cutting production costs with policy support.

The focus on freeing up productivity and raising competitiveness is of course no different than the promises made by the earlier set of reforms, but supply-side doctrine proposes that rather than raising productivity by improving the distribution of demand and letting producers respond, Beijing will take steps to boost production efficiencies, confident that more efficient and profitable producers will trickle down into stronger consumption. Credit Suisse, in its December 21 report, specifies more concretely how Beijing plans to raise productivity:

The central committee of China’s communist party held the annual Economic Working Conference between 18 and 21 December. The conference listed five major tasks for 2016: (1) Reduce over-capacity. (2) De-stocking. (3) De-leveraging. (4) Lower corporate costs. (5) Improve weak links in the economy.

The meeting pointed out that supply-side policy should be given more attention in order to stabilize growth. The conference highlighted that promoting the supply-side structural reform is an innovation to help China to adapt to, as well as to lead, the new norm of the economy. In the coming years starting from 2016, China will promote the supply-side structural reforms on top of appropriate expansion of aggregate demand. China will maintain macro policy stability in order to create a stable macro environment for structural reform. China will enhance the strength of active fiscal policy through tax cuts and the periodic increase of the budget deficit. Steady monetary policy should be adapted with flexibility. China will maintain adequate liquidity and appropriate growth of total social financing. China will increase the degree of direct financing, lower funding costs and further develop the exchange rate mechanism.

An article in Xinhua proposes, similarly, the following policies that are consistent with Credit Suisse’s understanding:

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

Finally, another article, this time in the South China Morning Post, describes the intentions of President Xi for the proposed supply-side policies in the following way and in nearly identical terms:

Xi has listed the four big battles of the coming year as addressing overcapacity, cutting financing costs, reducing property inventory and preventing financial risks, China Business News reported.

The key objectives

As far as I understand these reforms, then, I would list the main objectives very broadly as consisting of the following:

  1. Reducing over-capacity. This will include encouraging mergers and acquisitions, as well as preventing bankruptcy. Because of very strong incentives that favor gross production over productivity, including pressure, mainly from local governments, not to fire workers, Chinese companies have been very reluctant to close down capacity even as demand has plunged globally. Because companies that maintain capacity at the behest of local officials can have them pressure banks to finance rising inventories, the obvious consequence is rising debt collateralized by permanently rising inventory, and with no formal mechanism to write down either, wealth will be overstated. It is not clear to me exactly what policies will be implemented to address over-capacity, but policymakers at the Economic Working Conference stressed that the balance between social stability and structural reform should be dealt with carefully. Overcapacity must be reduced, in other words, but not by firing workers to the extent that the resulting unemployment is destabilizing. It will not be easy to do one however without risking the other.
  1. Reducing real estate inventory. Xu Lin, director of the Department of Development Planning at the country’s top economic planner, the Central Leading Group for Financial and Economic Affairs, explains in an interview with Caixin in November that “the key step [in reducing the inventory of property] is to help migrant workers in cities to settle down through household registration reforms, thus creating more demand for housing and reducing excess inventory of property. The mega cities of Beijing, Shanghai and Guangzhou are suffering from population pressure, so they have strengthened controls on population growth. But there are many other big and medium-sized cities with little population pressure that should enhance efforts on household registration reforms. But those efforts have been inadequate.” We have already seen tentative “experimental” policies aimed at liberalizing the hukou regime, which determines the residency status of all Chinese, but the biggest problem, as is well recognized, is that the supply of hukous is for lower-tier cities whereas most demand is for the top tier cities.
  1. De-leveraging and otherwise strengthening balance sheets. Much of the focus here seems to be on making debt-servicing costs more manageable for heavily indebted entities, especially provincial and municipal borrowers, many of which are struggling. According to an article last week in the People’s Daily, Zheng Gongcheng, a member of the National People’s Congress Standing Committee, said there are a great many zombie companies among State-owned enterprises. “Their existence can only increase financial loss and the pressure to repay debt.” What makes this especially difficult is the highly politicized nature of lending, which the supply side reforms will try to address. As Caixinexplained in another article: “Banks were sometimes strong-armed by local government officials to extend loans to these [zombie] companies because they feared letting them go under would cause social instability, a risk-management executive at one bank said. ‘But these companies are doomed,’ he said, adding that forcing banks to lend to them ‘amounts to dragging down the quality of the loans to non-performing.’”
  1. Fiscal expansion, including tax cuts. Fiscal expansion is usually seen as a demand side policy, but in this case tax cuts will be designed and implemented as much to improve business efficiency as to boost demand.
  1. Lowering corporate costs directly and by reducing government bureaucracy. Again, according to Xu Lin, “I think the core idea is to reduce transaction costs created by institutional arrangements. Businesses are paying quite high costs in transactions, taxation, financing and social security. High transaction costs in China are mainly created by institutional hurdles. Reforming the supply side will reduce costs and make it easier for enterprises to do business. It will encourage business innovation, boost quality and efficiency of the supply system, and improve the supply structure. Eventually, supply side reform will lead to higher productivity of the economy and improve enterprises’ competitiveness.” There has been a great deal of complaining in the past about the cost of bureaucracy and most of the reformers seem to stress the need for streamlining bureaucracy.

The goals, then, seem to be to take advantage of the urgency generated by recent events to force through a series of difficult reforms that will improve China’s economic efficiency over the longer term, but that must at the same time address the vulnerabilities that China faces in the shorter term that can easily overwhelm any larger reform program. These reforms clearly will not be easy and just as clearly face significant political constraints.

How will the reforms proceed?

I won’t pretend that I can lay out with any subtlety the specific reforms that Beijing must implement in order to improve the long term functioning of its economy, and can only wish the reformers the best of luck in what promises to be an immense task, but I do want to address, perhaps a little abstractly, the kinds of policies that will directly move China towards or away from the optimal adjustment path. Again, I want to make the distinction between the two types of reforms to which I earlier referred:

  1. China, like every other economy, has institutional constraints that prevent it from achieving the sort of frictionless system in which incentives, including the design and implementation of economic laws, reward economic behavior that increases social wealth, and in which land, labor and capital resources are exploited as productively as possible. These reforms, which I sometimes refer to as “asset-side” reforms, are not always clear-cut among economists and are no less subject to fashion than men’s hair-styles, but it is pretty normal that at any point in time there is a widely accepted consensus about what constitutes an appropriate set of reforms. The goal of these reforms is to identify institutional or investment constraints that reduce efficiency and eliminate them, with the goal of increasing productivity.
  1. In highly unbalanced and heavily leveraged economies in the late stages of a particular growth model, another set of reforms are designed specifically to speed up the rebalancing process and to reduce leverage.

I have already pointed out that historical precedents had always made it easy to predict the sequence of events:

  • During the later stages of the period of rapid expansion in economic activity, and in spite of ample evidence that included an overwhelmingly consistent collection of historical precedents, the economic advisors to the Beijing government, along with most of the research analysts covering China, would fail to recognize the relationship between growing imbalances, capital misallocation, and deteriorating balance sheets. Nor would they recognize the symmetrical role of balance sheet inversion, in which what had caused them to confuse speculative profits in a period of expansion with higher-than-expected productivity would necessarily cause the contractionary phase to slow even further because the symmetry of speculation meant that losses would be magnified just as profits were. Just as inverted balance sheets made growth unexpectedly high in the expansion phase, in other words, they would necessarily make growth unexpectedly low during the contraction.
  • At some point, however, debt levels would become so high that these same economic advisors would recognize the need for economic rebalancing, and for reforms that would accommodate the rebalancing in a way that lessened the chance of disruption.
  • However because of a continued failure to understand the balance sheet component, the proposed reforms were always likely to be the asset-side reforms described above. For that reason it was also fairly easy to predict that the reforms would have very little impact in improving the underlying imbalances in the Chinese economy or in reducing the country’s reliance on surging debt to stabilize growth rates. It was inevitable that barring some major positive shock, debt would rise far more quickly than the economic policy advisors had predicted, and China’s vulnerability would rise to dangerous levels.

So to repeat myself

So far China has followed the same unfortunate path as all its predecessors. The recent announcement of supply-side reforms is no more than an explicit recognition that this is exactly what has happened. Beijing clearly now faces two options. One option is to recognize that productivity growth will not pull China out of its rising debt burden and to focus on liquidating assets to pay down debt and to fund wealth transfers to the household sector.

The second option is to embrace “supply-side” reforms which design improvements in economic efficiency in the elimination of institutional constraints that are dramatic enough to lead to a surge in productivity powerful enough to allow China to grow its way out of its debt burden. China, in this case, will not have to allocate losses directly or indirectly to households, businesses or governments, nor will the PBoC have to monetize the debt, which of course is simply another way of allocating the losses to the household sector. At the same time the household share of GDP will rise so rapidly that investment can quickly decline with no impact on growth or unemployment.

No country in history as ever managed to pull off this second option. This doesn’t make it impossible for China to do so, but it is all the more worrying that no country has suffered from economic imbalances or from debt burdens as deep as those of China today. Frankly I find it difficult to work out arithmetically any such outcome with numbers that are consistent systemically except under assumptions of near frictionless transitions and many years of implausibly high levels of wealth transfer from the state to ordinary households, on the order of at least 3-4% of GDP.

If I am right, the best way for China to avoid a very painful and possibly disruptive adjustment is for the supply-side reforms to be designed and implemented to accommodate rebalancing. Each important reform must be designed either to accommodate or boost a rapid increase in household income or wealth or it must be structured to pay down debt. As I will show it is important to understand that wealth transfers are fully compatible with supply-side reforms, depending on how the reforms are formulated.

How the evaluate the reforms

To return to the main objectives of the supply-side reform plan I listed above:

  1. Reducing over-capacity. The purpose of reducing over-capacity must be to reduce the growing gap between the rise in debt that is required by companies to maintain unnecessary production facilities and the declining economic value to Chinese households of what is produced. Inevitably there will be lots of other considerations invoked by the relevant stakeholders and regulators involved in the problem of over-capacity, but they are barely relevant. If the reformers understand that the measures they take should be valued primarily in terms of their impact on reducing China’s debt burden, these reforms will be consistent with a smoother and ultimately less costly economic adjustment.

The difficulty in closing capacity of course is that it also usually means increasing unemployment. This is simply yet additional confirmation that all policy choices for Beijing boil down to choosing among higher debt, higher unemployment, and higher wealth transfers. But closing down unnecessary capacity can pay for itself, even if unemployed workers are temporarily put on the government payroll (causing debt to rise, but usually by less than it had before), but only temporarily as Beijing takes other measures to boost household income through wealth transfers from the state and so to boost consumption, a form of demand which is likely to be more labor intensive than the demand created in the process of over-capacity.

There seems to be a very clear consensus about at lleast some of the targets of the over-capacity drive. On Friday People’s Daily reported a statement released a day earlier by Premier Li Keqiang: “Steel and coal sectors should take the lead in cutting overcapacity, digest unreasonable inventories, reduce costs and improve efficiency.”

Steel and coal have been so universally recognized as problem sectors that it is pretty clear that they will not be able to escape significant cuts, but after a decade or two of extremely cheap credit (often negative in real terms), widespread moral hazard, and corporate governance incentives that prioritized production and employment above all other measures, it would be astonishing if over-capacity and bloated inventories were not a blight on most industrial sectors dominated by the state or by large companies with access to state patronage. Because these are likely to be the key causes of misallocated credit, and because measures that cut back on overcapacity are likely to be painful, and so politically resisted, if the measures do not extend well beyond steel and coal their impacts are not likely to be sufficient.

  1. Reducing real estate inventory. Conceptually there is no easier reform to explain than this one, and while I recognize that there may be innumerable legal and political implications, in fact the economics are brutally simple and incontrovertible.

The economic value of an empty apartment to the Chinese economy is exactly zero, minus running costs and depreciation, which are only partially mitigated by the positive economic impact of their role as a secure form of savings. The moment an empty apartment is occupied by a Chinese family, Chinese wealth and income are immediately increased by the value that family attaches to the change in its living standards. China is notorious for the sheer quantity of its empty apartments, and these empty apartments represent an enormous expenditure of labor and resources by the Chinese people of which a large amount of wealth is destroyed every day that the apartments remain empty.

To get a sense of the magnitude of the cost to China of residential vacancies, we would need to begin with an estimate of the number of vacant apartments. I have seen estimates of the number of empty apartments in urban China range from 64 million to as much as 89 million. I have read elsewhere that roughly between one in four and one in five urban apartments in China is empty. I assume these two sets of numbers are consistent. For comparison sake I understand that urban vacancies in China are roughly ten times the global norm – i.e. in the rest of the world one in forty to one in fifty urban apartments are typically empty.

If we assume that there are in fact 60-70 million empty apartments in China, and further assume that the average size of these apartments is 50-60 square meters and the average square meter costs roughly $1,500, then the market value of empty apartments in China is between $4.5 trillion and $6.3 trillion. The real economic value of an apartment is not necessarily the same as its market price, especially if a speculative real estate bubble has artificially boosted prices, so let us assume that the fundamental value of these apartments to Chinese households is actually between one-third and one-half of the market value. If these apartments were actually occupied, in other words, Chinese households would feel wealthier by between $1.5 to $3 trillion dollars, or roughly 12-25% of GDP.

If somehow vacancies in China were immediately to adjust to global norms, these back-of-the-envelope calculations suggest that the annual impact on household wealth would be the equivalent of an annual increase in household income of 2-3 percentage points – which increases the income of households by 4-6%, assuming that the income of ordinary Chinese households is roughly 50% of GDP.

This is not a negligible number. If the supply-side reforms Beijing is contemplating include measures that reverse the institutional distortions responsible for the very high vacancy rate in China, household income would be the equivalent of a 4-6% higher every year, and the household income share of GDP would be raised by 2-3 percentage points, which isn’t much less than has been accomplished over four very difficult years.

Reforms that fill up empty apartments, in other words, are clearly consistent with rebalancing, and are the kinds of reforms that will lower the adjustment costs for China. What kind of reforms can fill empty apartments? That I leave to smarter people than me, but if the carrying cost of an apartment, which is currently very low, were to increase significantly, most obviously by instituting an annual property tax, apartment owners would have very strong incentives either to sell or to rent out their apartments to generate enough income to cover the cost of holding apartments. The risk of course is that by forcing some owners to sell, this could cause the market to drop sharply, and while I would argue that lower housing prices represent, paradoxically, an increase in Chinese wealth, along with a redistribution of wealth from the richer to the poorer (and, not incidentally, might help President Xi flush out additional corruption), it might have a destabilizing impact on the banking system which would have to be addressed.

The point is that by placing real-estate-related reforms in the context of rebalancing, we can quickly tell which reforms are helpful and which are not. We can also see that houkou reforms aimed at diverting population flows to empty apartments in secondary cities, and away from the highly prized Beijing-Shanghai tier of cities, avoids addressing a big chunk of potential rebalancing value – empty apartments in those cities – and so these must be addressed by other policies. Finally building new low cost apartments for the poor represents an increase in debt, unless it is funded by the sale of state assets, and an increase in economic activity, but an increase in debt would only be justified by labor shortages in the relevant lower-tier cities – shortages that constrained the productivity of existing investment facilities, which is unlikely to be the case.

  1. De-leveraging and otherwise strengthening balance sheets. The purpose of this set of reforms and its consistency with the appropriate goals of rebalancing is pretty self-explanatory. There is one important point, however, that is often missed.

Debt exchanges that lower debt-servicing costs for provinces, provincial borrowing vehicles, or large corporate borrowers do not advance the rebalancing process or lower China’s adjustment costs in the least, contrary to expectations. All they do is reduce unbearably high debt-servicing costs for insolvent or nearly-insolvent borrowers by transferring part of the debt-servicing costs elsewhere. If a provincial borrower is able to swap out of an expensive loan into a bond with a much lower coupon, its debt-servicing costs will of course have plummeted, and it might finally have additional breathing space which it can put to good reforming use (although it can just as easily abuse the benefit), but every RMB it saves represents an equivalent reduction in the profitability of the bank or of some other lender, and so also a reduction in its retained earnings, and it will increase the contingent liabilities of the central government by the same amount.

The provincial debt swaps, in other words, do not reduce debt and do not reduce debt-servicing costs. They simply transfer debt from China’s provincial balance sheet to Beijing’s central balance sheet. Some economists are sophisticated enough to argue that because of the convexity of financial distress costs, this debt transfer will lower slightly overall financial distress costs for China, but this is only true if the resulting increase in central government debt – in the form of contingent liabilities, in this case – has no impact at all on the perception of central government creditworthiness. It would be extraordinary, however, if it had no impact.

  1. Fiscal expansion, including tax cuts. The optimal role of fiscal policy in lowering China’s adjustment costs is another case of reforms whose purpose should be fairly straightforward. If fiscal policy is designed to reduce income inequality, or to raise household wealth and fund this increase in wealth by the liquidation of state assets (and not by increasing debt), it will advance the rebalancing process, lower adjustment costs, and reduce the risk of disruption. Because there are a near-infinite number of ways fiscal policies can accomplish or not accomplish these objectives, it isn’t meaningful to try to list them, but the optimal set of policies involving changes in fiscal expenditures and perhaps a reallocation of tax collection, in which revenues of RMB 11.1 trillion were accumulated in 2015, according to People’s Daily, is quite clear: faster growth in after-tax, disposable household income, in which the lower the income, the faster the growth, and a reduction of outstanding debt.
  1. Lowering corporate costs directly and by reducing government bureaucracy. These may seem like the most obviously useful set of reforms, but this is only because economists mis-conceptualize the value of improvements in asset-side efficiency. These kinds of reforms, if done correctly, will benefit China in the long-term by raising productivity growth, but as in the case of the reforms implemented by Mariano Rajoy in Spain, they do not address the rebalancing process, and their net impact on reducing the country’s debt burden takes far too long to matter to China’s adjustment process. The historical precedents indicate that however effectively the reforms are designed and implemented, if China’s economic adjustment is excessively costly or economically or socially disruptive, they won’t even matter in the long term.

A new beginning, or more of the same?

My description of the kinds of supply-side reforms that Beijing may be contemplating may seem overly abstract, but the purpose of my very long essay is not to propose specific reforms that will help resolve China’s rebalancing. It is to warn against falling into the trap of economic orthodoxy. China’s problem is not that a spate of recent exogenous shocks has perturbed the economy from its path of high growth, and so it does not require efficiency-enhancing improvements to the way it manages the asset side of the economy in order to return to that high growth equilibrium.

China’s problem is a systems problem, and it is the same problem every country that has experienced a similar investment-led growth miracle has experienced. China must switch from the current growth model to a completely different growth model as smoothly as possible, and the more debt it has, and the more distorted the structure of that debt, the more difficult it will be to manage this switch smoothly. This new growth model requires that household income comprises a much greater share of GDP than it currently does, and one way or another this new model will be imposed upon the Chinese economy. The first of the only two important questions is whether the higher household income share of GDP is a consequence of a rise in household income or a drop in GDP.

Because the quality and structure of Chinese debt severely limits the options available to Beijing and significantly increases the risk of a shock causing a disruption or a crisis, one way or another debt will eventually become a lower share of China’s GDP. The second of the only two important questions is about the manner and speed with which debt is reduced. Put differently, the only way to reduce debt is to allocate the cost to some sector of the economy, and broadly speaking these sectors are the household sector, the private sector, the state sector, and the various more specialized subsectors within these three – for example households can consist of rich households versus the rest, the state sector can be divided among the central government and the provincial governments, the private sector can consist of SMEs, large corporations, labor-intensive industries, capital-intensive industries, the export sector, etc.

China can choose to avoid reducing debt for as long as possible, as Japan has done, but the cost is a near permanent state of economic stagnation and the risk is that a poor, volatile economy like that of China is unable to last as long as Japan, in which case it’s debt burden will be reduced in the form of a debt crisis or in the form of monetization by the PBoC, which is simply another way of saying that the cost of the debt will be implicitly allocated to household savers, as was the case in the Chinese debt crisis of the late 1990s.

But this would make rapid growth in consumption impossible. Without the ability to boost GDP with explosive growth in investment, as China did following the debt crisis of the late 1990s, this also means that GDP growth must collapse, and could even become negative.

Alternatively China can choose to reduce debt explicitly by allocating the costs to some sector of the economy. As I have discussed many times, including in my 2013 bookAvoiding the Fall, arithmetically and logically the only appropriate sector is the government sector, and given the need for President Xi to further centralize power if Beijing is to implement reforms successfully, it is obvious that debt costs must be allocated to provincial governments.

Of course this is politically easier said than done, but nonetheless these are the options open to China. It must rebalance and it will. It must reduce its debt burden and it will. It can do what many other countries have done in similar circumstances and waste time and resources by implementing the kinds of reforms beloved of academic economists that do not directly address the rebalancing or the debt directly, and so significantly raise its ultimate adjustment cost while running an increasing risk of crisis. Or it can take steps aggressively to direct the rebalancing and reduce the debt.

China has done the former during the past several years but Beijing’s recent announcements about supply-side reforms suggest that its leaders are frustrated by the ineffectiveness of the proposed reforms and are determined to set out on a very different path. Whether or not this very different path ends up being more of the same we will learn only over the next two or three years.

But whatever happens, this year will clearly be an important one for China, apropos of which, happy Year of the Monkey, which begins in two weeks. They say if you’re very smart you’re likely to do well this year, otherwise it’ll be a very tough year.



[1] The Chinese growth model is simply a variation on what I call a “Gershenkron” growth model, which has three main characteristics:

  1. Rapid economic growth is driven by rapid growth in investment. To achieve this rapid growth in investment, the financial system is structured so as to maximize credit expansion, and credit is directed primarily into infrastructure investment and investment in manufacturing capacity.
  2. In order to force up the savings rate so that savings can easily be directed into investment, direct and indirect taxes are used to constrain the growth in consumption by constraining the growth in the household income share of GDP. As households retain a smaller and smaller share of GDP, their consumption also becomes a smaller and smaller share of GDP. Because household consumption comprises most consumption in any economy, total consumption also declines as a share of GDP, and its obverse, savings, rises. Ideally the result is such rapid growth in GDP that even as the household share contracts, household income overall grows rapidly.
  3. The institutional settings that maximize credit growth and that constrain the growth in household income are further linked because the direct and indirect taxes on the household sector that constrain growth in household income also subsidize investment. In China’s case these taxes have mostly been indirect and include low wage growth relative to productivity growth, an undervalued currency, environmental degradation, the rights of eminent domain, moral hazard and, most importantly, financial repression.

Many countries have employed variations on the Gershenkron model and have achieves spectacular growth. All of them, however, have ended up with very difficult adjustments and significant debt problems. The sequence is usually the following:

  1. At first it is easy to identify productive investments and the system pours credit into these areas, achieving very and unbalanced rapid growth that is both wealth-creating and sustainable.
  2. At some point however the economy begins to reach investment saturation, and this is especially a problem in poor countries because most poor countries are poor because they do not have the institutional ability to absorb and exploit resources productively. When they reach this point continued rapid credit expansion results in credit growth that exceeds the growth in debt-servicing capacity, and the country’s debt burden begins to grow unsustainably.
  3. At this point the economy must switch to a new growth model that focuses not on continued expansion in investment but rather on implementing the institutional reforms that will allow businesses and citizens to exploit resource more efficiently. These reforms are usually described as a kind of “opening up” or “liberalization”, and require substantial changes in the educational, financial, and legal systems as well as an elimination of the direct and indirect taxes that had constrained the growth in household income and the subsidizing of investment.
  4. Because these reforms are always strongly opposed by the elite that grew up around and had benefitted from the Gershenkron model, the reforms are strongly resisted and in every case in history the result has been a dangerously excessive build-up of debt.
  5. Ultimately either the reforms are implemented against strong political opposition or, if they are not, the economy suffers from a crisis, usually a debt crisis, in which it rebalances disruptively. Whether or not the rebalancing occurs disruptively, the longer the debt burden is allowed to grow the more painful the adjustment.

[2] And as Albert Hirschman reminded us, all rapid growth is necessarily unbalanced.

[3] The orthodox world seems to be one that approaches that described by Adam Smith, in which we can assume a near-infinite number of economic entities, none large enough to have an impact on input or output prices, and in which there do not seem to be significant institutional constraints. In fact the only variables that operate as institutional constraints, and so the only variables that can prevent rapid adjustment towards equilibrium, are wage stickiness, along perhaps with certain kinds of price stickiness.

I suspect that in many orthodox models household savings preferences are also implicitly a kind of constraint that can occasionally change independently for reasons that are not specified (i.e. if there is a change in the household savings rate that cannot be modeled by demographics, income levels, unemployment, or various kinds of economic uncertainty, we simply assume that households have decided to become more or less thrifty). Efficiency in this world is usually maximized when the economy achieves some idealized equilibrium. Exogenous shocks can move the economy away from this equilibrium, and wage and price stickiness, along perhaps with rigidities in savings preferences, will slow the adjustment process by which the economy returns to equilibrium, but in the long run if left to its own devices the orthodox world always returns to equilibrium, rendering economic policy-making largely useless.

In the short run however the orthodox world accepts that fiscal and monetary policies can speed up the adjustment towards equilibrium, largely it seems by countering these constraints, or by setting interest rates in order to manage investment and consumption. There is a great deal of disagreement between those who seem to think that monetary policy is largely ineffective and those, known as monetarists, who followed Keynes in attaching importance to changes in the demand for money while berating him for not stressing the inflationary impact of money creation. Whether the disagreement between the two is a trivial one or is of major theoretical and practical significance seems mainly to depend on how seriously you take the neo-classical synthesis, but I think both the orthodox and the unorthodox would agree that it isn’t a good idea to confuse anything Keynes might have actually said or believed with any of the various “Keynesian” schools.

I try to describe this “orthodox” world because even though I suspect most mainstream economists would agree that the Chinese economy in no way resembles one that is comprised of a very large number of agents too small to affect output or input prices, in which there no major institutional constraints, in which unsustainable credit expansion cannot persist except over a very brief period, and imbalances return automatically and fairly quickly towards efficient equilibrium. As I have discussed many times, however, this world is very rigidly embedded into most of their models and analyses.

For those who are interested, Hyman Minsky lists the conditions implicit in the world of orthodox economists, with tremendous sensitivity, in the 5th chapter of his bookStabilizing an Unstable Economy. In my September 1 blog entry I argued that economists typically focus on managing the asset side of the balance sheet, and almost never on the liability side, because they implicitly understand both the extent and the nature of economic growth to be almost wholly a function of the ways in which assets are managed. If you want to increase the growth rate of an economic entity, in other words, you must do so by improving the efficiency with which its assets are managed.

But this is only true under certain specific circumstances. In any economic entity in which either debt levels are high enough to introduce uncertainty into the debt-servicing process or the balance sheet is sufficiently distorted or inverted to transform the incentive structure or exacerbate or otherwise affect the impact of exogenous changes, the relationship between the value of assets and the value of liabilities can in itself increase growth, reduce it, or cause it to collapse.

[4] This very important but surprisingly poorly understood feature of balance sheet fragility was something that Irving Fisher often discussed when he insisted on the distinction between the events that trigger a crisis and the underlying “cause” of the crisis. In the early stages of the GFC, for example, optimists often pointed out that the total outstanding amount of US sub-prime mortgages was too small to matter much to the US economy, but the fact that something so “small” triggered so large a disruption simply means that balance sheets were extremely fragile and increasingly susceptible to smaller and smaller shocks. That is why while it is true that the Chinese stock market is too small to matter in any “fundamental” sense, that doesn’t mean we can completely rule out in the future its impact on a larger disruptive process.

[5] The only clear historical exception I can find in the past 200 years is the case of Romania in the 1980s. Nicolae Ceausescu, worried by political instability in Poland after it had been forced to restructure its debt (Poland was one of the 32 sovereign creditors participating in the “LDC Debt Crisis” of the 1980s), and concerned perhaps about the implications of a debt restructuring for his domestic reputation as a policymaker, chose to repay in full the $13 billion the country owed, which it did ahead of schedule in 1989 by imposing brutal austerity. Few think it is a coincidence that shortly thereafter, when he and his wife were captured quickly executed, there was general jubilation among Romanians.

Colombia and the USSR were technically not among the restructuring countries, although they traded as such (their loans were “voluntarily” rolled over by banks unwilling to add to the pool of formally restructured sovereign debt) and engaged in direct and indirect discounted buybacks. Chile was among the restructuring “LDCs” and was one of the only major restructuring countries, I believe, that did not request or receive a Brady restructuring with a formal discount. It was however among the most active participants in direct and indirect discounted buybacks, especially through its famous “Chapter 18” and “Chapter 19” debt-equity swaps.

A well-known economists suggested to me that the only exception he could think of was England after the Napoleonic wars, and although I am not sure whether it indeed is an exception, it is noteworthy that except for the case of Romania, which is not really an exception because it did not grow its way out of the debt but rather imposed brutal austerity, we would have to go back 200 years to find an exception. It is surprising that this very consistent and remarkable history has not at least been acknowledged by economists who have recommended with great confidence programs aimed at allowing overly-indebted sovereign entities to grow their ways out of their debt burdens.

[6] There is a great deal of confusion about this. In a January 13 panel discussion organized in Moscow at the Gaidar Institute Conference at which both Peking University colleague Lin Yifu and I participated, Dr. Lin proposed China’s experience during the past decade as precisely one case in which a country with an excessive debt burden was able to grow its way out of the debt with no partial forgiveness and no allocating to some other sector a substantial portion of debt servicing costs.

But it turns out that China was not an exception. China during this time had nominal GDP growth ranging typically from 16% to 20% and its GDP deflator was typically 8-10%. Interest rates however were extraordinarily low by any standard. The lending rate was around 7% and the deposit rate around 3.5%. While the standard explanation is that bad loans were resolved by transferring them to the AMCs and liquidating them efficiently, in fact the AMCs purchased most of the loans in two tranches, one at full face value and one at 50% of face value. I believe that they were able to liquidate only a portion of this portfolio, and at less than 25% of face value.

The AMCs received the full funding for these purchases from the banks that sold them the bad debt in the form of 10-year bonds, many or most of which were subsequently rolled over for a second ten-year period. Clearly this did not involve any transfer of value.

However under the nominal GDP growth and GDP deflator conditions described, a lending rate of 7% was clearly concessionary by any standard, and by at least 5-7 percentage points. In that case it is easy to calculate that the amount of debt forgiveness for just the first 10-year period ranges from 28% to 36% on all loans. The costs were borne, of course, by household depositors, who bore an additional cost to recapitalize banks equal to approximately 9% of their savings, in the form of a spread between the lending rate and the deposit rate that was roughly double the standard spread.

China did not simply grow its way out of its loan problem of the late 1990s, in other words. It implicitly passed onto households between an amount equal to between a third and a half of the value of the loans in order to recapitalize the banks and grant debt forgiveness to insolvent borrowers. It was no coincidence, of course, that during this time the household income and consumption shares of GDP plummeted, from already low levels. The impact of lagging consumption growth on GDP growth was countered, obviously, by soaring investment.

While this was a very successful way of repairing the damage caused by bad lending in the 1990s, China of course cannot use the same mechanism again. Rebalancing requires that consumption growth exceed GDP growth, and Beijing fully understands that it cannot use a surge in investment to counter the impact of such a huge transfer of wealth from the household sector.

[7] A recent editorial in Caixin makes the point a little bluntly: “Some officials have recently placed their hopes of avoiding painful reforms on the “belt and road” initiatives, arguing that they will export their way out of excess. But new markets opened by these programs will not be big enough to absorb all of China’s excess capacity. We have already witnessed backlashes in some developing countries against China’s steel exports. Such resistance will become stouter.”

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