As the debate over the rebalancing of the Chinese economy continues, I thought it might be useful to discuss a few recent articles on just that subject as a way of helping to illustrate the debate. This issue of the newsletter, like the last, will be a little conceptual, by which I mean rather than discuss actual events I want mainly to discuss ways of framing the debate. Among other things, as the title implies, I want to suggest what a bullish argument on the Chinese economy must accomplish in order to be credible
…In both of the “debates”, and in conversations I have had with other senior officials, my “opponents” (although that is too strong a word since there were many areas of agreement) largely constrained themselves to three arguments, which are the same three very unsatisfying arguments that we have heard many times before. First, they presented historical data showing rapid Chinese growth rates in the past three decades and proposed past growth rates as evidence of rapid Chinese growth rates in the next two decades.
Second, they asserted (many times) that since past predictions of failure have all turned out to be wrong (a widespread misperception, by the way), future predictions must also be wrong. And third, they produced a number of what seem to me largely circular arguments – for example the claim that urbanization leads to growth and growth to urbanization, and so the process must continue, or the claim that since productivity has soared, past investments in the aggregate have been justified, even though the data “proving” the increase in productivity implicitly assumes that past investments have been economically justified. Except for reports of capital fleeing China, one could easily get the impression that even senior Chinese non-economists really don’t understand why the likes of Wen Jiabao, Li Keqiang, and now Xi Jinping seem so worried.
…I am not saying of course that there is no credible argument for the bull case. In order to argue that we will not see a sharp slowdown in Chinese growth, however, I would propose that it is not enough to claim that some expert or the other has predicted that Chinese growth will not slow down. Nor can we argue (which is much the same thing, I suspect) that China has grown rapidly in the past so it must grow rapidly in the future. And finally, and most foolishly, we cannot assert, as I have heard many times, that Beijing leaders cannot tolerate growth below 8%, so of course growth will not drop below 8%.
How to be bullish on growth
To counter the current level of pessimism with the bull case it seems to me that we must answer specifically three questions. The first question, of course, has to do with debt. How much debt is there in China, in other words, whose debt servicing costs (adjusted upwards to eliminate interest rate and other subsidies) exceed the economic value creation of the projects funded by that debt.
Just as importantly, we need to show which sector of the economy will be forced to pay for the difference. Remember that excess debt doesn’t pay for itself, and if you cannot identify who is paying, then you haven’t resolved the problem. Many people, for example, argue that bad debt isn’t a problem for the same reason that China “grew out” of its debt crisis of the late 1990s. This is idiotic. China did not grow out of the debt. It merely forced the cost of the crisis onto the household sector through repressed interest rates and a wide spread between the deposit and lending rates.
This solved the banking crisis, but at the expense of the household sector and so directly caused China’s already very low household consumption rate to collapse. The important implication is that bad debt this time around cannot be resolved in the same way if we expect consumption to power economic growth, rather than lag it as it did during the period in which the banking crisis was resolved.
I have discussed in this newsletter several times the likelihood of falling steel prices causing a surge in bad loans – as banks discover the non-existence of the collateral.
…The same analysis suggests that this will turn out not to be a problem only in the steel industry. Comparable losses will pop up in a wide variety of industries, most obviously copper.
…These kinds of conditions, of course, must be part of our analysis of Chinese debt and why it is not going to be a problem if we are to proffer a much more bullish story on Chinese growth. All these bad debts must be resolved, and one sector of the economy or the other will necessarily be on the hook to make up the difference between the real cost of the debt and the economic value created by the debt. Which sector?
Investment and consumption
The first question, on debt, is of course closely related to the second important question, which has to with overinvestment. Are there significant areas in which Beijing can and will invest so that the real increase in economic value creation exceeds the unsubsidized cost of capital?
Even this question is a little more complicated than simply looking for good investment opportunities in China and then assuming that the bulk of future investments will go there. There are of course many areas in which the value of investment is likely to be positive in the very long term, such as primary education and social housing, but it is important to remember that these don’t pay off their investments for at least a generation or so, in which case they do not help address the current imbalances.
On the contrary, they make them worse for many years before they start reducing debt and rebalancing the household sector. The only kind of investment growth that can help China address its debt overhang is investment in projects in which the increase in productivity in the next five to ten years exceeds the unsubsidized cost of the investment.
This is a very simple but powerful condition. Any debt-funded investment that does not satisfy this condition must make the debt problem worse. The bull case must identify trillions of dollars of such potential investment and then show that in spite of constraints that led in the past to uneconomic investment, these “good” investments are likely to be made on a substantial scale.
The third question is about future sources of growth. Since it is now widely accepted that investment growth must slow sharply (unless we can find – and execute in spite of political constraints – many trillions of dollars of these new “good” investments) it is obvious that only a surge in consumption growth can replace investment.
So the question for the bulls is: how specifically will China cause consumption to surge? Since at least 2005 Beijing has tried to force up the growth rate of consumption and it has not been able to do so. More worryingly, there is some evidence that the growth rate of consumption may be dropping.
But – and this is just arithmetic unless we assume explosive growth in the external sector – if investment growth drops, consumption growth must rise by a much larger number (because consumption is much lower than investment) to maintain the same level of growth. If you cannot specify the mechanism that will cause consumption to grow (and please don’t propose an improvement in the social safety net), unless you deny that China must reduce investment growth you have no choice but to accept that GDP growth will slow sharply.
Any China bull that does address these three questions is missing the point. I am of course not suggesting that there is no answer to these questions. I’ve already written extensively on steps China can take – economically efficient but politically difficult – to address both debt and consumption growth. Any bullish forecast, however, that cannot come up with answers to these three questions is as useful as forecasts in 1989 and 1990 that Japan would get over its own domestic imbalances and continue growing by 7% annually for the next two decades – because it had always grown quickly in the past.
…So if anyone wants to continue to be very bullish about Chinese growth prospects over the next decade, it seems to me that he must address and answer these three questions:
1. How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
2. What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
3. What mechanism can be implemented to increase the growth rate of household consumption?