By Michael Pettis
No matter how sincere its intentions, what Beijing says it will do over the next few years is meaningful only if its policies are both internally consistent and do not violate external constraints. As I proposed two weeks ago, in this post I will try to lay out as logically as possible the economic options available to Beijing, with some discussion of their limitations. Any decision made by Beijing that is not consistent with these options, I will argue, is not worth taking seriously as a prediction of the future.
To try to work out what these options might be I will begin with two key assumptions. The first is that the fundamental imbalance in China is the very low GDP share of consumption. This low GDP share of consumption, I have always argued, reflects a growth model that systematically forces up the savings rate largely by repressing consumption, which it does by effectively transferring wealth from the household sector (in the form, among others, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidize and generate rapid GDP growth.
As a consequence of this consumption-repressing growth model, Chinese growth is driven largely by the need to keep investment levels extraordinarily high. What’s more, the very high growth rate in investment, combined with significant pricing distortions, especially in the cost of capital, has resulted in massive overinvestment and an unsustainable increase in debt. China cannot slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP.
My second major assumption is that China must and will rebalance in the coming years – its imbalances, in other words, cannot get much greater and we will soon see a reversal. There are two reasons for saying this, neither of which has to do with the claims being made by Beijing that they are indeed determined to rebalance the economy.
The first reason is the debt dynamics. Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a “lost decade” of very low growth.
At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP. How? When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but it will rebalance through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.
Before any journalist reading this decides to write an article with the headline “Peking University Professor Predicts China Collapse,” I must stress that I am not saying that a collapse in growth must happen, or even that it is likely to happen. My argument here is only that if the unsustainable rise in debt isn’t addressed and reversed, China must eventually reach its debt capacity limit, and this will force a catastrophic rebalancing.
I expect however that Beijing will begin rebalancing well before we reach the debt capacity limit. I will discuss later how Beijing can engineer the rebalancing process, but the point here is just that either Beijing forces rebalancing, or rebalancing will be forced upon China in the form of a debt crisis. One way or the other, in other words, debt will force China to rebalance.
The second reason for assuming that China will rebalance is because of external constraints. Globally, savings and investment must balance. This means that for any set of countries whose savings exceed investment, like China, there must be countries whose investment exceeds savings, like the US. To put it another way, the world can function with a group of underconsuming countries only if they are balanced by a group of overconsuming countries.
For the past decade the underconsuming countries of central Europe and Asia, of which China was by far the most important, were balanced by overconsuming countries in peripheral Europe and North America. But conditions are changing. The overconsuming countries are being forced to reduce (in the former case) or are working towards reducing (in the latter case) their overconsumption.
To the extent they succeed, by definition unless there is a surge in global investment – which given the weak state of the world is very unlikely – underconsuming countries must increase their total consumption rates, or else the world economy cannot balance savings and investment. This global rebalancing must involve China. As the biggest source of global underconsumption by far, it is very hard to imagine a world that adjusts without a significant adjustment in China.
This adjustment won’t be easy, especially if Japan, as I argued two weeks ago, is attempting to resolve its excess debt problems by forcing up its savings rate. One way or the other, however, it must happen, either with a surge in consumption in the underconsuming countries or with a fall in production – both of which accomplish the same thing, albeit in very different ways.
How can China rebalance?
How plausible are my two assumptions? I think the first one may have been controversial in some quarters as recently as three years ago, and there still are a few who disagree, but it is pretty much accepted among most economists, and it has certainly been a formal part of Beijing’s discourse. Everyone from Premier Wen and Vice Premier Li on down has insisted that Beijing’s consumption imbalance has reached danger levels, and that China must and will rebalance.
Here, for example, is the South China Morning Post on the subject:
“China is landing quite well. Its inflation is down, investment and growth has slowed,” said Zhu Min, IMF deputy managing director, yesterday during his first speech in Hong Kong since assuming his new position in July of last year. “However, it still needs to carefully manage its investment-driven development model, as investment takes up about 48 per cent of gross domestic product.”
Zhu’s words echoed a string of heavyweight calls for reform, including ones from Premier Wen Jiabao and Vice-Premier Li Keqiang and scholars at China’s central bank and the national state council. Li said over the weekend that “reforms have entered a tough stage”, and that “China has reached a crucial period in changing its economic model and [change] cannot be delayed”.
The fear is that the current situation, in which exports and investment contribute to most of China’s GDP growth, is no longer sustainable. Export growth to Europe, the largest trading partner with China, had dropped almost to zero, and an investment driven economy had left the country with a huge pile of debt that could potentially go sour, economists said.
My second assumption – that China will necessarily rebalance in the next few years – is I think also very plausible. In fact over the long run it is actually more than just plausible. It is an arithmetical certainty because it can only be violated if China has unlimited borrowing capacity and if the world has unlimited appetite for rising China trade surpluses. Neither is true.
Where some analysts might disagree with my second assumption is in the issue of timing. China bulls continue to argue that there isn’t yet a significant overinvestment problem in China, which implies that debt is not rising at an unsustainable pace, or if it is, that it can continue rising for many more years before the debt burden itself becomes unsustainable. This, for example, is the view of the folks at Dragonomics, and it is a view often expressed sympathetically in The Economist.
This disagreement with my assumption also implies that the consumption imbalance is temporary and can resolve itself gradually and over time as the benefits of earlier investment begin to emerge and eventually overwhelm the total costs of those investments. Of course if this is true China does not need a surging current account surplus because if investment isn’t being wasted it can keep investment rising faster than savings for many more years. The current account surplus, remember, is just the excess of savings over investment.
The key vulnerability of my argument, then, is whether or not you think investment in the aggregate is being misallocated in China and has been for many years. If you agree that it has, and that it has reached unsustainable levels, then you must also agree that consumption must become a greater share of GDP over the next five to ten years. What’s more, you should also agree that the only way to increase the consumption share of GDP is to increase the household income (or wealth) share of GDP.*
China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption.
This is the key prediction, and it implies that one way or the other Beijing will engineer a transfer of wealth from the state sector to the household sector. As I see it, the various ways in which this transfer can take place can all be accounted for by one or more of the five following options:
- Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.
- Beijing can quickly reverse the transfers in the same way.
- Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.
- Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt.
- Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
Notice that all of these options effectively have China doing the same thing: In each case the state share of GDP is reduced and the household share is increased. There are however very big differences in how the changes are distributed among various parts of the household sector and the state sector.
Notice also that the changing share of GDP tells us little or nothing about the actual GDP growth rate, or about the growth rate either of household wealth or of state wealth. It just tells us something very important about the relative growth rates. For example we can posit a case in which GDP grows by 9% annually while household income grows by 12-13% annually. In that case the rest of the economy would grow by roughly 5-6% annually (household income is approximately half of GDP), and the distribution of this growth would be shared between the sate sector and the business sector. This might be considered the “good case” scenario of rebalancing.
Alternatively, we can posit that annual GDP growth is 0%. In that case the annual growth in household income might be 3-4% while the state and business sectors contract at roughly 3-4%. This would be the “bad case” scenario.
The political economy of rebalancing
It is worth making three points about these different scenarios. First, in both cases China rebalances, but the way in which it rebalances can have very different growth implications. Second, notice that even in the bad case, household income growth can be quite robust, which means that fears of social instability as Chinese growth slows are very exaggerated if a slowdown in Chinese growth occurs with real rebalancing.
But – and this is the third point – that’s not all. The real cost of the rebalancing, it turns out, falls on the state sector, and we will have to keep this in mind as we consider the choices that Beijing must make.
Remember that for the past twenty years, and especially in the past ten years, the state and business share of a rapidly growing economic pie was also growing, which meant extraordinary growth in the value of assets controlled by the state sector. The household share of the growing economic pie of course contracted, but the rapid growth in the pie ensured that households nonetheless saw their income grow quite rapidly even as their share of total income declined.
When we reverse this process, as we must if there is to be rebalancing, any slowdown in GDP growth will be minimally felt by the household sector (if the rebalancing is managed in an orderly way), but even a scenario of very high GDP growth must result in much slower growth in the value of state sector income and assets. Of course if GDP growth actually slows sharply, which I expect it will, the growth in the value of state sector assets will collapse and perhaps even turn negative.
In my opinion this change in the growth rate of the state sector will be at the heart of the political economy choices, and difficulties, that Beijing will be forced to address in the next few years. It is likely to be much easier to keep political leaders happy when the value of the state sector is growing comfortably in the double-digit range than it is when it is growing in low single digits, or even contracting.
Minxin Pei from Claremont McKenna (and also the Carnegie Endowment) implicitly makes a similar argument in a clear and intelligent recent piece for Project Syndicate. In it he says:
When sound economic advice is divorced from political reality, it probably will not be very useful advice. The history of multilateral financial institutions like the International Monetary Fund and the World Bank is littered with well-intentioned and technically feasible economic policy prescriptions that political leaders ignored. But that has not stopped these institutions from trying.
The latest attempt is the World Bank’s just-released and much-applauded report China 2030: Building a Modern, Harmonious, and Creative High-Income Society. As far as technical economic advice goes, the report is hard to top. It provides a detailed, thoughtful, and honest diagnosis of the Chinese economy’s structural and institutional flaws, and calls for coherent and bold reforms to remove these fundamental obstacles to sustainable growth.
Unfortunately, while the Bank’s report has laid out a clear economic course that Chinese leaders should pursue for the sake of China, the Bank has shied away from the most critical question: Will the Chinese government actually heed its advice and swallow the bitter medicine, given the country’s one-party political system?
Pei argues that there are serious political constraints to Beijing’s ability to force the necessary reforms recommended by the World Bank. For example when it comes to reducing the power of inefficient and wasteful state-owned enterprises:
There is little doubt that reducing the SOEs’ power would make the Chinese economy far more efficient and dynamic. But it is hard to imagine that a one-party regime would be willing to destroy its political base.
The consequences of rebalancing
In a sense Pei makes the same argument I do, but from a different angle. I say that you can discuss as much as you like what Beijing proclaims it will do, but what it actually does will necessarily be constrained by what is economically possible. Pei says you can talk all you want about what economic policies Beijing will follow, but what it actually does will necessarily be constrained by what is politically possible. If you were to superimpose Pei’s political constraints on top of my economic constraints, you would presumably be left with a much more accurate measure of what can actually happen.
I leave the politics of economic decision-making to people like Minxin Pei and UC San Diego’s Victor Shih, but in thinking about the economic constraints it might be useful to examine each of the five options I have listed above. This allows us to see what the consequences for growth each of the options might involve, what disadvantages they have, and how they would play out.
1. Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, raising the foreign exchange value of the currency, and raising wages, or by lowering income and consumption taxes. This path simply means the reversal of the process over the last decade during which the imbalances were created.
Repressed interest rates transfer wealth from household depositors to state and business borrowers, so interest rates must be gradually raised to approach nominal GDP growth rates, and as this happens the hidden transfers will be reduced to zero or close to zero. An undervalued currency transfers wealth from households to the tradable goods sector, so the value of the currency must be raised, and this will cause the transfer to drop to zero. Low wage growth transfers wealth from workers to employers, so rising wages should be encouraged, and this growth in wages relative to productivity will reduce the transfer to zero.
- This policy fits into the gradualism which has pretty much been the default setting for most Chinese economic policymaking since the dramatic reforms put into place by Zhu Rongji, China’s Vice Premier and Premier in charge of economic policymaking until 2003.
- Since China’s export success and economic growth depends heavily on hidden subsidies from the household sector, this strategy allows the subsidies to be removed slowly so that Chinese businesses have time to adapt. As they do, the adverse employment impact of removing the subsidies can be counterbalanced by the positive employment impact of rising household consumption, so that there is no surge in unemployment.
- Rebalancing is inflationary. As rebalancing forces consumption up relative to production, we will see a reduction in China’s ability to keep inflation down even in the face of rapid monetary growth. In fact this is likely to be the case under any of the rebalancing scenarios – inflationary pressures will increase as the policies that kept inflation in check by constraining consumption growth are eased. However it is worth noting that most Chinese inflation until now has been food intensive and so has resulted in significant transfers of wealth from the poor, for whom food is an important component of consumption, to the rich, for whom it isn’t. Inflation under the rebalancing scenario will not primarily affect the food sector and is far more likely to affect the rich and middle classes. In that sense it might be less socially disruptive for the poor.
- The biggest problem with this strategy is that it is too slow and too late. Five or six years ago Beijing could have begun rebalancing gradually, but Beijing no longer has enough time. Remember that the total value of these subsidies are enormous – for example I have cited in earlier newsletters studies that suggest that the value of hidden subsidies to the SOE sector in the past decade may be anywhere from five to eight times their aggregate profitability. This means that gradually removing the subsidies at a pace the Chinese economy can handle will result in worsening domestic imbalances for many years before there has been enough of an adjustment. During this time the impact of those distortions – declining consumption relative to GDP, misallocated investment, and rising debt, above all – will continue to grow.The more bad investment China accumulates, the more costly the eventual adjustment will be and the more the adjustment process must be slowed. Gradual adjustment increases the risk of China’s reaching debt capacity limits to almost near-certainty. It is too risky, in other words, for China to adjust gradually, even though Beijing would like nothing better, and some of the policymakers in Beijing seem to realize this.
2. Beijing can quickly reverse the transfers by forcing up real interest rates in the next two years, raising the foreign exchange value of the currency in a large one-off revaluation, and raising wages quickly.
- By adjusting very quickly Beijing would immediately put a stop to the worsening of the domestic imbalances, it would eliminate the strong incentives within China to waste money on a stability-threatening scale, and it would allow Beijing finally to get a grip on its ballooning debt.
- Eliminating the hidden subsidies abruptly would cause a massive increase in financial distress. This would lead almost certainly to a surge in unemployment as exporters and borrowers are forced into closing down operations. In the short term, rather than see household income in the aggregate rise, we would probably see household income decline because the negative impact of rising unemployment would exceed the positive impact of reversing the wealth transfers. The feedback effect of declining household consumption could force the economy into a downward spiral, much like that of the US during the Great Depression. China’s economy would still rebalance in this case – probably through negative growth in household income and even more negative GDP growth – but it would rebalance under very difficult economic and social conditions. Needless to say this would also result in difficult political conditions.
3. Beijing can directly transfer wealth from the state sector to the private sector by effectively privatizing assets and using the proceeds directly or indirectly to boost household wealth.
- This is the most efficient way to increase household wealth at the expense of the state sector. Beijing could transfer wealth directly, by giving peasants land, by giving households shares in state-owned companies, by privatizing state assets and using the proceeds to shore up the social safety net, or in a number of other ways. It can also do so indirectly by selling and privatizing assets and using the proceeds to shore up the banks or to clean up loans. Remember that non-performing loans, which for our purpose should include loans that would be non-performing if lending rates were raised to levels that eliminated the hidden subsidy, represent a future claim on the household sector. By eliminating this future claim, household wealth will immediately increase – and this would most likely manifest itself as higher deposit rates returned to depositors. The combination of privatization plus the elimination of subsidized capital would eliminate the tendency for the Chinese financial system to waste capital on a massive scale.
- Transferring assets from the sate sector directly or indirectly is only meaningful in the context of a significant reform in corporate governance. As the whole “vested interests” debate in China suggests, and as the Minxin Pei essay I cited above argues, there is tremendous resistance to the loss of power and control this would impose on many important and powerful sectors and families within China.
4. Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt. This is what Japan did after 1990, when government debt rose from roughly 20% of GDP to the 200-250% of GDP as the government effectively absorbed the bad loans in the banking sector.
This may at first seem counterintuitive as a form of wealth transfer, but remember that my taking over your debt has the same net impact on your and my wealth as my giving you my assets. In either case I am transferring wealth to you. How does this benefit the household sector? Mainly because as corporate debt is absorbed by the state it allows them to stay in business (i.e. not fire workers) and expand even while wages are rising (and it is rising wages that will increase household income).
- This turns out to be very easy to do politically because it does not entail taking away assets, or the control over those assets, from anyone.
- As we saw in the case with Japan, this strategy eventually leaves the government after a decade or so struggling with too much debt. The debt burden itself becomes the biggest impediment to growth since the direct or hidden taxes required to service it reduce consumption-driven growth, and the size of the debt limits policy choices for the government.
- This strategy also prevents the right kind of interest rate adjustment because the burgeoning government debt forces the central bank to keep interest rates low or risk government insolvency. In the end interest rates must adjust one way or the other, and the only way Japan was able to raise real interest rates to their “natural” level, and so prevent the worsening of investment misallocation, was through annual GDP growth rates of less than 1%. Since the gap between the nominal lending rate and the nominal growth rate is essentially the measure of the subsidy that net depositors provide to net borrowers, as growth rates dropped, so did the financial repression tax.
5. Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources. Hiring unemployed and unproductive workers means a transfer of wealth from the state to the workers. If this transfer is paid for by the household sector (through explicit taxes or through hidden taxes, like higher financial repression taxes caused by expanded government borrowing), it will have a minimal impact on household consumption. If it is paid for out of state assets, it will improve household consumption.
- This protects workers from rising unemployment.
- Hiring and paying unproductive workers is extremely inefficient and can only be a temporary solution to the rebalancing problem. More importantly, it doesn’t address the fundamental problem of how these payments are to be funded.
How will Beijing choose?
As I see it these are ultimately the only options – or at least the major set of options – Beijing can choose to follow over the next few years if it wants to avoid a debt crisis. Of course Beijing doesn’t have to choose only one of the above options. What is more likely in fact is that policymakers end up choosing a combination.
For example we can posit the following. Beijing can choose an intermediate path between the first and second options, and raise interest rates sharply over the next two or three years while also raising the value of the RMB by 10-15% in an overnight maxi-revaluation.
In order to protect workers from the resulting surge in unemployment, Beijing can instruct state-owned companies and local governments temporarily to hire a huge number of workers for make-work programs (the fifth option) and initially pay for this by increasing borrowing (the fourth option). At the same time it can begin a massive program of privatization, which should include transferring ownership of land to peasants, and selling off assets and using the proceeds to shore up the social safety net and to pay down debt in the banking system.
This would certainly work economically to rebalance China in a way that guarantees fairly high growth rates over the rest of the decade, but is it politically possible? Here I would defer to Minxin Pei, who might argue that the scale of privatization required is not possible politically. In that case China would end up being forced into rebalancing via the fourth option, with a long-term surge in government debt.
And this is my point. If you believe my assumptions are correct, then you should agree that China has no choice but to follow one or more of these paths. If privatization is not an option, then a collapse in the economy caused by a rapid adjustment in interest rates and the currency (the second option) might be. If that is ruled out, then perhaps the outcome will be a surge in government debt (the fourth option again), and so on.
This what I mean by the economic constraints that limit the choices Beijing can make. It doesn’t matter what anyone thinks or wants Beijing to do, if the plan violates the economic constraints, it cannot be done. To be really complete we should outline the political constraints, the environmental constraints, the demographic constraints, the external trade constraints, and so on, although of course this is way beyond my ability, but each of these exercises allows us to escape from the confusion of stated intentions and to focus on the possible.
This is an abbreviated version of the newsletter that went out two weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
* Technically there is another way, and that is for household debt to surge as households borrow to fund consumption, but most evidence suggests that consumer financing is correlated with household wealth, and anyway it will take China many years to develop a robust consumer financing infrastructure.