Michael Pettis has recently published a post discussing an article that appeared in the FT some weeks ago, authored by Gabriel Wildau, Yuan Yang and Tom Mitchell, which discussed the economic dilemmas China will have to face in the (near) future given the current high levels of corporate debt and (still) high levels of corporate investment. We found both Pettis’ post and Wildau et al. article very interesting and quite similar in spirit to what we have written several times (here and here), and because we have not published anything on China for several months, we thought it could be a good time to provide a brief update of our views.
But first, it may be useful for our readers to explain briefly the main arguments posed by Wildau et al. and Pettis, respectively. The main goal of the FT article is to go through three different counterfactual rebalancing scenarios, discussing also the extent to which they could happen or not. Although the hypothetical scenarios are discussed in a heuristic way and the article does not crunch any numbers in detail (as we usually do, or for that matter, Pettis), we cannot but agree on the importance of that approach. Because several economic variables are, in principle, politically determined by Beijing, the dynamics of the Chinese economy are more ‘deterministic’ than in any other economy of the world, so the paths that the rebalancing process can take can be reduced to a handful of possible scenarios.
The first possible scenario proposed by the FT article (the most optimistic one by any standard), which we can dub ‘the conventional wisdom up to now’, posits that because consumption and the needs of the Chinese population (holidays, healthcare, education, and so on) are growing, there is an ‘unlimited demand’ for everything. According to this scenario, we are told that the growth in consumption will fill the void left by investment, and that the rebalancing process will proceed smoothly with high GDP growth rates and no major financial disruption.
The other two scenarios are quite similar, in the sense that they argue that the rebalancing will not proceed in a smooth way: China will either face a long period of stagnation à la Japanese (scenario 2) without a severe crisis, or a shorter but more dramatic economic downturn (scenario 3). The FT article argues that one possible trigger for the latter outcome could be a wave of shadow-bank defaults, a sector that has recently grown tremendously (more on this later).
On the other hand, Pettis’ post works more carefully through the assumptions of the different scenarios. For regular Pettis’ readers, it would not be a surprise to find out that he thinks that the most likely scenario is the prolonged economic downturn, although he sees increasing evidence that we may not be so far anymore from the third one. As he says:
I continue to think that a financial crisis in China is unlikely, but as debt levels rise, it takes smaller and smaller shocks to cause balance sheet unraveling, and so a crisis becomes increasingly likely if the debt burden continues to soar. Contrary to widespread beliefs, financial crises are not caused by insolvency. They are caused by systemic asset-liability mismatches acute enough that a collapse in liquidity make impossible to bridge.
As our readers know, we have little disagreement with Pettis’ analysis, but we would like to stress two points in which we differ. First, we think that the rebalancing process could be handled easier if the growth rate of nominal GDP were higher, not lower. And second, at this point, the most likely outcome for China will be a severe economic crisis, and not a long period of stagnation, as Pettis suggests. Scenarios 1 and 2 could have been the most likely outcomes several quarters ago, but they are not on the table any more, given recent developments (or lack thereof). Since we wrote our first piece on the Chinese rebalancing in the summer of 2015, we have not seen any material evidence (rather, quite the opposite) that the rebalancing is under way. Although it is true that ‘supply side’ reforms (i.e. closing down excess capacity) have gained a bit of momentum over the last year, the steps taken so far are inmaterial for the size of the problem. We think that there is virtually no way at this point to accomplish the rebalancing process without a severe financial crisis, unless Beijing takes an exact number of measures that we deemed to be highly unlikely.
Are lower GDP growth rates more beneficial for the Chinese rebalancing?
The crucial step in the rebalancing process is how to manage the high levels of Chinese debt in an efficient way. The faster Beijing reins in the levels of debt, the higher the likelihood that the rebalancing will be carried out in an orderly fashion. Pettis has been advancing this valuable idea for long, at a time when many international analysts did not see any reason for concern in Chinese debt levels. But Pettis believes that it will be easier to stabilise the debt if China’s GDP growth is lower. As he explains elsewhere:
The model shows that even making fairly optimistic assumptions and accepting the lower end of debt estimates, debt cannot stabilize unless growth slows very sharply. If growth does slow sharply enough—to an average of 3% over the next five years – and if at the same time the financial sector is reformed so rapidly that within five years China’s economy is able to grow with no increase in debt (so that China actually begins to deleverage), debt can remain within a 200-220% of GDP range.
To control the level of total debt (a nominal variable), what clearly matters is the growth of nominal GDP. As we showed through a simple ‘accounting-consistent’ model of the Chinese economy, the rebalancing process could be better handled with higher nominal GDP growth rates (this is because profits, as a share of GDP, will inevitably fall as the rebalancing proceeds, so firms will have to pay down debt with lower and lower cash-flows). Higher nominal GDP growth rates may be compatible, at least, with two different macroeconomic configurations: i) high growth in real GDP driven by a surge in real consumption that more than offsets the fall in real investment, coupled with low inflation, and ii) low growth in real GDP (with low levels of consumption growth and even lower levels of investment growth, so as to achieve a rebalancing path) coupled with high levels of inflation.
Regarding the first possibility, we (like Pettis) simply cannot see how consumption can grow fast enough in order to offset the fall in investment. The growth of the ‘new economy’, while happening, is grossly overrated as a solution for the rebalancing. The only way consumption could surge from current levels would be either through transfers from the government to households (as Pettis suggests) or directly through government consumption. But it should be clear that a surge in consumption will not happen simply because of a ‘change in the Chinese way of living.’
The second possibility is more intriguing, because (leaving monetary policy and exchange rate issues aside for a while) inflation would dilute the nominal debt without a major surge in real consumption. As we have discussed several times in the past, the rebalancing process is particularly tough not just because the scale of the problem has become quite massive, but because a lower investment share (as per the Levy-Kalecki profit equation) almost implies a lower profit share; and because the debt is concentrated in the corporate sector, firms will have fewer cash-flows as the rebalancing process moves ahead. This is the main reason why we disagree with Pettis regarding the relationship between debt and growth rates: because firms will see their cash-flows diminish due to a lower investment, they will have to replace those cash-flows from elsewhere if the debt burden has to remain manageable; but if a reduction in household saving or an increase in government deficit are not enough to fill the investment gap (let alone an improvement in the current account in the brave era of the incoming Trump administration), inflation can help to reduce such a burden.
Crisis or ‘just’ a period of long stagnation?
On the other hand, Pettis envisions that the most likely scenario for the Chinese rebalancing (following FT’s terminology) is scenario 2, a long period of sluggish economic growth à la Japanese, and not a deep crisis. We think the latter path is more likely. Almost as a corollary of what we have just said, the rebalancing will further deteriorate the balance sheet of a corporate sector already highly leveraged, so it will take, as Pettis would put it, ‘smaller and smaller shocks to cause balance sheet unraveling’. As a consequence, the credit quality of the loans that sit in banks’ balance-sheets will further deteriorate.
As Morgan Ricks explains in his latest and splendid book, The Money Problem, at the heart of every deep economic crisis there is a banking panic provoked by a mismatch between short-dated liabilities and long-dated assets. If the government does not guarantee the validity of the claims from the deposits (as it was the case until the creation of deposit insurance), a bank run will ensue. As Ricks notes, such a bank run does not neccesarily only involve retail clients, but it can also involve institutional investors, as it was the case in 2007. In the case of China, all economic units have behaved as if there were an implicit guarantee from the government to bail out embattled institutions. But in many cases, as with wealth management products, there is none. However, from the point of view of making the system ‘panic-proof’, it would be much better for Beijing to take on these assets, and not spreading them to households. But the way the first debt-equity swaps have been designed invite us to think that Beijing is not going to take that path and will let households to shoulder many of these looses.
Finally, we would like to say a word on Chinese shadow banking. Although our previous argument does not rely on the rise of shadow banking, its surge of the last few years strengthenes it.
The rise of shadow banking is well documented and is due to: i) the implicit guarantee provided by the government to investors who have bought these products, ii) the need to meet increasing levels of debt to finance growth outside traditional banking channels and iii) the reduction in external reserves, forcing thus the banking system to operate with a lower level of deposits and loans.
The total amount of shadow finance has been increasing lately and by many estimates probably exceeds 70% of GDP. CLSA, in their report ‘Shadow Gang’, which dates back to September last year, estimates that by the end of 2015 the amount of shadow finance was well above $50 trillion. The following chart summarises the distribution of shadow assets:
Because most of this funding is of short-term nature (the CLSA report finds that WMPs have an average maturity of less than a year), the loans funded are probably much longer than one year and a vast majority of these products do not have a (real) government guarantee, this is a recipe for financial instability. As Pettis notes, ‘what looks like significant asset-liability mismatches within the Chinese financial system are in fact manageable because the regulators can restructure most of the relevant liabilities’. But it remains to be seen how and when Beijing decides to restructure such liabilities; the balance sheet of banks and non-banking financial institutions is one the biggest sources of concern, and the likelihood of not handling properly these issues is high, in our view.
All in all, very little has changed since we wrote our last piece on China, so the best way to update our views is just to repeat what we said there, with minor modifications (in italics):
- The rebalancing process does not only imply higher consumption and lower investment, but also a redistribution from profits to wages. Once the role of investment as a macroeconomic source of corporate profits is acknowledged, such a logical mechanism becomes obvious.
- Given that it is unlikely that households’ saving falls enough to compensate lower levels of investment (together with the low odds of getting higher current account surpluses in a world of lacklustre demand), government deficits are the only viable option to fill that gap. Also, it remains to be seen how the Chinese current account will perform under the new Trump administration. At the very least, we should not expect any relief for China coming from foreign demand.
- […] The conditions imposed by the rebalancing process on the corporate sector will be extremely tough, and the only way Beijing will have to provide some relief will be through fiscal deficits.
- […] [T]he rebalancing could be achieved easier with high GDP growth rates, but given the difficulty in keeping high real growth rates, the only way left to square the circle is through high levels of inflation.
- Beijing may continue to postpone the rebalancing with additional and preplanned doses of investment; it is doing that now intermittently, but eventually it will have to give up.