Some unpleasant arithmetic for the Chinese economy

 

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[this is the translation of a previous post]

As you may know, in September 1973 Salvador Allende’s socialist government was overthrown in a coup d’etat. What is less known is that with that government one of the most interesting applied projects in the history of economics came to an end: Cybersyn. Cybersyn was a centralised management system for the Chilean economy devised by the British scientist Stafford Beer, whose theoretical work up to then (in the field of cybernetics) focused on how to develop complex systems that could be self-regulated in a natural way, using the human nervous system as a model. Beer’s works were known worldwide, so in the midst of the Cold War and the centralism vs. market debate in its heyday, the Chilean socialist government thought that it would be a good idea to have the most advanced theoretical arsenal for socialist planning on its side. At the peak of the Chilean system there would be 7 men, who, through an operations room receiving data in real time, would be in charge of most of Chilean economic life. Take a look at this photo to realise how advanced the system was despite being barely in existence for two years – and, even if you don’t believe it, the photo doesn’t come from Star Strek, but surely Spock would have been very proud to call it his workplace. Although we will never know if the system could have worked for long (personally, we don’t think so, but we do think that the system was far more superior than the one used by the USSR at the time), the project can be considered the paradigm of centralised planning in an economy – and the Walrasian auctioneer became flesh, or rather, circuits.

The Chinese economic performance in the last two decades and its possible evolution has become a crucial point for any debate on the future of the global economy. Lately (let´s say, for the last 4-5 years), the debate has been gaining momentum, with (at risk of simplifying) two sides clearly identified: those who think that the current Chinese economic model is sustainable, based on the fact that, after all, it has been a success story and  that there is no reason why it should not continue to be so, and those who believe that the model will come to a halt, and that the sooner Chinese authorities accept this fact, the less painful the subsequent adjustment will be. The debate, as one can imagine, has been influenced by the implicit Western collective perception (and the implicit belief of many western economic analysts) that China is a sort of huge Cybersyn. While Western economies have been suffering from lacklustre economic performance and recurring financial crises in the last few years, public opinion has perceived China as an example of economic success, in part due to what is thought to be detailed and controlled economic planning. Although both sides of the debate agree on the extent of the success of the Chinese strategy so far, we are on the sceptics’ side and think that China has a tough decade ahead and that, furthermore, Chinese government will face severe economic restrictions when conducting economic policy. Therefore, this post will put some numbers to support such an intuition and to better understand which constraints the Chinese economy will face in the next decade.

What about Chinese rebalancing?

The Chinese economic debate has been centred on how to rebalance the economy (shifting resources from investment to consumption), whether such a shift is feasible or not and how long the adjustment process would take.

The main feature of the Chinese economy is its incredibly large share of investment in GDP, which delivered the spectacular growth seen in the last decade. Although some commentators usually depict the Chinese economic model as an export-led growth strategy, the truth is that such a picture is misleading: it is better to say that it is an investment-led growth model helped by the favourable balance of the external sector, which has been instrumental in taking the Chinese investment model to its limits, never reached before in any other country that has followed a similar development path. Historically, current account deficits have been one of the most severe constraints on investment-led growth strategies. In order to appreciate how China has relied on a capital-intensive strategy, the following figure shows the evolution of GDP (in real terms) as well as the relative share of the demand components since 1990:

China Real GDP and its components

Own elaboration

To get an idea about the numbers involved, the average share of consumption and investment relative to GDP in developed countries is around 65-70% and 20-25%, respectively. China saw a rise in its investment share from 35% in 2000 to 41.6% in 2007, a development which started to worry the analysts; however, since the global financial crisis the share has kept climbing, up to 48% in 2013! In contrast the consumption share has taken the exact opposite path, being barely 50% of Chinese GDP (and from these 50%, private consumption makes up just 36.5% and the rest, 13.5%, being government consumption). In other words, the average growth of real GDP of 10% in the last 13 years has taken place due to an increase of the relative weight of investment over consumption. The Chinese rebalancing debate focuses precisely on the implications of the huge investment share and why in the long run such a model is not sustainable.

Looking at China in retrospect, one may wonder why, it is important to make a distinction between consumption and investment for growth purposes. In fact, one might think that investment is a good thing (at any rate, better than consumption) given that it improves future productive capacity and infrastructure. However, there are (at least) two reasons why relying heavily on investment is not sustainable over time. First, investment-led growth is debt-intensive, since investment is not only financed via equity but with debt too. When countries start with low levels of debt and capital, the domestic sectors have a great capacity to take on more debt, given low leverage and the fact that most investment projects are quickly profitable, helping thus to reduce the debt burden. As the level of capital goes up, even higher investment expenditures are needed to keep at least a constant growth rate, so corporate debt soars. The following figure shows the debt incurred (loans plus bond issues) by the Chinese non-financial corporate sector, as a share of GDP:

Chinese non-financial sector financing needs, 1992-2012

Own elaboration

Though the previous figure does not show the total volume of debt, this recent report by McKinsey gauges the total volume of debt: at the end of 2014, amounts to 282% of GDP. Corporate sector debt amounts already to 125%, in both cases well above the levels of other developed economies (whose debt-capacity is higher for several reasons, e.g. more flexible financial systems and higher income levels), as Australia, US, Germany and Canada.

The second reason why an investment-led model is unsustainable is purely historical: as Michael Pettis explains (the economist from the sceptics’ side who has presented these ideas in the most consistent way), economies that have followed this model have ended up in deep crises from which recoveries are slow – deleveraging processes are usually painful. The list is long: US in the 19th century, the German economy in the 1930s, the communist Russia, Brazil in the 1970s and, more recently, many countries from the Asian miracle – such as Japan and its two lost decades since 1990.

Some numbers on the arithmetic of the rebalancing

Is it possible for the Chinese economy to have a soft landing from an investment-led economy to a consumption-led economy? To answer this question we have built the following scenario, which we think an orderly adjustment is most feasible. This scenario assumes a real GDP growth rate of 5%, real consumption growth between 10% and 7% (declining over the decade) and a nil real investment growth rate, whose share in 2023 in GDP shrinks to around 31%. Taking into account that a full adjustment should be considered to be with levels lower than 25%, we nevertheless assume this 31% to be a substantial rebalancing from the current levels. The time period considered is 2013-2023 for several reasons, fundamentally: i) a new Chinese government was elected in 2013, which has been suggesting that a more sustainable growth model would be appropriate and ii) a decade is an appropriate period of time for this kind of processes, neither excessively long to be deemed irrelevant nor excessively short that makes any adjustment seem to be unachievable. We think that the assumption of a real GDP growth rate of 5% is the one with the highest likelihood of achieving a successful soft landing: growth rates around 7% would not be viable, because they would imply consumption growth rates in real terms hardly achievable, around 12% in the first few years. Obviously, with lower GDP growth rates such high consumption growth rates would not be needed, but then it would imply that investment would be declining every year at a rate of around 2% – which would place the corporate sector –as we will see- in a very difficult financial situation due to the lack of the necessary resources for debt repayment.

Although the real GDP growth rate assumed is the one we consider most favourable for a soft rebalancing (and hence it should not be interpreted as our forecast), we would like to give an overall view to our readers on what the most likely growth rates are usually considered to be. International opinion has been (almost) invariably optimistic, anticipating until just few years ago that China could keep growth rates around 8-10% for the rest of the decade. Given the current government goals, even the most optimistic analysts have tempered their forecasts to growth rates around 7% (still an optimistic figure for us). On the other hand, the economist Michael Pettis has been betting for an average growth rate for the decade 2013-2023 of around 3-4% (the bet has been very famous in this murky world of Chinese predictions): given the actual growth rates of 2013 and 2014 (and the expected for 2015), it means that if at the end of the decade the average growth rate has to be effectively 4%, the growth rates in the coming years will have to be clearly less than 4%.

The next table shows the main assumptions for the simulation of our scenario as well as the final result of the adjustment process:

Scenario for Chinese rebalancing

Own elaboration

Finally, we have assumed that the contribution to GDP from the external sector (net exports) and government will be neutral, growing both at 5%. The reader will understand later the implications of the neutrality assumption.

The main result of this scenario is that entails private consumption growth rates above 10% in the first years. We only envisage two possible ways for Chinese consumption to grow over its current levels (another way that will be mentioned later, transferring resources from government to households, has been already ruled out given the public sector “neutrality” assumed in our projections). The first way is a rise in the real interest rates on deposits. Interest rates in China are regulated by the government (both for loans and deposits) and have traditionally been low in comparison to the growth of the economy (do the math: loans with a nominal interest rate of 7% and a nominal GDP growth rates in excess of 12%), which has allowed investment to be financed almost free – and, as you can imagine, it has led to the financing of ruinous investment projects. Given that the most prominent assets in households’ balance sheet are banking deposits, a rise of the interest rate on deposits would increase the flow of interest received by households, upon which additional consumption could be created (again, read this post by Pettis for additional considerations on these situations of low interest rates, known as financial repression). The second way to stimulate consumption is through higher wages. This process entails a redistribution of income from capital income (e.g. corporate profits) to labour income. Besides the immediate increase in households’ purchasing power, the inflation generated by raising wages would be another positive aspect, since it produces an artificial deleveraging effect reducing the debt burden in real terms. The negative aspects, as we will see in the following section, fall on the Chinese corporate system.

A “Minsky moment”? The rebalancing and the financial stability of the Chinese corporate sector

Even assuming that a relaxation in financial repression and rising wages take place (and assuming away, for instance, the political dimension by which Chinese elites could go against rising wages), we think that both changes would have devastating consequences for the Chinese corporate sector. In any possible rebalancing scenario of the Chinese economy, the share of corporate profits in GDP will inevitably fall. To understand why it must (and will) be like that, we have retrieved the Chinese corporate profits using the Levy-Kalecki profit equation, which gives a clear picture on how profits at the aggregate level have been generated (the details of the equation were explained in other post dealing with the US economy). The latest data from national accounts is for 2012 (a bit dated, we agree; the latest flow matrices available are from 2012), but enough to explain why profits will fall in any possible rebalancing scenario:

China Levy-Kalecki 2012

Own elaboration

At the aggregate level, gross investment (of depreciation) is always a contribution to business profits, which means that the high Chinese investment volume has increased (excluding the capital goods bought abroad, a small quantity given how the Chinese industrialisation has proceed) business profits. The negative side is that the high level of households’ savings has been a drag; it is surprising to realize that although the level of profits relative to GDP has been high in comparison to other countries (in US, currently in record levels, they reach 11% against the 20.6% of China), at the end of the day it has not been so high given the huge investment volume (and the external sector contribution).

Given the flat investment of our most favourable rebalancing scenario, both rising wages and rising interest rates will have adverse effects on corporate cash-flow generation. Though wages are a cost but at the same time revenue through higher levels of consumption, the part saved by households does not return as revenue to firms, so in net terms rising wages reduce business cash-flow. Given the already acquired debt and the debt they are continuously acquiring, we think it is highly unlikely that firms will be able to meet successfully any rebalancing scenario (not even the one explained above, which we consider especially favourable) in the future. We can reckon for 2014 a level of business cash-flow of 10 billion yuan and a level of investment of 20 billion. Internal resources flows are clearly low now. Our scenario assumes the same level of investment together with a reduced cash-flow generation of around 8.5 billion. The delicate financial situation is thus aggravated.

Probably the area in which the corporate sector insufficiency of internal resources will first unfold is in those companies of the construction and capital goods sector, for two reasons: first, these firms exhibit the highest leverage ratio among their peers and, second, because investment will not increase as the economy moves towards higher consumption levels, their cash-flow generation will shrink (firms selling consumption goods will have better prospects). At any rate, the possible channels through which early minor defaults spread to provoke a generalised collapse are multiple and, as in any “Minsky moment” with excessive corporate leverage, of unpredictable nature. Therefore, we conclude that any possible rebalancing scenario will come together with a “Minsky moment”; in that case, financial difficulties in the corporate sector will become crystal clear.

So we are left with the only two possible ways the Chinese economy can alleviate the rebalancing pressures on the corporate sector: government spending and the external sector. Government can gradually increase social spending and transfers to households, financing both items through higher taxes so as to reduce the household sector high saving rate and – especially – with an increase in government debt. Private sector deleveraging – as we have learnt in Western economies recently – cannot materialise if governments do not take heavily on debt. Regarding the external sector, a comeback to the period 2003-2007, when the balance of payments largely contributed to Chinese growth, would be very welcome by Chinese authorities. It is paradoxical that an attempt to rebalancing may rest on a comeback to the export-led growth model. Internal pressures for a strong devaluation of the yuan will be significant, and it remains to be seen the impact of such a decision in China’s international commercial partners.

As a conclusion, we can venture that a Chinese soft landing towards a less investment oriented model is highly unlikely. The only chance is through a large increase in government spending and exports, which we think is not feasible. The change to a consumption-led model is bound to produce severe problems in the Chinese economy. The temptation to stick with the current model is thus irresistible – this is very evident given the latest attempts to promote mammoth investments in telecommunications and internet – something that will compound the problems later. When investment stops in China, the lack of alternatives in the short-run will be evident. At that moment China will have its severe crisis; it will overcome it, and then will be able to keep growing in a more balanced way.

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