Chinese policy makers were gathered at the National People’s Congress (NPC) a couple of weeks ago to discuss the economics goals for the next few years. Given the recent turmoil in Chinese financial markets, it was an important meeting for international analysts.
Several issues were addressed at the NPC, but the most important one was the strict commitment of the Communist Party to keep sustainable (and moderately high) growth rates. For this year they have abandoned fixed targets and they have opted for some flexibility in their goals (e.g. 6.5% – 7%). ‘More active’ fiscal policies, through higher current and investment expenditures and tax cuts, were also put forward in order to achieve deficits around 3% of GDP – which is in stark contrast with the government position of the last years. But as we will see in a while, these goals (6-7% nominal GDP growth plus 3% of fiscal deficits) do not meet People’s Bank of China projections for government debt, unless other ‘extraordinary’ government operations (bailouts of banks and local governments in particular) are brought into the picture. Finally, the Communist Party has also suggested higher levels of inflation (around 3%) than in recent Chinese history.
The following graph, courtesy of Natixis, summarises in a neat way the room for fiscal manoeuvre of Chinese authorities. Chinese government debt stood at 50% of GDP by the end 2015, in contrast to the 90% of the US and the UK – let alone the Japanese levels, well above 200%.
In a detailed report, the PBoC has laid out a scenario for the next decade estimating the fiscal effort Beijing would deploy for a given set of assumptions. In one of the baseline scenarios, with GDP growth rates around 6%, the PBoC reckons that the debt/GDP ratio would reach around 70%: higher than current levels but still lower than Western economies. These numbers have been a relief for some economic commentators, because even with an effort of 20% of GDP, the Chinese fiscal position would still be comfortable, and all that with the rebalancing challenge accomplished by that time.
Some counterfactual medium-term scenarios for government debt
We think that the previous estimations are quite problematic, not because they are done up to 2025, but because they do not fully take into account the impact of such expenditures on the rest of the sectors of the economy. In other words, any projection for the Chinese government debt (and fiscal policy) has to be consistent with at least three macroeconomic requirements:
- Average GDP growth rates above 5% for the next decade. This ‘constraint’ has been set by Beijing, aiming to growth rates of around 6% up to 2020 – so Chinese income would double from 2010 to 2020. Our personal opinion is that such high growth rates are far from being realistic (see here), but that is not the point here: these are top policy priorities for Beijing, and any numerical analysis should take them into account in order to see how logically consistent they are.
- Rebalancing the economy from investment to consumption. See our earlier discussions for further elaboration.
- A corporate sector capable of a decent cash-flow generation during the rebalancing process. Although it seems that the rebalancing challenge is finally getting more attention in the media, it is still widely unacknowledged that the rebalancing process not only implies moving resources from investment to consumption, but also, and almost tautologically, a redistribution of income from profits to wages. Since at the macroeconomic level investment generates profits, a lower investment share in GDP almost always leads to a lower share of corporate profits. And because the rebalancing process will reduce the investment share, it means that Chinese corporations will have to find additional cash-flows somewhere else. Obviously enough, some sectors (commodities and capital goods industries) will be more affected than others (consumption sectors), but the overall picture for corporate profits follows logically from the rebalancing requirements.
The following counterfactual analysis imposes these conditions on the Chinese economy for the next ten years (we are using the same time span as the PBoC did). For the sake of convenience, the nominal GDP of 2015 has been normalised at 100. The data comes from the 2012 flow matrix published by the NBSC and adjusted in order to take into account the evolution of the Chinese economy from 2012 to 2015 (e.g. government deficit closed last year at 2%). Although there are several variables to project, the interpretation of the model gets greatly simplified because the three previous requirements reduce the degrees of freedom of the model quite a lot.
The projection for the GDP expenditure components looks like as follows:
As you can see, for GDP growth rates of 6% and for ‘target’ investment and consumption shares in 2025 of 70% and 30%, respectively, the growth in total (private plus public) gross investment would be close to zero and the balance of payments would move from a surplus to a balanced position. This is, of course, only one of the multiple scenarios we could have designed (for we could alternatively have assumed, for instance, higher growth rates in the first few years), but it shows the constraints of some expenditures components once growth and consumption and investment shares are given.
But this scenario is also compatible with PBoC fiscal projections, because as it can be seen in the following table our GDP projections imply a government debt of around 70% (78%) in 2025:
Since GDP growth rates are high in the simulation, Beijing could run high budget deficits without increasing very fast government debt. Although Beijing has aimed at deficits of around 3%, it should not surprise us to see much higher levels in 2-3 years’ time.
But the million-dollar question is: what would be the implications of these numbers for corporate profits? At the macroeconomic level, corporate profits (non-financial plus financial corporations) can be best understood using the Levy-Kalecki profit equation (here we will be using the LK profit equation plus depreciation, because we are interested in debt repayment capacity to service financial obligations). Since we have already projected GDP expenditure components and the government budget position, we only have to rearrange the accounts (and to assume a certain growth rate for wages) in order to retrieve a projection for total cash-flows. Such a projection is as follows:
Such cash-flows, in turn, are needed to finance corporate investment: we have assumed that the difference between investments and cash-flows is the increase in corporate debt. Since the debt that matters because of its size is the one owed by non-financial corporations, we have made a cash-flow projection only for non-financial corporations. The share of total LK profits in GDP would move from around 22.7% to 14.1%, in line with other developed economies (remember that here we are dealing with cash-flows, not net profits), so we could also say that from the income side of the equation the Chinese economy would be rebalanced.
Although the evolution of debt levels seems OK at first sight, closer inspection reveals that once one computes the level of debt as a proportion of LK profits, then things get worse. For the rebalancing process, we claim that corporate debt should be measured against corporate profits, and not against GDP, because the latter implicitly assumes that total GDP is the relevant measure to gauge corporate financial health; when functional income distribution is roughly constant, then this assumption is not harmful and it is indeed a useful simplification, but that is not the case if a rebalancing process is under way. Once we take instead the ratio of corporate debt to non-financial profits, such measure climbs from 9.6 to 11.4, a very high ratio that we will never see, given the crazy number of bankruptcies that would occur before reaching these numbers. At risk of repetition, the implicit redistribution from profits to wages of the rebalancing process logically implies that, although corporate debt may improve as a percentage of GDP, it may worsen at the same time against corporate cash-flows, so this latter ratio is much more informative of the Chinese corporate sector financial health.
How much the public deficit would need to be in order to improve the balance sheet of corporations, keeping the rest of the variables constant? Doing a back-of-the-envelope calculation, if we assume a debt/cash-flow ratio of 7 times (such ratio would be the business equivalent of gross debt/EBITDA after taxes), that would imply that the government would have to take on the debt equivalent of 4.4 times the LK non-financial profits in order to cut down non-financial corporate debt from 11.4 to 7 times. Given that non-financial profits would be around 14%, the total amount of debt would reach roughly 60% of GDP (4.4x times 14%), which, together with the already projected government debt of 78% in Table 2, would add to a number close to 150%, very well above PBoC estimations – more than twice.
It should be stressed again that the previous analysis should not be interpreted as ‘economic forecasts’, but rather as a framework to understand the plausibility of hypothetical scenarios (under certain assumptions) that can be maintained for a long period of time. Beijing, for instance, could decide to take on all that debt and close idle capacity much before 2025, trimming down thus the growth in corporate debt. Under this scenario (which we deem to be very likely), government debt would not reach the levels aforementioned and would stay close (and probably above) to 100%. Nevertheless, we think that the previous analysis clearly shows the set of choices (and restrictions) for the Communist Party and that, in any case, we will see substantially higher levels of government debt than the ones estimated by the PBoC.
- Chinese fiscal policy cannot be understood in isolation of the rest of constraints: either political constraints imposed by Beijing (e.g. growth rates higher than 5%) or purely economic constraints (rebalancing process accomplished by 2025).
- 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 logical mechanism becomes obvious. As the projections made clear, even if corporate debt falls relative to GDP, it can still increase relative to corporate cash-flows. Therefore, unless income distribution is fairly stable, corporate debt must be measured against corporate profits, and not against GDP – as it is usually done.
- 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.
- In our view, PBoC estimations (government debt reaching ‘only’ a 70% debt level) are, to put it mildly, very conservative. 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. For a government-debt-to-GDP ratio of 70% in 2025, the financial health of the corporate sector would be unsustainable much earlier than that. Even without taking into account the NPLs that Beijing will have to take on at some point, government debt levels will be closer to 100% than to 70%. The sooner Beijing reins in the growth of corporate debt, the smaller the levels of government debt in 2025 will be.
- And finally, alternative scenarios (not displayed here) of the model show that the 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. Whether Beijing will follow this route or not remains to be seen (there can be serious political considerations, as the reaction of the Chinese population for the dilution of their savings), but it is clear that the recent pronouncements at the NPC to raise inflation rates show that (unlike many Western analysts) Beijing has already understood the crucial role inflation will play in the next years.