Chinese Recovery On Paper

Is China really growing at the reported 7.5% rate? I have frequently stated “no chance”. Malinvestments in housing, vacant cities, vacant malls, and roads with no traffic prove the point. Michael Pettis at China Financial Markets reiterates that view in regards to credit expansion and GDP growth.

First, please consider the New York Times article Chinese Recovery On Paper.

The National Bureau of Statistics in Beijing announced on Wednesday that economic growth climbed 7.5 percent in the second quarter, compared with a year earlier. But independent surveys of businesses across China show that in sector after sector, sales and confidence are still deteriorating.

“All of them are pointing in the opposite direction from this supposed G.D.P. number,” said Leland Miller, the president of China Beige Book International, a New York data service that surveys 2,200 private businesses across China each quarter to gauge economic activity.

One of the biggest engines of Chinese economic growth in recent years — construction and other investment in the private sector — is sputtering, while exports have only begun to recover from a weak winter and retail sales growth is leveling off. That leaves government investment and spending, which are running strong, propelled by redoubled lending this spring by the state-controlled banking system to the national railroad system, local governments and state-owned enterprises.

The result has been frenzied spending on the construction of railroad lines — up 32.1 percent in June from a year earlier — and subsidized housing. Steel output in China is setting records by tonnage as a result, even as the number of housing starts in the private sector is falling steeply.

Total lending has now risen faster than economic output, even before adjusting for inflation, in every quarter since late 2011. Lending accelerated further in June, according to figures released on Tuesday by the central bank, the People’s Bank of China. Yet Mr. Miller’s survey and others show that private businesses are becoming less and less interested in borrowing money because they see few opportunities to invest it profitably.

“Although there is no way to predict with accuracy and certainty the point at which China will reach the limits of its debt capacity, I believe that current rates of credit expansion can continue at most for another 3-4 years,” Michael Pettis, a finance professor at Peking University’s Guanghua School of Management, wrote in his newsletter after the release of the data.

From Pettis via Email

Impact of Debt on Chinese Growth

  • Over the short term Beijing can successfully target nearly any GDP growth rate it chooses as long as two conditions are fulfilled. First, it must be willing to allow credit to expand as rapidly as required to achieve the GDP growth target. Second, it must have enough debt capacity for credit to expand at the required rate.
  • Although there is no way to predict with accuracy and certainty the point at which China will reach the limits of its debt capacity, I believe that current rates of credit expansion can continue at most for another 3-4 years.
  • Growth in credit can be subject to “sudden stops”, especially when external financed, but even in systems in which sudden stops can be controlled, like that of China, debt capacity is nonetheless limited.
  • In the case where a significant amount of new debt is used to fund projects whose economic value is less than the value of the debt, and in which the gap between the two is not recognized and written down, the debt capacity limit is reached when credit growth is not enough to exceed the acceleration in the rolling over of unrecognized bad debt.
  • Maximum debt thresholds in rich, developed countries are much higher than they are in poor, developing countries. Even though analysts often do this, comparing China’s debt ratio with that of a developed country like, for example, Japan, tells us nothing about China’s relative ability to manage its debt burden.
  • Failure to recognize bad debt overstates reported GDP growth. Once a country stops accumulating bad debt, however, its reported GDP growth will be understated by the same amount by which it had previously been overstated.
  • Debt is not neutral to economic growth. When a country has “too much” debt, market perceptions of its deteriorating creditworthiness cause agents to change their behavior in ways that reduce growth to less than what it would have been without the debt. This process can be intensely self-reinforcing.

In my many meetings with investors around the world, some of the most urgent questions I get about China’s future growth prospects have to do with attempts to understand the very different kinds of debt constraints that China faces from those faced by the US, Europe and Japan.

I will argue that, like for any country, there are two important consequences of China’s current debt burden that will affect China’s future GDP growth.

  1. Debt is not neutral to growth, in spite of what much academic economic theory implies. An excessive debt burden reduces future productivity and employment growth.
  2. The way China has failed to recognize uneconomic investment in the past has caused GDP growth to be overstated, and for similar but opposite reasons will cause GDP growth in the future to be understated.

China’s debt burden, in other words, can cause future GDP growth to drop for two entirely different reasons. First, it can reduce the real value of future economic activity. Second, it will cause a shift in the reporting biases, from overstatement of growth to understatement of growth. Together these two effects will cause reported GDP growth to drop sharply, although real wealth creation need not drop by nearly as much.

One of the key sources of rapid growth for China 20-30 years ago was the way Chinese savings were forced up to extraordinarily high levels by policies whose explicit or unintended consequences were to constrain consumption growth. As these savings were channeled into productive investment, workers’ productivity surged and Chinese wealth exploded.

About roughly ten years ago, however, what had been a winning strategy turned into its opposite. The combination of moral hazard, very low real lending rates, and a powerful political infrastructure built around cheap credit led to a period of massive capital misallocation. The consequence was both surging debt and an increasing reliance on continued credit growth to power economic activity. I have written many times before, including in my most recent book, why historical precedents should have left us unsurprised that this would happen.

But now, as part of China’s reform, the conditions that led to capital misallocation must be reversed. This will not be easy. In China a powerful institutional infrastructure has been built around the existing capital allocation process. To control capital allocation is to control the economy, and one of the ways to evaluate the extent of political and economic change in China is precisely by watching reforms in the banking system as they manifest themselves in changes in the capital allocation process. This is why changes in the pricing and transmission of credit are politically so important in China today, and why these changes are likely to be subject to significant political maneuvering.

Implications for Growth Prospects

  • There is no mystery as to why Chinese growth rates have remained high long after the vulnerabilities in the Chinese economy have been identified and seemingly accepted as consensus among the economic policymaking elite. Beijing can achieve any growth target it wants as long as it allows the credit growth needed to accommodate the GDP growth target.
  • Unfortunately it is not clear to me that GDP growth rates much above some minimum level (I would suggest 3-4% at most), can occur without excess credit creation, which I define to mean that the growth in credit exceeds the concomitant growth in debt servicing capacity. In that case reported GDP growth will exceed “real” GDP growth by the amount of bad debt that the banking system fails to write down correctly.
  • Because reported GDP growth can be any number determined by Beijing, subject to the debt constraints described above, it is useless for analysts to try to predict, based purely on economic conditions, whether or when China will have a hard landing. Until China reaches its debt capacity constraints, growth will only slow when Beijing feels sufficiently confident of itself politically to rein in credit growth and so allow GDP growth rates to drop sharply.
  • The longer it takes to slow GDP growth, however, the sharper the subsequent deceleration in growth.
  • The limit of Beijing’s ability to determine GDP growth rates is set by its debt capacity limits. There are too many relevant variables to permit any credible prediction of how long China can continue to allow credit to grow at current rates, but my instinct is that Beijing has at most 3 to 4 years to get credit growth under control. Some analysts believe that China has much less time and others believe there is much more time, but there is no way a priori to determine who is right. This is probably the most important “uncertainty” about China’s adjustment process.

GDP overstatement will automatically be written down over future years. For this reason even if the Third Plenum reforms are successful and are quickly and efficiently implemented, so that Chinese growth becomes much healthier, reported GDP growth rates must nonetheless fall substantially. The longer it takes for GDP growth rates to fall, the more they will fall.

Because short-term costs are inversely proportional to the long-term benefits, however, and because recent history suggests that Beijing is still unlikely to choose long-term benefits if short-term costs are high, there is a chance that China’s adjustment period may stretch out beyond President Xi’s expected decade in power.

We must remember, however, that when credit growth is finally constrained, the drop in reported GDP growth rates will exaggerate the adverse impact of financial-sector reform on the economy. Just as China’s economy has not been nearly as healthy as the last decade of growth might imply, it will not be as “sick” as the next decade implies.

China vs. Japan Debt Capacity

When my more experienced students at Peking University want to set me off on a tirade they goad one of the newer students into telling me that because Japan’s government debt to GDP ratio exceeds 200%, and Japan has no problem serving its debt, China has a long ways to go before its debt level becomes a problem. That this kind of logic is so obviously wrong after even the most cursory examination, and nonetheless yet is repeated so often by economists, is frustrating.

It should be obvious that different countries, like different industry sectors, have different debt thresholds, depending both on the structure of their economies and on the structure of their borrowing. Developing countries, whose economies tend to be more volatile and whose financial markets shallower, must automatically have lower thresholds than developed ones. In addition, countries with rigid and less credible financial, legal and political systems must necessarily have a harder time adjusting to the added volatility that comes with higher debt levels (debt increases the volatility of earnings in a linear fashion).

Because poor, developing countries are much more likely than rich, developed ones to be in the group of countries with rigid and less credible financial, legal and political systems, their ability to absorb the volatility associated with debt must necessarily be lower. Different levels of credibility show up especially in pro-cyclical reaction to debt. It is a pretty safe assumption, for example, that rising financial uncertainty in rich countries like Japan won’t be associated with the kind of capital flight we see in developing countries, for example flight capital from China in the past five or six years.

Whereas rich countries can often have government debt-to-GDP ratios that exceed 100%, we have seen countless poor countries forced into default or restructuring with government debt-to-GDP ratios at 50-70%. Poor countries simply cannot rack up the amount of debt rich countries regularly do, and to say that one of the poorest such countries, China, should compare its debt capacity to that of Japan is not the less inane for having been repeated so often.

By the way it is even a mistake to say that Japan’s current debt levels are not a problem. We don’t know if they are not a problem. All we can say with certainty is that when interest rates are extremely low – close to zero – they haven’t been a problem. But remember that while economists mistakenly tend to focus only on real interest rates as the cost of debt, nominal rates matter too because of their cashflow and amortization implications. When the nominal rate is zero on a bullet loan, there is effectively no principal amortization, but as soon as rates become positive, borrowers must implicitly amortize a portion of the loan principal. The higher the nominal rate the greater the implicit principal amortization.

Japan’s debt burden, in other words, may be manageable only because nominal interest rates are close to zero, and this has been possible mainly because nominal GDP growth in the past 20 years has also been close to zero. Any substantial nominal GDP growth in Japan would force Tokyo to choose either between repressing interest rates, which would put downward pressure on consumption (which means of course that China, in similar circumstances, would not have that option), or, by allowing interest rates to rise with nominal GDP, to begin amortizing principal (even with zero real rates), which would cause Tokyo’s fiscal deficit to explode.

Avoiding the Fall: China’s Economic Restructuring

Inquiring minds will want to pick up a copy of Michael Pettis’ latest book Avoiding the Fall: China’s Economic Restructuring, in which he discusses the above (and much more) in more detail.

Mike “Mish” Shedlock