- 2018-10-19
How can China escape the debt trap?
"If something can't go on forever, it will stop." This is the "Stein's law" named after its inventor Herbert Stein. Stein is the chairman of the White House Council of Economic Advisers under Richard Nixon. Rüdiger Dornbusch, a German economist based in the U.S., added: "The crisis took much longer than you thought, and then it happened much faster than you thought."
These famous sayings help us think about China's macroeconomic issues. To grow with the government’s growth rate target, the debt-to-gross domestic product (GDP) ratio needs to be rapidly increased. This cannot last forever, so it will stop. However, because the Chinese government controls the financial system, this can last a long time. However, the longer the delay, the greater the possibility of a crisis, a sharp slowdown in growth, or both.
I once said that maintaining the isolation of the financial system between China and the rest of the world is in the interests of both. The rapid growth of debt and the huge size of China's financial system pose a threat to global stability. China must first balance its economy and stabilize its financial system before opening up capital flows. Western financiers have different views on this. We should ignore such partial interests.
However, this raises a big question: Will China achieve the required rebalancing? While maintaining stable growth, China experienced an explosive growth of debt, which also happened in the West before the financial crisis of 2007-2008 and the subsequent Eurozone crisis. As an International Monetary Fund (IMF) paper emphasized: "Between 2009 and 2015, credit grew by an average of about 20% per year, which is much higher than the nominal GDP growth rate and previous growth trends." Japan, Thailand, and Spain before the crisis share disturbing similarities.
The turning point of these credit trends appeared in 2008. This is no coincidence. Between 2000 and 2007, the ratio of China's total savings to GDP surged from 37% to nearly 50%. About half of this extraordinary increase provided funds for new domestic investment, and half supported the growth of the trade surplus. Then came the Western financial crisis. China believes that its huge trade surplus is no longer sustainable-this perception is correct. China has instead increased investment. At this time, the ratio of China's investment to GDP has climbed from 34% in 2000 to 41% in 2007, and then jumped to 48% in 2010.
To achieve this improvement, the Chinese authorities have promoted explosive credit growth. Before 2008, China basically exported the credit surge accompanying the huge increase in savings. After the financial crisis, China reimported it. The conclusion of a recent analysis by Credit Suisse is that if the Chinese government is to achieve its actual growth rate of 6.5%, credit growth must reach about twice the nominal GDP growth rate. The IMF also said that the growth of credit has caught up with the decline in corporate asset returns, the deterioration of corporate reputation, the decline in investment efficiency, and the rise in financial complexity. We have seen this phenomenon in other regions. So is there any difference between China and them?
The answer is both yes and no. The answer is yes because, similar to Japan, China is a creditor country with a high savings rate. The Chinese government controls the financial system and enforces foreign exchange controls. China is likely to avoid a crisis. However, the answer is also no, because the Chinese authorities will need to achieve lower and lower growth rates with increasing credit expansion. After that, China's growth may stop in a gradual weakening, rather than a sudden stop.
What are the possible ways to escape this trap? One option is for the government to suspend credit growth. If China’s growth relies solely on consumption, one can expect it to fall to 3%-4% per year. But the ratio of China's investment to GDP is still close to 45%. If the growth rate is so low, such a high investment rate is unreasonable. Investment will therefore fall, leading to a recession. The only way for the Chinese government to avoid this scenario is to take over the investment process, thereby negating market-oriented economic reforms.
The second option is to suspend credit growth and allow savings to flow out by substantially expanding the current account surplus. However, Donald Trump's trade negotiations with Xi Jinping in Florida showed that this would be unacceptable. Countries that are willing and able to maintain corresponding external deficits do not exist.
The third option is to suspend credit growth and sharply increase consumption to offset the decline in investment. The problem here is that the ratio of household disposable income to GDP is only slightly higher than 60%, while private consumption accounts for about 40% of GDP. By Asian standards, this savings rate is not too high. More than half of national savings consists of profits and government savings.
If people want consumption to grow faster than they are now, they need to increase the share of household income in GDP or the share of household wealth in total wealth. The former will squeeze profits and investment. The latter will mean the transfer of public assets to the family. Both of them do not seem to be feasible either technically or politically. So consumption will not prevent economic stagnation.
The final (and perhaps the best) option is for the Chinese government to put large amounts of debt on its balance sheet. It can restructure existing debt and become the main borrower in the future. China will become an immature Japan. Although government debt will grow, this borrower will be the most capable of repaying China. At the same time, the private economy will be able to make adjustments based on market signals.
Now, only by allowing rapid debt growth in China can the growth rate exceed 6%. All ways to escape this trap are difficult. The Chinese economy is slowly rebalancing to a consumption-led model. But this will take more than ten years. Can debt growth continue until then? I doubt it.