China: Choosing More Debt, More Unemployment, Or Transfers

By Michael Pettis

I have often written in this blog and elsewhere about the three policy choices Beijing faces as it tries to manage through the adjustment process. My argument is that subject to two very plausible assumptions, every economic policy Beijing implements ultimately can be abstracted to one choice among three options. These two assumptions are:

1. China has overinvested in infrastructure and manufacturing capacity to such an extent that in the aggregate the cost of additional public sector investment exceeds the present value of future increases in productivity generated by the investment. China’s public-sector investment, in other words, is value destroying, and because it is funded by debt, additional investment causes China’s real debt servicing costs to rise faster than its real debt servicing capacity.

2. China’s long-term sustainable growth rate is substantially below the economy’s current GDP growth target, and so the economy is only able to meet the growth target by increasing its debt burden.

I was discussing this earlier today with a friend of mine who asked if I would post on my blog a piece I wrote last year for my clients. I am not able to post the full piece, but I decided to post the following edited abstract. I have not had time to read though it to remove incongruities or anachronisms:

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Since 2010-11, and even more so in the past year or two, it has often been difficult to evaluate the consistency of Beijing’s policies within China’s economic rebalancing. This shouldn’t be surprising. For one thing, as I have tried to show many times before, rebalancing is an intensely political process and almost by definition it must undermine the so-called “vested interests” who were previously the great beneficiaries of decades of unbalanced growth. For this reason it must be driven by the constant give-and-take of the political process.

For another thing, there continues to be a lot of confusion about just what it is that Beijing must do, and there are still far too many economists who believe that certain types of reforms will allow Beijing to sidestep some of the politically difficult decisions involved in rebalancing. For example many economists still argue that the right combination of interest rate reforms and reforms to financial-sector corporate governance can transform the Chinese banking system quickly enough and radically enough that Beijing can allow investment growth to remain high without a commensurate growth in the country’s debt burden.

This is almost absurd. Many countries under easier circumstances – in which interest-rate distortions were less extreme, for example, as was moral hazard, or the links between parts of the banking system and the political distribution of power – have tried to do just that, and none has succeeded nearly quickly enough, if it has succeeded at all, to matter.

A country’s financial system, after all, can only change in ways that are consistent with changes in the political system and with the distribution of political and economic power, and it is hard to imagine how this would happen in China quickly enough to break the link soon enough between investment growth and growth in the debt burden. Among other things a reform of this nature would require the elimination of moral hazard, but moral hazard has become so fundamental to the stability of the Chinese banking system and to the way credit, and with it wealth and political influence, has been distributed during the past two or three decades, that it is hard to believe that its rapid elimination would not be too disruptive for Beijing to allow.

For these reasons it isn’t at all surprising that Beijing’s policies will appear inconsistent from time to time. To make it easier to evaluate policymaking amidst this confusion, however, I have said a number of times that any policy Beijing chooses must involve, usually implicitly, some combination of three outcomes. In every case, in other words, we will see as a consequence of the policy one or more of the following:

• Higher unemployment, the limit of which is largely a political issue involving social instability, with the added wrinkle that certain types of unemployment are likely to be perceived as more politically costly than others – e.g. because returning to family farms acts as a kind of safety valve, even though a significant fall in living standards, unemployment among migrant workers is likely to be less costly, or because university graduates are presumably more communicative and have higher expectations, their unemployment might be more costly.

• Higher debt, by which I really mean a higher debt burden, or an increase in debt relative to debt-servicing capacity, and this can rise until credit growth can no longer be forced up to the point where it can be used to roll over existing debt with enough margin fully to fund as much new economic activity that Beijing targets.

• Higher wealth transfers, in which governments – and because the Xi administration is seeking to centralize power this is most likely to involve local governments rather than central government entities – must liquidate assets and use the proceeds directly or indirectly either to increase household wealth or to pay down debt, with the main constraint on Beijing’s ability to direct this process likely to be the tremendous political opposition of the so-called “vested interests”, for whom government control of these assets is an important source of power, patronage, and wealth.

The trade-offs between a higher debt burden, higher unemployment and greater wealth transfers to the household sector may come into sharper relief in 2016 because although unemployment still seems to be fairly low, in spite of much lower growth in the past three years, there is now reason to worry that any additional reduction in growth may begin to show up in the unemployment numbers.

Although I have explained this framework many times before, I don’t think all of my clients understand what I mean by it. I recently met with a senior European official who is a long-time subscriber to my newsletter, and although he has always been very supportive of my work, even when my analysis of the Chinese economy was widely considered outrageously contrarian, he confessed that he was a little skeptical that something so simple could provide much value in describing something as complex as the Chinese economy.

I explained to him that the unemployment-debt-transfer framework was not so much “simple” as it was “flexible”, and to show him what I meant, I went on to describe a series of recent adverse shocks to show how the framework clarified the various scenarios. The exercise seems to have worked. After I had finished he seemed to be much less skeptical and in fact seemed pretty ready to embrace the framework I had recommended.

Working through the scenarios

I thought it might be useful if I replicated the exercise by positing some adverse event, and then working through the consequences. No matter what the adverse event or policy decision, it is almost always easy to show that except for a very limited number of easily-specified and highly improbable scenarios, every response Beijing chooses, including that of no response, must result in some combination of higher unemployment, higher debt, and higher wealth transfers.

To move from the abstract to something specific, I will assume, as occurred in 2009-10 as a consequence of the global crisis, that for reasons external to China there is a sharp contraction in its current account surplus, mainly caused by a sharp fall in exports. I will the try to list every logically possible outcome, even those that seem obvious or obviously implausible, to show how flexible this framework and how useful in allowing us to evaluate policymaking:

1. Let us assume, then, that a sharp fall in exports causes a reduction in demand relative to the quantity of goods and services China produces. Either Beijing responds to the sharp fall in exports or it does not. In the latter case one or more of three things must happen. First, exporters can close down production facilities and fire workers. Second, they can close down production facilities and retain the workers. And third, they can keep production facilities running. There is no other possible outcome if Beijing does not respond to the sharp fall in exports.

2. We can work through these three outcomes. In the first of the three cases, if exporters close down production facilities and fire the workers, then clearly unemployment rises. Second, if they close down production facilities and retain the workers, because they can no longer pay the workers out of the revenues they generated they must borrow, sell assets, or draw down savings, in all of which cases effectively the debt burden rises (in the latter two cases because assets decline with no change in debt). And finally, third, if they do not close down production facilities, they must finance rising unsold inventory and, again, the debt burden rises.

3. These are the three possible outcomes if Beijing does nothing in response to as sharp fall in exports. It is far more likely however that Beijing would respond to counter the decline in demand. Any economy has three sources of demand, consisting of net exports, consumption and investment, and Beijing can respond with policies that counter the fall in demand by promoting each of these sources of demand. First, it can attempt to rebuild exports by becoming more competitive – most likely by devaluing the RMB, by forcing down wages, or by reducing interest rates. Second, Beijing can also counter the impact of lower net exports on demand by boosting government consumption, which causes the debt burden to rise because it must be financed, or by implementing policies that boost household consumption. Finally, Beijing can counter the impact of lower net exports on demand by boosting investment.

4. Rebuilding exports by devaluing the RMB, by forcing down wages, by reducing interest rates, or by any other subsidy of production costs effectively reverse the rebalancing process, and it is precisely because of the deep imbalances that Beijing is in the position of being forced to choose among the three outcomes. These policies ultimately boost exports by indirectly transferring wealth from households to subsidize the tradable goods sector. The result, of course, of reversing the rebalancing process is that contrary to Beijing’s explicit goals Chinese demand relies less on household consumption and more on investment, and because the financial sector misallocates capital systematically. Unless China is able, very improbably as I have argued, to reform the financial sector deeply enough and quickly enough, the cost of a more competitive (i.e. more highly subsidized) export sector is ultimately a rise in the debt burden, unless of course Beijing is willing to tolerate higher unemployment or to implement greater wealth transfers from the state to the household sector. I have discussed this many times before in other issues of this newsletter so I will not explain why again beyond the above, but it should be quite obvious.

5. If rather than make exports more competitive Beijing chooses instead to boost household consumption, there are two ways it can do so. The sustainable way is to boost household income or household wealth. Less sustainably it can also encourage households to increase consumer debt, the result of which, of course, is a rising debt burden. If however Beijing wants to boost household consumption by boosting household income or household wealth, even as export growth is falling sharply, it can only do so by transferring wealth directly or indirectly – in the latter case, for example, by improving the social safety net or by socializing transportation, medical or other costs – from local or central governments. The impact this will have on China’s overall rebalancing depends on how the wealth transfer is funded. If these costs are funded by government borrowing, the debt burden rises. If they are funded by the sale of assets, there is a transfer of wealth from the government to households.

6. Finally, as it did in 2009-10, Beijing can counterbalance the sharp fall in exports by initiating a major investment program. Again, needless to say, the impact this will have on China’s overall rebalancing depends on how the wealth transfer is funded. If these costs are funded by government borrowing, as they were in 2009-10, the debt burden rises. If they are funded by the sale of assets, there is a transfer of wealth from the government to households.

This rather simple exercise can easily be repeated for any other set of conditions, and it shows what it means to say that every adverse economic event and every set of policy choices Beijing might implement ultimately boils down to choosing among these three options. I have used a fall in exports to show how constrained Beijing’s policy choices are, but I could just have easily done the same using as an example any change in the currency regime, the reform of the hukou system, the de-industrialization of the bankrupt northeast provinces, the development of the OBOR and Silk Road projects, changes in interest rates or minimum reserves, protecting the stock market from crashing, the provincial bond swaps, changes in the tax regime, improving energy and environmental policies, and so on. In every case Beijing is implicitly forced to choose among these three options.

Many research pieces and analyses, and perhaps Beijing policymakers themselves, implicitly assume that there are other possible outcomes. But because they do not specify these alternatives, except vaguely and unrealistically, they conceal more than they reveal. In fact there are only two other outcomes that are logically and practically possible, but neither is highly plausible or sustainable.

The first alternative assumption is that there is a sharp drop in the household savings rate, so that household consumption rises as a share of household income. Proposals to rebalance the economy by improving retail distribution, for example, implicitly assume that this will happen. But it can happen only if either Chinese households on average decide to become less thrifty, which is unlikely in a period of rising economic uncertainty (and anyway most likely requires rising consumer debt), or if there is a significant redistribution of wealth from the higher-saving rich to the higher-consuming poor, which might be politically very difficult to accomplish in a short enough time period.

The second possible alternative assumption buried in most analyses – but which again is neither highly plausible nor sustainable – is for a radical reform of the financial sector and a major re-channeling of capital away from its existing uses and into productive uses that do not entail a faster rise in debt than in debt-servicing capacity. Aside from the fact that the most productive users of capital are actually reducing their demand for capital in the face of weak Chinese and global conditions, the type of transformation required in the financial sector, and the transformation in the political institutions needed to accommodate this financial-sector transformation, are far more radical than any country has ever been able to manage. I have explained why I believe this outcome is extremely implausible several times in other issues of this newsletter.

Clearly from an economic point of view it is easy to see that Beijing should always prefer policies that transfer wealth from the state sector to the household sector, because every other policy implicitly or explicitly involves something which is either unsustainable, like rising debt, or politically unacceptable, like rising unemployment. In fact it does. The most widely praised economic reforms proposed during the Third Plenum in 2013 do exactly that.

The problem, of course, is that local and provincial “vested interests” strongly oppose the concrete steps needed to achieve this transfer in large part because their economic and political power depends directly or indirectly on control of local government assets, or on their abilities to transfer wealth from the household sector into their own projects. The alternative to rising debt or rising unemployment, in other words, requires that power be sufficiently centralized in the Xi Jinping administration that it is able to overcome these vested interests.

This suggests very clearly what we should be watching for in 2016 as the most important indicator of whether or not Beijing will be able to manage a successful economic adjustment, with growth slowing sharply but gradually and in a non-disruptive way. China’s success will depend on the extent to which Beijing in 2016 is able to centralize power, to begin to sell off government assets (probably local and provincial, and not central, government assets), to rein in credit growth, and to accept much lower GDP growth rates while keeping household income growth from dropping too sharply. If it cannot do this, China’s adjustment is likely to be much more difficult, much longer lasting, and perhaps much more disruptive.

Aside from this blog I write a monthly newsletter that covers some of the same topics covered on this blog, although there is very little overlap between the two and the newsletter tends to be far more extensive and technical. Academics, journalists, and government officials who want to subscribe to the newsletter should write to me at chinfinpettis AT yahoo DOT com, stating your affiliation. Investors who want to buy a subscription should write to me, also at that address.