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Debt overhang economics with Chinese characteristics

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Greetings. For the rest of August, my wonderful colleagues Claire Jones and Chris Cook will keep Free Lunch going — I will be back in the saddle in September. Today, one last set of reflections around my economics-y summer readings.

China’s reversal of fortune has generated a host of writing in the past few weeks. On our own pages, check out recent commentary by my colleagues Robin Harding, James Kynge, and Leo Lewis, as well as all the great reporting on the (bad) economic news from China. Other contributions that have caught my eye include the essay by Adam Posen I mentioned in my column last week, Michael Pettis’s Twitter thread on his argument, and my former colleague Matthew Klein’s good dive into the recent dismal economic data. And Adam Tooze has been prompted to devote his newsletter to a long series on China.

The underlying theme of all these pieces is “how much things have changed!” Only at the start of the year, expectations were that ending the draconian zero-Covid policy would lead to a boom. Instead, China is seeing slowing growth (Klein judges its economy is now expanding more slowly than the US’s), deflationary pressures, vanishing foreign investment, tumbling house prices, falling exports, and a youth unemployment rate that is getting so bad the government has decided to stop publishing it.

As the many contributions listed above indicate, there is no shortage of explanations. But sometimes it pays to keep things simple. There are tell-tale signs of one phenomenon in particular, including how Beijing is sending in crack financial teams to inspect local government finances, and that bank lending is plummeting. Complex as China’s economy is, and without denying deep, long-term forces, we can get a long way towards explaining the current malaise with the simple framework of a debt overhang or balance sheet recession.

Of course there is a lot else going on. Chinese manufacturing — the main export driver — is suffering also because of the slowdown in advanced economies. (A slowdown, let alone a recession, tends to hit industrial goods hardest because they are the most traded, and the industrial sector faces the additional headwind of US consumers recalibrating their huge shift during the pandemic towards goods and away from services.)

Another issue is that Xi Jinping has been changing his country from a developmental state to a “security state”. Strengthening autocracy comes with more arbitrary governance, which comes at an economic cost. My colleague James Kynge’s story of his friend Wang Ning — who is well paid but now severely disciplines his spending “to prepare for black swan events like an invasion of Taiwan” — perfectly encapsulates this phenomenon.

But it seems to me that so much of the current troubles in the Chinese economy can be explained by the debt overhang, that there is much to learn by focusing on that even while putting other issues momentarily aside. For readers in advanced economies in particular — especially those who followed those countries’ debt-driven crises in past decades — the exercise that the flurry of China-pessimistic readings should prompt is this: ask how much of China’s current predicament we can make sense of by comparing it with the US in 2008, the eurozone in 2010, or for that matter Japan in the 1990s?

I think quite a lot. A huge increase in debt fuelled a globally unprecedented economic share of construction during China’s pre-Covid decade, as I wrote about two years ago (see chart). As balance sheets expand — with more people both owning and owing ever more property-related debt, the risk that the value of the assets is no longer thought to cover the value of the liabilities increases. And like in those other places, at some point it becomes clear not all investments were worthwhile, the economy as a whole, and many people and business in particular, are in fact less wealthy than it seemed, and behaviour changes from making sure not to miss out on ways of getting rich to trying to avoid being the one holding the bag for losses.

Chart showing the share in GDP of construction and real estate activity in selected countries including China

All the signs are that this is what China’s economy is in the throes of. Here is my potted description of what is going on: local governments, which borrowed (often in obscure ways) to drive growth through local construction, are at the crux of the balance sheet mismatch between assets and liabilities. That means they stop financing new projects, which in turn kills the business model of the construction sector as well as a principal engine of growth. On the creditor side, doubt spreads whether those who financed local governments will get the return they expect — or even their money back at all. This largely means the household sector, whether directly or through banks (with private sector deposits funding banks’ loans to local governments and property developers). In the former case, you will get a direct effect of lost wealth. In the latter case, you will get a banking crisis thrown in.

If this diagnosis is right, what follows for policy prescription? There are four ways to confront a debt overhang. One is to do nothing, and hope things work themselves out, which is tantamount to accepting slow growth at best, and risk a downward spiral at worst (since slow growth can aggravate the debt problems). Another is fiscal stimulus in combination with structural reforms, as advocated by my colleague Robin Harding, as a way to break out of the funk. The hope is to boost growth fast enough that the debt overhang becomes more manageable and no longer drags the economy down.

If debts are large enough, however — if the shortfall between how wealthy people thought they were before and now realise they are is too big — then the first two approaches will not work. That leaves the last two: restructuring the debts — either through bailouts or writedowns.

Bailouts mean all creditors receive what they are due, because someone — the central government in this case — in one way or another gives the debtors the money they need to ensure that this happens. Writedowns mean some creditors have to realise losses on their claims. But economically speaking, both achieve a reshuffle of the national economy’s balance sheet — that is to say, it rearranges the liabilities and assets of various economic actors vis-à-vis one another. That means they both fulfil the same crucial goals, which are to strengthen the finances of debtors and remove the uncertainty about how much financial assets (especially credit claims) are worth.

Japan, the US, and the eurozone all made the same mistake of waiting for too long to bite the bullet on the need to restructure balance sheets. Even those that finally did, for too long opted to manage balance sheets by means of bailouts rather than writedowns. That led to a severe, sometimes fatal, increase in public debt — hence the need for rescue funds for several eurozone sovereigns and the toxic political stand-off between creditor and debtor economies within Europe’s monetary union.

As a veteran observer of the transatlantic debt crises of 10-15 years ago, I hope Beijing at minimum does not repeat the west’s mistakes. So far, the signs are not good — but there are glimpses of hope, such as the inspection of local government balance sheets. And importantly, the central government is in a much better fiscal position than western governments have been: it has huge net wealth abroad, which could be transferred to whomever has a balance sheet hole it wants to fill. The bailout route is open to it.

But should Beijing take it? While it would clear the decks and free people up to lend, invest, and plan long-term projects again — which would boost growth — it would encourage them to go about things just as they did before. We could then expect the same results, namely a new period of property-fuelled growth before ending up in the same predicament as today, but without the huge central government war chest to repeat the trick.

My view is, therefore, that the sooner you restructure balance sheets through writedowns, the better. The difficult policy and political choice you then have to make is who you force to bear the losses: local governments, banks, investors, or households. In each case you need to have a plan for how to move on. You need to organise what happens to a bankrupt local administration (and its officials). You need new, well-capitalised banks to populate the banking system. You need to compensate innocent victims among households, at least those too poor to bear the losses they face.

But if you do, it will be a lot cheaper than a bailout, and unlike the other policy paths it will set China up for renewed growth, perhaps of a higher quality. Investors, lenders, developers and local administrators will have learned they need to choose projects that really create economic value. What that requires is probably to start building things that benefit those at the bottom and not the top of the income distribution — in a nutshell dwellings and infrastructure to benefit those still in poverty rather than luxury apartments. And that would come on top of balance sheet restructurings that would have cut more into the wealth of the richest than bailouts would do.

Two thought-provoking things follow. One is that the politics of debt are strikingly similar in an autocracy such as China and in rich democracies. The other is that the tolerance of inequality, and the political willingness to reduce it, matters in both cases. That the polity which has brought more of humanity out of poverty than ever in history also seems committed so far to maintaining huge levels of inequality is perhaps the most striking observation one can make of China’s current economic travails.

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