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China isn’t deleveraging yet | Financial Times

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Good morning. Ethan here; Rob’s away this week. Stocks rose and yields fell yesterday after some jobs data that smelled of soft landing. The quits rate is back at pre-pandemic levels and job openings just keep falling. Goldman Sachs thinks the labour market is rebalancing fast. Disagree? Email me:

More on China and balance sheet recessions

Last week, I wrote about the case that a balance sheet recession is not the best way to understand what ails China. Classic cases of balance sheet recession, as first articulated by the economist Richard Koo, centre on falling asset prices forcing overleveraged households and businesses to cut debt all at once, crushing demand. But in China, asset prices are not widely falling. Home sales volumes have collapsed, but prices have only turned down some. And measures of aggregate indebtedness don’t suggest broad-based deleveraging. Domestic debt as a share of output is close to flat:

Chart of Chinese deleveraging

Rather, China’s problems look more like a consumer confidence deficit plus a meltdown specific to property investment. Consumers’ precarious zero-Covid experience, including its haphazard end, has likely left scars, worsening a pre-existing property downturn. One bit of data I cited to make this argument was a rise in consumers’ precautionary savings. But one esteemed reader thought this missed the point. The FT’s Martin Wolf writes:

Higher ex ante precautionary savings are an extremely plausible element in a balance sheet recession. The essence of such a recession is that economic decision makers are simultaneously poorer and more illiquid than they expected. Higher precautionary savings (due to weaker confidence in the future) are an inevitable consequence, though there are others, as well (weaker investment, for example).

In other words, maybe precautionary savings are just part of a larger balance sheet recession picture, rather than evidence against it. 

One way to push back here is to note that weaker investment has not materialised, other than in the property sector. In Japan’s 1990s balance sheet recession, many companies were overextended amid a broad-based asset bubble; in China, it is largely construction developers that are stretched. And unlike in the US housing crash, China’s real estate bubble is narrowly concentrated in new housing construction, says Adam Wolfe of Absolute Strategy Research. China “never saw credit being used to inflate the value of existing homes,” he points out.

Because the problem is so specific to property development, overall fixed-asset investment has held up, as this chart from Gavekal Dragonomics shows:

Private FAI growth by sector

I put this to Martin, who offered a useful synthesis in reply:

These are good points. Nonetheless, a balance sheet recession in the property sector alone (it was a huge part of the Japanese balance-sheet recession, as in the Spanish and Irish) will surely have a large effect on the economy. The [Gavekal chart above] shows significant falls in real estate investment, which has been a powerful motor of the Chinese economy. Also, in the Chinese context, I would suggest that a move from massive leveraging to flat debt is clearly contractionary. So, I would argue that this is a balance-sheet recession, but so far a weak one or one in very early stages. That is, it is a recession triggered by the end of debt accumulation.

The key point is that an end to China’s leveraging up is enough to badly hurt demand. However, absent clearer evidence of deleveraging, it’s hard to see how China fits the bill of balance sheet recession in Richard’s Koo original sense. Martin adds:

My perspective is, admittedly, not really Koo’s, which focuses on asset prices and debt (that is stock adjustments). I am more interested in sectoral balances (that is flow adjustments, which bear directly on aggregate demand). 

This distinction is important. Does China confront a problem of stocks, or of flows? If what the country faces is rapidly deteriorating stocks of debt and assets, supporting demand is hard. Fiscal policy can help, but ultimately a lot of private sector actors will need to mend their balance sheets. It can take years. This is the classic balance sheet recession story.

But if what China faces instead is dwindling flows of new debt, the picture is different.

Households usually save more than they invest, whereas corporations invest more than they save. In China, cautious households are now saving even more and investing less (most household investment is in property). Unless those higher net savings are redirected into investment through borrowing, aggregate demand will fall. But who can borrow in China right now? Developers cannot access credit. The rest of corporate China is in OK shape, but not so much as to begin a fresh borrowing binge. The only plausible borrower is the state, which is reluctant. This is how a drying up of new debt flows can squash demand.

(Careful readers will point out here that, in theory, an excess of savings could also show up as a bigger current account surplus. This is true, but seems unlikely to close the gap.)

Happily, traditional Keynesian stimulus, particularly direct transfers to households, can solve this problem of flows, offsetting household savings with government borrowing. Unhappily, Chinese authorities appear uninterested in the ready-made fix. As the Wall Street Journal reported over the weekend:

But top leader Xi Jinping has deep-rooted philosophical objections to Western-style consumption-driven growth, people familiar with decision-making in Beijing say. Xi sees such growth as wasteful and at odds with his goal of making China a world-leading industrial and technological powerhouse, they say.

Xi believes Beijing should stick to fiscal discipline, especially given China’s deep debt. That makes stimulus or welfare policies akin to those in the US and Europe less likely, the people said…

Chinese officials told their counterparts at multinational institutions that the many hardships Xi survived during the Cultural Revolution — when he lived in a cave and dug ditches — helped shape his view that austerity breeds prosperity, the people said.

Whether austerity breeds prosperity may be learned the hard way in China.

One good read

Alexandra Scaggs’s Grayscale rant.

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