Yves here. A certain amount of complacency has set in about China’s unsustainable economic model, simply because the Middle Kingdom has managed to stay a day of reckoning. I remember similar doubt fatigue setting in during the blowoff phase of the dot-com bubble. Even with more worrying sightings, such as distress in wealth management products (the riskiest part of China’s shadow banking system), many of the bearish sorts believe that China has enough control over its economy that it will engineer a soft landing. Yet it’s hard to ignore stories like these:
My last trip to Shanghai and surrounding cities and my earlier trip in November was eye opening. A couple of years before I was in Shenzhen China vising a PC Board manufacturer to discuss $160,000 in premium freight and scheduling charges which were partially our fault. In the end I recouped half which I thought was fair and made some good contacts
On the way in and out of Shenzhen, we passed an enormous outdoor mall of acres of store fronts unoccupied. Fast forward to 2013/14 and I found the same around Shanghai in Ningbo, Shuzhou, Wuzhen, Wuxi, Nanjing, Haimen, Hangzhou, etc. I am sure you have read about China building infrastructure to keep labor busy. They built ghost towns/malls and housing which the people can not afford. China built for GDP.
Michael Pettis has pointed out more than once that China resolved its last bank crisis of 2002-2003 by having households bear the cost, which led China’s consumption share of GDP to fall. That moves it further away from adjusting from being an export-driven economy to one where internal demand plays a much bigger role. Even though China’s export share has indeed fallen, what has taken its place is not consumer demand but an unheard-of level of investment, much of it in unproductive residential real estate.
Pettis works though some of the implications of China’s high (for an emerging economy) debt levels and how they might be resolved.
Cross posted from MacroBusiness
Exclusively from Michael Pettis’ newsletter:
1. GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%.
2. In that case all GDP-related data is biased in a predictable way. Productivity numbers, for example, are biased upwards, and real worker’s productivity is lower than the numbers posted officially.
3. Losses that are rolled over do not disappear. They are implicitly amortized over the period of the loan, which, assuming that loans are rolled over indefinitely, means that every year a declining portion of that loan is effectively written down.
4. There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created.
5. GDP growth is only artificially boosted during the period in which the total amount of losses rolled over exceeds the amount of the amortization. After that GDP growth is artificially constrained.
6. My numbers above assume that the overstatement and understatement are symmetrical. In fact the process is not symmetrical because of the possibility of financial distress costs. The total value of overstated GDP during the period when losses are being rolled over is only equal to the total value of the subsequent amortization of those losses if there are no financial distress costs.
7. …We must also remember that the only way debt can be resolved is by assigning the losses, either during the period in which the losses occurred or during the subsequent amortization period. There is no other way to “resolve” bad debt – the loss must be assigned, today or tomorrow, to some sector of the economy. “Socializing” the debt, or transferring the debt from one entity to another, does not change this.
8. There are three sectors to whom the cost can be assigned: households, businesses, or the government.
9. …To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth.
10. …Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.
11. Finally Beijing can assign the losses to the state sector, by reforming the houkou system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector.