Global imbalances and the Chinese economy
China’s rebalancing timetable
We often read in the press rather alarming stories about the rise of an ugly and belligerent nationalism in China, but while these stories are certainly very real, after the November 13 bombings in Paris I was struck by a very different kind of Chinese behavior. A lot of young people that I know in Beijing – high school and college students, young professionals, musicians, etc. – were horrified by the violence that occurred in Paris and very eager to express a real sympathy for Parisians, which they did in the ways that young people express themselves today, via smart phones, social media, and all the other things that wouldn’t have occurred to me. I saw an awful lot of these expressions of sympathy and while these are no more than small gestures, of course, they are personal, not official. As someone who loves Paris I was very happy to see lines of solidarity immediately stretch out to include so many young Beijingers, most of whom have never even been to France.
To turn to more mundane topics, last week I received an email from Jorge Guajardo, the former Mexican ambassador to China, with whom I regularly exchange emails in which we discuss the political and economic challenges associated with China’s economic adjustment, along with any insights that his knowledge of Mexican history might provide. While the differences between China and Mexico are obvious, too few of the analysts trying to understand the political economy of China’s adjustment seem to know much about Mexico, or indeed about other developing countries that have undergone similar experiences and whose histories can provide a useful framework with which to understand China.
It is far more common for example to look at the US and Japan for external references and comparisons, even though these two countries have social and political institutions that are far less like those of China than many, if not most, other developing countries. The differences in wealth alone are quantitatively so great that they also become qualitative hurdles. The US, after all, has 7.2 times the per capita GDP of China, according to the IMF, and American households earn around 11 times the per capita income of Chinese households. Japan has 4.8 times the per capita GDP of China and Japanese households nearly 6 times the per capita income. Mexico, on the other hand, has only 1.4 times China’s per capital GDP and less than 2 times the per capita household income.
By the way one of the ways of expressing Chinese rebalancing is to think of it as a closing of the gap between the difference in per capita GDP and per capita household income. In his email Guajardo asked me for details on Chinese consumption levels in order to understand China’s progress on rebalancing demand within its economy, and in my response I referred to this release in October from China’s National Bureau of Statistics:
But the gap is not narrowing quickly enough to rebalance the economy by the end of President Xi’s term in 2023. There are different ways to measure the household income share of GDP and I have no strong arguments in favor of one way or another, but, according to the Economist Intelligence Unit, “Chinese Disposable Personal Income as a Percent of GDP” bottomed out in 2011 at 41.5% and is now rising, reaching 44.0% in 2014. According to the World Bank the “Share of household disposable income and labor (wages) in GDP” bottomed out in 2011 at 60% but in their June 2015 China Economic Update their data only runs to 2012. I am not sure why these numbers are so different.
If we assume that disposable household income is currently half of GDP, eight years of real GDP growth of 6.9% and real disposable household income growth of 7.7% will only raise the household income share of GDP to 53.1% in 2023, a little more than 3 percentage points higher and still below its 21st Century average and leaving China as dependent as ever on investment and the current account surplus. At this rate it would take 25 years for disposable household income to raise by 10 percentage points of GDP, which I would argue is the absolute minimum consistent with real rebalancing.
Even if the gap were to narrow twice as quickly as it is currently narrowing (i.e. if the growth in household income exceed the growth in GDP by 1.6 percentage points) it could easily take 10-15 years for China to adjust sufficiently that its economy can return to sustainable growth. Unless there are far more radical policies implemented to speed up the growth in the household income and consumption shares of GDP, in other words, (and this basically means stepping up the transfer of wealth from the state sector to the household sector), at the current rate we are not going to see sufficient rebalancing for at least 10-15 years.
But does China have 10-15 years? The maximum adjustment period, as I’ve long argued, is largely a function of the country’s debt dynamics. Beijing can keep growth high enough that unemployment is held to acceptable levels only as long as debt can grow fast enough both to
The model shows that even making fairly optimistic assumptions and accepting the lower end of debt estimates, debt cannot stabilize unless growth slows very sharply. If growth does slow sharply enough—to an average of 3% over the next five years – and if at the same time the financial sector is reformed so rapidly that within five years China’s economy is able to grow with no increase in debt (so that China actually begins to deleverage), debt can remain within a 200-220% of GDP range.
But if financial sector reforms fail to result in a sharp improvement in the efficiency of lending, and if Beijing does not permit the economy to slow rapidly, it will be almost impossible to keep debt from rising significantly. Even assuming that higher debt levels do not generate financial distress costs that depress economic growth further (an assumption with which I strongly disagree), there is a real question about whether China can continue another five years without sharply adjusting its growth model during this time.
Making debt sustainable
The model must start with current debt levels, and then project both the growth in debt and the growth in GDP. Although there is a lot of concern about the quality of the data, we do have enough information at least to establish the minimum debt levels. As of the third quarter of 2015, total social financing (TSF), often used as the best proxy for total direct or indirect obligations of the Chinese government and banking system (although it excludes a number of relevant debt categories), had grown by around 12% year on year to RMB 135 trillion, which is equal to about 208% of China’s GDP.
Because of the provincial bond swaps completed this year, in which TSF debt was converted into non-TSF debt, debt actually grew by at least one percentage point faster than the growth in TSF, so with nominal GDP during that same period growing by 6.2%, to say that debt is growing twice as fast as nominal GDP is probably conservative. If we make the heroic assumption that debt-servicing capacity is growing in line with nominal GDP, we can assume, very conservatively, that debt is growing a little more than twice as fast as debt-servicing capacity.
Of course debt growing faster than debt-servicing capacity is unsustainable, so we will set as our first financial sector target the point at which the two grow in line with each other. Once China can reach this point, we will assume that it has resolved its adjustment and that any further increase in debt is sustainable and no longer causes uncertainty about the allocation of debt-servicing costs, and with it financial distress costs, to rise.
This is also a fairly heroic assumption. All the historical evidence – even more so for developing countries – suggests when an economy is perceived as being excessively leveraged, there is significant downward pressure on growth and increasing financial fragility until the economy begins systematically to deleverage. Deleveraging usually occurs either because the government has implemented policies that explicitly assign losses to sectors of the economy that are able to absorb these losses without creating financial distress conditions, or because creditors are forced into explicit or implicit debt forgiveness (for example through debt restructuring). We will assume however that deleveraging isn’t necessary, and that it is enough merely to keep the debt-to-GDP ratio stable.
For our model we are going to propose an average growth rate for a ten-year period, and we will assume that during this period, nominal GDP growth drops by a constant amount every year to reach this average growth rate. Nominal GDP growth will decline in a straight line from 6.2%, in other words. We will also assume that at first debt will grow just over twice as fast as GDP, as it is doing today, but this ratio will decline in a straight line until, at the end of ten years, debt is growing at the same speed as nominal GDP, so that the debt-to-GDP ratio is stable.
That is all it takes. If the total amount of debt today is equal to 208% of GDP, the total amount of debt as a share of GDP in ten years in our model will be wholly a function of the GDP growth rate. Here are the numbers:
If Beijing tries to maintain high growth rates of around 6%, unless there is a dramatic and disruptive change in the financial system it is unlikely to be able to do so without seeing debt grow at the end of ten years to 274% of GDP, something that no country under relevant circumstances has accomplished. Even if Beijing sharply reduces growth, to 3% on average (if household income grows at 5%, as China rebalances, household income will rise from 50% to 61% of GDP), debt must still reach nearly 251% of GDP without disrupting the economy.
One great advantage of this model over most others is that it makes very explicit the relationship between credit growth and GDP growth, so that it is impossible accidentally to posit scenarios in which debt is implicitly assumed to decline inconsistently with GDP growth acceleration. Debt levels in this model are specifically associated with different GDP growth levels, so that this model allows us to acknowledge that a country can safely service and refinance higher debt levels if it is believed to have greater growth potential.
It is clear from the model, however, that without a major change or disruption in policymaking, current debt dynamics will be hard to sustain, even with assumptions underlying the logic that are very conservative. What the model tells us is that if GDP growth declines in an orderly way – which assumes that there will be no unexpected shocks or disruptions – and if Beijing is able to reform the financial system and improve the relationship between credit growth and nominal GDP growth so that the two are sustainable at the end of ten years, there is almost no scenario under which debt does not rise sharply, in many cases perhaps out of control.
Many analysts argue that total debt in China in fact exceeds TSF, and believe that the true debt level is closer to 250% of GDP, and perhaps even more if we include the substantial number of corporate receivables that have surged in recent years. If this were true, and for those who want to make the appropriate adjustments, increasing the initial amount of debt by 42 percentage points, to 250% of GDP, would cause an increase in the final debt numbers ranging from 51 percentage points of GDP for growth rates of 3% to 54 percentage points for growth rates of 6%.
Tweaking the model
A more serious criticism is that Beijing has been trying to reduce the credit intensivity of growth at least since Wen Jiabao’s famous “Four Uns” speech of March, 2007, but has failed to do so. Credit is growing more slowly than it has in the past but not because the financial system has become more efficient but simply because debt levels have become too high, causing regulators to force down the growth in credit without seriously improving the efficiency of the financial sector. The result is that lower credit growth simply means lower GDP growth.
It is difficult to model the many ways credit intensivity of growth can change, but if we simply assume that there is no improvement except as growth slows, so that the ratio between credit growth and GDP growth stays constant, the table below shows debt levels at the end of ten years at different GDP growth rates:
On the other hand if we make assumptions that are far more favorable, if less plausible, and propose that nominal GDP will grow at 3-6% on average for the next ten years, but that the relationship between the growth in credit and GDP growth will improve much more dramatically than in our first set of scenarios, it is still hard to work out a good scenario. Let us propose that at the end of ten years, instead of debt growing at the same pace as GDP, as in our first set of scenarios, the efficiency of the financial sector will have improved to such an extent that it can generate up to 6% GDP growth without any increase in debt at all. We will also assume that to get there does not require a financial crisis or any debt forgiveness, and that the financial sector gets there smoothly.
This would be a remarkable achievement, and probably unprecedented in history, and it would be just barely enough to solve China’s debt problem. Here is the table that lists the debt-to-GDP ratio as a function of GDP growth:
It is in my opinion almost impossible that China would be able to improve its financial efficiency so dramatically without a significant slowdown in growth, but at least mechanically it is clear that if China were able to do so while maintaining nominal growth rates on average of 5-6%, by the end of ten years China’s debt to GDP ratio would be largely unchanged, although this would only happen after having risen to 235% during the first five years.
This set of scenarios probably represents the absolute upper limit of optimism for anyone who hopes that China can adjust smoothly and non-disruptively over a ten-year period without a dramatic change in policy, most importantly a process of wealth transfer in which as much as 2-4% of GDP is transferred from the state sector to ordinary households every year for many years. Under these scenarios debt stabilizes at a sustainable level at the end of the ten-year period, and growth rates remain reasonably high, but it is important to specify the assumptions to make clear just how difficult and unlikely this set of scenarios is likely to be:
Varying the adjustment period
If we do the same exercise using the same assumptions we used in our very fist set of scenarios, but allow for a longer adjustment period, say fifteen years, we get the following results:
These numbers are clearly too high and show that there is no point in trying to develop scenarios in which China adjusts more slowly over a longer period of time. The argument that the more carefully and slowly Beijing manages the adjustment process, most especially the reform of the financial sector, the less likely it is to be disruptive, can only be true if we assume that there is no limit to Beijing’s ability to raise debt credibly.
If instead we go in the other direction and assume that Beijing adjusts more aggressively, and if we do the same exercise using the same assumptions but this time posit a seven-year adjustment period, we get the following three sets of results. The first set assumes that at the end of the 7-year period debt is growing at the same rate as nominal GDP:
The second set assumes that at the end of the 7-year period the nominal growth in debt is zero:
In this scenario debt rises to roughly 225% of GDP during the first four years before declining. And finally the third set of scenarios assumes that there is no improvement in the credit intensity of growth:
For the sake of completion, I will make the same set of assumptions and assume that Beijing moves even more aggressively, and in the first set of scenarios gets the growth in credit to keep pace with the growth in nominal GDP within five years, and in the second set of scenarios gets credit the growth in credit to drop to zero within five years. Here is the relationship between credit growth and GDP growth:
Once again in the second set of scenarios, in which the improvement in the financial sector is so dramatic that within a few years China begins to deleverage and in five years GDP is able to grow with no growth at all in credit, debt rises to 27-19% of GDP in the first three years before declining.
I can keep going but the conclusions are pretty clear.
What matters is the associated growth in credit. If growth next year of 7% were achieved with 18% growth in credit, things would actually be getting worse, not better. On the other hand if China grew next year by 5%, with credit growing at “only” 8%, this would represent a significant improvement in China’s medium- and long-term growth prospects. This is something that a lot of economists seem to have real trouble in understanding. There is no “good” level of economic growth independent of the associated growth in credit.
Ultimately, and to repeat Conclusion 5 above, Beijing must continuously choose between a rising debt burden, rising unemployment, or rising transfers of wealth from the state sector. All of its policy options boil down to one or more of these three. So far it has mostly chosen the first, but this can only go on until the country reaches debt capacity limits.
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To turn to more mundane topics, last week I received an email from Jorge Guajardo, the former Mexican ambassador to China, with whom I regularly exchange emails in which we discuss the political and economic challenges associated with China’s economic adjustment, along with any insights that his knowledge of Mexican history might provide. While the differences between China and Mexico are obvious, too few of the analysts trying to understand the political economy of China’s adjustment seem to know much about Mexico, or indeed about other developing countries that have undergone similar experiences and whose histories can provide a useful framework with which to understand China.
It is far more common for example to look at the US and Japan for external references and comparisons, even though these two countries have social and political institutions that are far less like those of China than many, if not most, other developing countries. The differences in wealth alone are quantitatively so great that they also become qualitative hurdles. The US, after all, has 7.2 times the per capita GDP of China, according to the IMF, and American households earn around 11 times the per capita income of Chinese households. Japan has 4.8 times the per capita GDP of China and Japanese households nearly 6 times the per capita income. Mexico, on the other hand, has only 1.4 times China’s per capital GDP and less than 2 times the per capita household income.
By the way one of the ways of expressing Chinese rebalancing is to think of it as a closing of the gap between the difference in per capita GDP and per capita household income. In his email Guajardo asked me for details on Chinese consumption levels in order to understand China’s progress on rebalancing demand within its economy, and in my response I referred to this release in October from China’s National Bureau of Statistics:
Based on the integrated household survey, in the first three quarters of 2015, the national per capita disposable income was 16,367 yuan, a nominal growth of 9.2 percent year-on-year or a real increase of 7.7 percent after deducting price factors, which was 0.1 percentage point higher than that in the first half of the year.
I am not sure how comparable the two numbers are, but with real GDP growing at 6.9% and nominal GDP at 6.2%, it seems that disposable household income is growing 0.8 percentage points faster in real terms and 3.0 percentage points faster nominally (I am assuming population growth is more or less flat as the household income numbers are per capita). I don’t know how to reconcile these two numbers, but the gap between the growth in household income and growth in GDP, which is at the heart of rebalancing, is clearly reversing. After decades in which GDP growth sharply outpaced the growth in household income – and, with it, consumption growth – we must see this reversal, so that the growth in household income exceeds GDP growth by enough that the consumption share of GDP can return to healthy levels.But the gap is not narrowing quickly enough to rebalance the economy by the end of President Xi’s term in 2023. There are different ways to measure the household income share of GDP and I have no strong arguments in favor of one way or another, but, according to the Economist Intelligence Unit, “Chinese Disposable Personal Income as a Percent of GDP” bottomed out in 2011 at 41.5% and is now rising, reaching 44.0% in 2014. According to the World Bank the “Share of household disposable income and labor (wages) in GDP” bottomed out in 2011 at 60% but in their June 2015 China Economic Update their data only runs to 2012. I am not sure why these numbers are so different.
If we assume that disposable household income is currently half of GDP, eight years of real GDP growth of 6.9% and real disposable household income growth of 7.7% will only raise the household income share of GDP to 53.1% in 2023, a little more than 3 percentage points higher and still below its 21st Century average and leaving China as dependent as ever on investment and the current account surplus. At this rate it would take 25 years for disposable household income to raise by 10 percentage points of GDP, which I would argue is the absolute minimum consistent with real rebalancing.
Even if the gap were to narrow twice as quickly as it is currently narrowing (i.e. if the growth in household income exceed the growth in GDP by 1.6 percentage points) it could easily take 10-15 years for China to adjust sufficiently that its economy can return to sustainable growth. Unless there are far more radical policies implemented to speed up the growth in the household income and consumption shares of GDP, in other words, (and this basically means stepping up the transfer of wealth from the state sector to the household sector), at the current rate we are not going to see sufficient rebalancing for at least 10-15 years.
But does China have 10-15 years? The maximum adjustment period, as I’ve long argued, is largely a function of the country’s debt dynamics. Beijing can keep growth high enough that unemployment is held to acceptable levels only as long as debt can grow fast enough both to
- Roll over the large and growing amount of debt whose principal and interest cannot be serviced from earnings generated by whatever project the debt funded, and
- Fund the required amount of additional investment or consumption to generate enough economic activity to keep unemployment from rising.
The model shows that even making fairly optimistic assumptions and accepting the lower end of debt estimates, debt cannot stabilize unless growth slows very sharply. If growth does slow sharply enough—to an average of 3% over the next five years – and if at the same time the financial sector is reformed so rapidly that within five years China’s economy is able to grow with no increase in debt (so that China actually begins to deleverage), debt can remain within a 200-220% of GDP range.
But if financial sector reforms fail to result in a sharp improvement in the efficiency of lending, and if Beijing does not permit the economy to slow rapidly, it will be almost impossible to keep debt from rising significantly. Even assuming that higher debt levels do not generate financial distress costs that depress economic growth further (an assumption with which I strongly disagree), there is a real question about whether China can continue another five years without sharply adjusting its growth model during this time.
Making debt sustainable
The model must start with current debt levels, and then project both the growth in debt and the growth in GDP. Although there is a lot of concern about the quality of the data, we do have enough information at least to establish the minimum debt levels. As of the third quarter of 2015, total social financing (TSF), often used as the best proxy for total direct or indirect obligations of the Chinese government and banking system (although it excludes a number of relevant debt categories), had grown by around 12% year on year to RMB 135 trillion, which is equal to about 208% of China’s GDP.
Because of the provincial bond swaps completed this year, in which TSF debt was converted into non-TSF debt, debt actually grew by at least one percentage point faster than the growth in TSF, so with nominal GDP during that same period growing by 6.2%, to say that debt is growing twice as fast as nominal GDP is probably conservative. If we make the heroic assumption that debt-servicing capacity is growing in line with nominal GDP, we can assume, very conservatively, that debt is growing a little more than twice as fast as debt-servicing capacity.
Of course debt growing faster than debt-servicing capacity is unsustainable, so we will set as our first financial sector target the point at which the two grow in line with each other. Once China can reach this point, we will assume that it has resolved its adjustment and that any further increase in debt is sustainable and no longer causes uncertainty about the allocation of debt-servicing costs, and with it financial distress costs, to rise.
This is also a fairly heroic assumption. All the historical evidence – even more so for developing countries – suggests when an economy is perceived as being excessively leveraged, there is significant downward pressure on growth and increasing financial fragility until the economy begins systematically to deleverage. Deleveraging usually occurs either because the government has implemented policies that explicitly assign losses to sectors of the economy that are able to absorb these losses without creating financial distress conditions, or because creditors are forced into explicit or implicit debt forgiveness (for example through debt restructuring). We will assume however that deleveraging isn’t necessary, and that it is enough merely to keep the debt-to-GDP ratio stable.
For our model we are going to propose an average growth rate for a ten-year period, and we will assume that during this period, nominal GDP growth drops by a constant amount every year to reach this average growth rate. Nominal GDP growth will decline in a straight line from 6.2%, in other words. We will also assume that at first debt will grow just over twice as fast as GDP, as it is doing today, but this ratio will decline in a straight line until, at the end of ten years, debt is growing at the same speed as nominal GDP, so that the debt-to-GDP ratio is stable.
That is all it takes. If the total amount of debt today is equal to 208% of GDP, the total amount of debt as a share of GDP in ten years in our model will be wholly a function of the GDP growth rate. Here are the numbers:
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 274% |
| 5% | 267% |
| 4% | 259% |
| 3% | 251% |
One great advantage of this model over most others is that it makes very explicit the relationship between credit growth and GDP growth, so that it is impossible accidentally to posit scenarios in which debt is implicitly assumed to decline inconsistently with GDP growth acceleration. Debt levels in this model are specifically associated with different GDP growth levels, so that this model allows us to acknowledge that a country can safely service and refinance higher debt levels if it is believed to have greater growth potential.
It is clear from the model, however, that without a major change or disruption in policymaking, current debt dynamics will be hard to sustain, even with assumptions underlying the logic that are very conservative. What the model tells us is that if GDP growth declines in an orderly way – which assumes that there will be no unexpected shocks or disruptions – and if Beijing is able to reform the financial system and improve the relationship between credit growth and nominal GDP growth so that the two are sustainable at the end of ten years, there is almost no scenario under which debt does not rise sharply, in many cases perhaps out of control.
Many analysts argue that total debt in China in fact exceeds TSF, and believe that the true debt level is closer to 250% of GDP, and perhaps even more if we include the substantial number of corporate receivables that have surged in recent years. If this were true, and for those who want to make the appropriate adjustments, increasing the initial amount of debt by 42 percentage points, to 250% of GDP, would cause an increase in the final debt numbers ranging from 51 percentage points of GDP for growth rates of 3% to 54 percentage points for growth rates of 6%.
Tweaking the model
A more serious criticism is that Beijing has been trying to reduce the credit intensivity of growth at least since Wen Jiabao’s famous “Four Uns” speech of March, 2007, but has failed to do so. Credit is growing more slowly than it has in the past but not because the financial system has become more efficient but simply because debt levels have become too high, causing regulators to force down the growth in credit without seriously improving the efficiency of the financial sector. The result is that lower credit growth simply means lower GDP growth.
It is difficult to model the many ways credit intensivity of growth can change, but if we simply assume that there is no improvement except as growth slows, so that the ratio between credit growth and GDP growth stays constant, the table below shows debt levels at the end of ten years at different GDP growth rates:
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 380% |
| 5% | 346% |
| 4% | 314% |
| 3% | 284% |
This would be a remarkable achievement, and probably unprecedented in history, and it would be just barely enough to solve China’s debt problem. Here is the table that lists the debt-to-GDP ratio as a function of GDP growth:
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 201% |
| 5% | 209% |
| 4% | 216% |
| 3% | 225% |
This set of scenarios probably represents the absolute upper limit of optimism for anyone who hopes that China can adjust smoothly and non-disruptively over a ten-year period without a dramatic change in policy, most importantly a process of wealth transfer in which as much as 2-4% of GDP is transferred from the state sector to ordinary households every year for many years. Under these scenarios debt stabilizes at a sustainable level at the end of the ten-year period, and growth rates remain reasonably high, but it is important to specify the assumptions to make clear just how difficult and unlikely this set of scenarios is likely to be:
- We are assuming that TSF captures the total relevant amount of debt.
- We are assuming that the growth in debt-servicing capacity is on average equal to the growth in nominal GDP.
- We are assuming that the financial system will adjust smoothly and without friction.
- We are assuming that there are no financial distress costs, so that as debt rises, it does not put downward pressure on GDP growth.
- Finally, and this is a fairly complex assumption, we are assuming that if there is unrecognized bad debt in the banking system that is being rolled over regularly, the interest cost is effectively zero. If the amount of bad debt in the system is low, we can safely ignore this assumption, but if say 20% of the loans consist of unrecognized bad debt, this will increase the growth rate of debt by perhaps 1-2 percentage points annually.
Varying the adjustment period
If we do the same exercise using the same assumptions we used in our very fist set of scenarios, but allow for a longer adjustment period, say fifteen years, we get the following results:
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 307% |
| 5% | 297% |
| 4% | 286% |
| 3% | 276% |
If instead we go in the other direction and assume that Beijing adjusts more aggressively, and if we do the same exercise using the same assumptions but this time posit a seven-year adjustment period, we get the following three sets of results. The first set assumes that at the end of the 7-year period debt is growing at the same rate as nominal GDP:
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 250% |
| 5% | 245% |
| 4% | 241% |
| 3% | 236% |
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 200% |
| 5% | 205% |
| 4% | 211% |
| 3% | 217% |
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 317% |
| 5% | 297% |
| 4% | 277% |
| 3% | 259% |
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 235% |
| 5% | 232% |
| 4% | 229% |
| 3% | 226% |
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 199% |
| 5% | 203% |
| 4% | 207% |
| 3% | 212% |
| Nominal GDP growth | Debt as a share of GDP |
| 6% | 281% |
| 5% | 268% |
| 4% | 256% |
| 3% | 243% |
I can keep going but the conclusions are pretty clear.
- Credit growth in China is too high as are current debt levels, and the sooner Beijing gets credit growth under control, the better. This latter statement in itself is not controversial of course, but my simple debt model shows just how urgent it is for Beijing to get credit growth under control. It clearly does not have ten years or even seven years. It might have five years, but only if the markets – Chinese investors, businesses, and savers, both wealthy and middle class – are convinced that it is moving in the right direction.
- There is no obvious level at which debt levels for any country are too high, but China is already at the very high end among developing countries, and of course the more debt rises relative to GDP, the greater the risk of some kind of debt-related disruption.
- If you ask most economists why “too much debt” is bad, they will tell you that it is because the higher the level of debt, the greater the risk of a debt crisis. Unfortunately this very unsophisticated answer turns the discussion about debt into a discussion about why China will or will not have a debt crisis at current or future projected debt levels.
It also means, unfortunately, that for those who believe (and I include myself in this group) that the structure of Chinese financial markets and Beijing’s high credibility give it protection from the risk of debt crisis – so that a debt crisis is unlikely except at very much higher debt levels – there is little to worry about. In fact the real cost of excessive debt levels is what finance specialists call “financial distress” costs, and I have explained elsewhere how debt can become excessive. China is already experiencing financial distress costs and as debt rises, these costs will make it harder and harder for China to achieve target growth rates except at the expense of even more debt, so that rising debt automatically means lower growth than otherwise.
There is so much evidence supporting the view that high debt levels in an economy reduce that economy’s growth that it is surprising how few economists understand the urgency of getting credit growth under control. In the past whenever growth has slowed sharply in an overly indebted economy, economists blame the inadequacy of reforms and the cowardice of policymakers, but if slower growth has happened in every single case of excessive debt, it is absurd to blame the pusillanimity of policymakers. We are already seeing how rising debt levels have caused Chinese growth to drop below projections year after year, and already economists are shifting the blame from their ineffective models to the incompetence of Beijing’s economic stewardship. And as debt continues to grow, the economy will continue to slow, and economists will continue to blame Beijing’s incompetence.
- The great difficulty of reducing credit growth is that it will lead to higher unemployment as manufacturing capacity is closed down and less infrastructure built. The only way to prevent rising unemployment is by opening up or increasing other sources of demand that do not require even faster growth in credit.
Some of these other sources of demand, like a greater current account surplus or enough of a realignment of the financial sector towards productive investment, are too impractical or uncertain to rely on, and in the end the only certain alternative source of demand is domestic consumption. Domestic consumption, however, is constrained by the low household income share of GDP, as I explained in the opening section of this essay, and so Beijing must speed up the process as much as it can. Ultimately the only way it can do so is by transferring wealth from the state sector to the household sector, something it is trying to do and which is recognized in the Third Plenum reforms, but this is politically very tough.
I would argue that if China can engineer a process by which at least 2% of GDP is transferred directly or indirectly to the household sector every year (or is used to pay down debt), it can easily avoid a debt problem or many years of economic stagnation. If it doesn’t, however, it is hard to see how China can adjust quickly enough to avoid at the very least a “lost decade” or two of low growth.
- In every one of its economic policymaking choices, Beijing must ultimately choose between higher debt, higher unemployment, or higher transfers of wealth from the state sector to the household sector. Every single policy results in some combination of the three. The time frame within which this must be resolved is set by deb capacity limits, and as my model shows, Beijing probably has no more than five years, perhaps much less, within which to resolve the rebalancing if it wants to avoid a disruptive rebalancing.
What matters is the associated growth in credit. If growth next year of 7% were achieved with 18% growth in credit, things would actually be getting worse, not better. On the other hand if China grew next year by 5%, with credit growing at “only” 8%, this would represent a significant improvement in China’s medium- and long-term growth prospects. This is something that a lot of economists seem to have real trouble in understanding. There is no “good” level of economic growth independent of the associated growth in credit.
Ultimately, and to repeat Conclusion 5 above, Beijing must continuously choose between a rising debt burden, rising unemployment, or rising transfers of wealth from the state sector. All of its policy options boil down to one or more of these three. So far it has mostly chosen the first, but this can only go on until the country reaches debt capacity limits.
Aside from this blog, every month, sometimes more often, I put out a 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 and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation. Investors who want to buy a subscription should write to me, also at that address.
In this, I have a question: Yukon Huang, in China’s Debt Dilemma, argues that views like yours (indeed, he specifically cites you) are overly pessimistic because asset price increases are sustainable and thus debt buildup is not an issue; he argues that the decline of growth impact from credit is due to most credit being allocated to FAI rather than GFCF, and that the only partial nature of FAI’s impact on growth figures means that we are underestimating added value to the economy. Thus, he believes that:
“[M]uch of the recent surge in China’s credit-to-GDP ratio can be thought of as financial deepening as China moves toward more market-based asset values. Once those values are established, land price growth and the
amount of credit being channeled to these uses will level off. This will lead to a gradual shift in the allocation of credit back toward growth-enhancing GFCF investment and to a rebound in the growth impact of credit, allowing over 7 percent growth to continue even as credit slows. ”
How would you respond to this argument, given it seems almost the polar opposite of the one you have made?
Also, apologies for any errors this post contains; as noted, economics is not my field.
As for Huang’s arguments, aside from the fact that China has evolved very much as I have been saying for the past six years, and not as Huang and the other optimists claimed (until 2009-10 they usually argued that a slowing China meant that growth would stabilize around 9%, but since then, perhaps for good reason, they have been very reluctant to provide a growth forecast, and have instead have simply accepted each new, lower growth rate as their growth rate they all along expected) I think there is a lot fundamentally wrong with the model he and most economists use and with which I strongly disagree. For example he argues very consistently that China’s high savings rate is the natural outcome of a rapid rise in income, in the sense that an increase in consumption tends to lag an increase in income when a person’s income rises very quickly. The problem with this is that it would be a good explanation only if China’s soaring savings were caused by soaring household savings, but in fact the household savings rate has not risen much (except of course in the past few years as uncertainty rose sharply), and anyway China’s soaring savings rate can so much more easily and logically be explained by the falling household income share.
Huang is of course right to say that debt used to fund investment is better “protected” by debt-servicing capacity than debt used to fund, say, consumption, but this much is obvious, and has never been doubted by me or anyone else. But when you misallocate investment, it is as if a portion of your debt is used to fund investment and a portion used to fund “nothing”, and when you misallocate it on such a massive scale, there is likely to be a lot of debt that cannot be serviced by the assets. It is obvious that borrowing $100 for consumption leaves you more exposed than borrowing $100 to create investment, but if the value of the investment is only $50, then if you do the latter twice, it is not obvious that you are any longer less exposed. I don’t see why they have trouble understanding this. If investment misallocation goes on long enough, at SOME point it must be too much.
It is not as if I am making the argument that this is the first time this has ever happened. Huang’s defense of bad investment is the same one used to explain why the Soviet investment spree in the 1950s and 1960s, or Brazil’s in the 1960s and 1970s, or Japan’s in the 1980s, and many others, could not lead to a debt crisis or a long period of stagnation, and it has always been wrong. If you misallocate investment long enough, simply refusing to recognize the fact is not a way to avoid the consequences. Eventually you will be forced into taking the loss.
Also how might inflation play a role? Can’t China just drop money like helicopter Ben and hope that inflation reduces the burden. Though clearly developed world experiences with Qe haven’t yet been inflationary. But Japan is clearly on the way to monetizing debt. Can’t China just do nominal gdp targeting, or perhaps that leads to more unsustainable credit growth.
“Once the government decided to inject public funds to rehabilitate the financial system, the first question it had to resolve was what exactly constituted “non-performing loans.” Before the crisis, only loans in arrears for six months or more had been classified as non-performing loans. In estimating the true magnitude of the NPLs, the government decided to include loans in arrears for three months in line with internationally acceptable standards. Using this standard, the government estimated the total size of the outstanding NPLs at 118 trillion won or roughly 28% of Korea’s GDP in 1998 This was twice the amount of NPLs estimated earlier on the old asset classification standards.
The actual amount of funds disbursed by 2002 substantially exceeded both estimates. It was no less than 160.4 trillion won, or 30% of the 2002 GDP.”
https://www.imf.org/external/np/seminars/eng/2006/cpem/pdf/kihwan.pdf
What you are describing above is an attempt to measure the accounting value of NPLs. This is useful because it may serve as a proxy, but it masks bad investment by transferring resources from good investments. For example assume two companies, one of which is insolvent and unable to service its debt and the other solvent and easily able to do so. if you merge the two, it is possible that suddenly all loans can be serviced and the former NPLs will no longer be included.
If you are interested in the profitability of a bank, it makes sense. If you are interested in estimating the amount of resources China will need to cover for misallocated investment, it doesn’t. However for what it is worth if you were to tell me that you had completed a very sophisticated analysis whose conclusion was that bad loans amounted to 30% of GDP, while I would be skeptical about your methodology, I would not be skeptical about your conclusion. It could easily be 30% or even more. The quicker Beijing recognizes and resolves the bad loans, the lower the total amount will be.
You might recognize process this if you had followed the US S&L crisis. If the US had closed down the S&Ls in the late 1970s, when it was clear that most of them were insolvent, the estimates are that it might have cost 1% of GDP. By waiting a decade, hoping that they might “earn” their way out of insolvency, the government may have quadrupled the total cost to taxpayers, although this cost was stretched out over a longer period.
Now that’s the governmental debt, and this is about private debt. However, a lot is various state-associated entities and governments do sometimes prop up private entities as well. We’ve seen that China has surpassed all previously countries in marshalling private resources for economic growth. Could they do the same for supporting existing debt?
I’m mostly saying this as a devil’s advocate, but I think we have to consider how much debt China will be able to bear when the government gets behind bearing it. These numbers might be too much, but I don’t think you can dismiss the government’s capacities out of hand based on prior examples.
Secondly, if you’re using Japan at 200% of GDP as a good example, I don’t know how that’s a good example. Japan has basically stagnated for 25 years now. 50% of their tax revenues go towards debt servicing costs while their yield curves are effectively flat. China has similar population demographics to Japan in the late 80’s and early 90’s too. The only thing we have to remember about China is that China is coming from a lower level of development, but much of China doesn’t have the same geographical advantages (basically the parts of China outside of Cantonia) for capital formation as Japan either.
Thirdly, China isn’t a developed country. Both the UK and Japan are at very, very high levels of development with liberal institutions that’ve been credible for centuries. For China, none of those things are true. There’s lots of internal divisions in China and, for all practical purposes, around 60-70% of Chinese territory is basically viewed as occupied territory.
Fourthly, there’s no real distinction between private debt and public debt in places like China or Japan. The entire financial system is basically a power-brokering mechanism for the ruling class. Thinking of China as a modern-day nation-state leads to faulty conclusions. China has an imperial governance system where the financial system’s existence is purely to build/maintain geopolitical momentum while serving as a power-brokering mechanism between elites. Almost all debt is probably explicitly or implicitly backed by the state. China also doesn’t have liberal institutions like the US, so it lacks the same flexibility to adjust.
Michael,
I’m reading Schiller/Akerloff’s “Phishing for Phools,” where they talk about how S&L managers were incentivized to loot their companies once it became clear they were insolvent (but were allowed to keep operating anyway). They make the point that bankruptcy law is in fact intended (in part) to prevent this kind of looting. I understand that bankruptcy laws and other rules are not the same in China now as they were in the US in the 1980s, but I wonder whether Chinese managers of insolvent companies also face similar incentives to loot.
As an aside, Schiller has an incredible knack for being timely with his books (2000 about the stock market, 2008 about the housing market, and this year more broadly about deception and manipulation). I wonder if he’s gotten lucky with his timing again.
I have a question. You have written on a number of occasions about transfers of wealth from the state to the household sector. This makes good sense to me in the abstract, but I have such a hard time understanding what it could mean in concrete, practical terms.
To pick an example: there is a certain industry, let’s call it M, for which China has built a large number of state-owned facilities. These are sometimes owned by regional gov’t and sometimes by the central gov’t. I’ve visited lots of these as I’ve had some years of dealings in the M business. They are uniformly unprofitable. It is impossible for them in their present condition — they way they are managed mostly, but in some instances even considerations about the physical facilities themselves, their locations, and above all the people who are available to staff them from top to bottom — to be competitive with M companies from other countries.
It seems obvious to me from a business point of view that selling or even giving these facilities (and their employees and intellectual property etc, whatever) to the private sector won’t change the basic fact of their unprofitability. What would be required is a wholesale reinvention of business M in China, which hasn’t and can’t happen precisely because of the existence of these facilities and more importantly their ownership. But such a wholesale reinvention will take decades, possibly generations. If on the other hand these facilities are simply sold as scrap or real estate, it will be a tremendous markdown and the household sector won’t get especially much out of it.
Now, if M is an isolated case then it’s perhaps no matter. But I can’t imagine why it would be an isolated case.
In brief, I don’t quite get the transfer from state to household thing. If what the state owned were very liquid assets that could be easily redeployed and if all the necessary conditions for successful redeployment were in place, I could see it. But it doesn’t look at all like that’s the case to me.
But this statement can’t be true in the abstract; it will depend on each company, its position in the national and international economy, etc. A film-making company that makes films that no one wants to watch will not find that people automatically like its movies more if it has less debt. A steel-making factory with a lot of debt will, even if that debt is transferred off its balance sheet, find itself in an industry with tremendous overcapacity in a marketplace that is slumping internationally. And so on. Admittedly offloading all the debt is a big help in pushing the company toward profitability, but … there’s also the question of whether the remainder of the balance sheet and the people in the company amount to a business that can at least break even.
If a company has no operating profit, and is restructured until it does, then it becomes profitable and thus the cost of its debt (once removed) is no longer being carried by the household sector.
If the company is closed for whichever reason, again, the cost of debt is removed from the household sector. In addition, it allows the household sector to compete for the same products (if they still exist and if it is possible, of course), it releases employees to the private sector; it might reduce pollution, which again is an external cost on the household sector etc. This of course has been done before, it’s very common in the textile industry for example to see private mega-companies which used to be SOEs. Then again, some of these companies might in fact have the same low cost of capital as SOEs due to their size and history.
But, yes, you are right in a way. The more I think about it the more it seems very unlikely to succeed, other than theoretically as an equation on a paper.
Increase in household debt can also be done via RE I guess, allow 20%, then 15%, then 10% equity, and if that is not enough go for 0%. This already started to some degree and of course will not end well.
(I’m replying to your comment below; for some reason the “Reply” button doesn’t appear below your comment in my browser.)
you write: “If a company has no operating profit, and is restructured until it does, then it becomes profitable and thus the cost of its debt (once removed) is no longer being carried by the household sector.”
the thing is that there is no easy way, probably no way at all in general, to restructure unprofitable companies so that they become profitable. there is no inexorable law that says that every company can be tweaked until profitable.
In China, there are many kinds of companies. There are some that are predominantly private-sector companies, that are very strong and well-managed companies with big markets, good solid management, and a staff of able employees. Huawei is a good example of this. So is Haier. But there are lots of examples. There are for examples lots of OEM manufacturers that are basically profitable enterprises; one sees hundreds of them advertising their products and services on alibaba and taobao. But because these companies are generally private-sector companies, there is nothing to transfer to the household sector from them.
Then you have SOEs. There are some big ones that are obviously profitable in the sense of operating profit. China Mobile is an example; it’s a real, solid company. But there are a huge number of gov’t-owned companies, ranging from these top-shelf big names down through the thousands of smaller companies that are owned by regional governments and cities and what-not. And a whole host of companies that are effectively government owned, because they are created by people who are closely connected to the government, using their extensive gov’t connections to raise money for the business, get special inputs for the business like land and buildings and special licenses and what-not.
I have had the good fortune to visit many such companies in China in a fair number of different industries. At the risk of painting with too broad a brush, one can make some fairly categorical statements about them. First, they are very much focused on the government as an ultimate source of “revenue”. They are highly tuned to gov’t initiatives, know how to get money from the gov’t, whether in the form of loans or in the form of purchase commitments from other such companies, or what not. They are machines for turning guanxi into cash. These companies are deeply unprofitable, regardless of what their income statements may indicate, for the simple reason that they don’t really exist for the purpose of turning a “profit” in the ordinary sense of the word. Yes, they have products and services; but invariably when one digs, the appearance and the reality diverge enormously. It’s a big mistake in my opinion to think of these in the same way as one thinks of, for example, an electronics manufacturer in Shenzhen that is making components for inclusion in exported electronic products. The companies I’m talking about would not exist at all were it not for the very distorted dynamics of the economy of China and its intimate relation to the government. They are backstopped by the government; they don’t “go bankrupt”; instead, heads roll. It isn’t realistic to think that such companies can be “transferred to the household sector”. Transfer what? The guanxi? That is their real asset. It isn’t the kind of asset that transfers well to the private sector, whatever that would mean. The critical point is that the management structure of those companies isn’t built in such a way that would allow them to be successful as private enterprises. Restructuring them so that they are profitable would mean firing the entire company — the managers who are not really managers at all, in any meaningful sense, and the employees who have been trained to please their non-managers while eeking out a meager living in exchange for a degree of financial security. The plant and equipment is in most cases lacking in one of a number of ways. Have been secured by people who are not really serious about the business for its own sake, the assets are often weirdly imbalanced (too much of this and none of that). It is often badly maintained; in other cases it is brand new having never really been used for its ostensible purposes. One sees every kind of weird thing.
Now, the question is, are there a bunch of SOEs out there that have an operating profit but that are weighed down by excessive debt, so that the main problem they face is debt load? I’m really skeptical. Michael indicates above that many of these companies have made bad investments, and that’s the origin of their balance sheet woes. What I have seen is that, in the first place, most of these companies *are* the bad investment; secondly, such investments as they have made have a heavy component of physical plant and equipment and recovering value from that means either simply selling those assets or else hoping against hope that the rest of the missing management structure and expertise can be filled in around it to make the company profitable. That seems fantastic to me.
(I wonder if Michael is thinking of investment companies of some kind, so that they have in effect entire secondary enterprises on their balance sheets that could be lopped off? But of what quality can an investment company be if it knowingly goes to the till in order to get some money to invest in a secondary enterprise that it almost certainly knows in advance will not be profitable?)
This all sounds very harsh; in fact I feel bad writing it down. But it’s what I’ve seen! Over a ten year span in China.
For emphasis: I know perfectly well that there are many good businesses in China with good management and able employees. But in my experience — the experience of only one person, admittedly — one seldom sees that in government-owned companies.
Of course, it’s really possible I’m just plain mistaken, that what I’ve seen isn’t representative, numerically. (I don’t believe that, haha, but I suppose it’s possible.)
Many years ago I spent several days visiting companies in Beijing in a particular field, with a Chinese companion. Every time we went into a business we could immediately know whether it was privately owned or a state-owned company. The privately owned businesses were bustling, had a bunch of recognizable stuff on display, a bunch of employees who were quite busy, and so on. The state owned ones had, invariably, the feel of walking into a gov’t office. Spartan surrounding, numbing colors or non-colors on the walls; and almost always a boss who either wasn’t in or who didn’t seem to be engaged in the way come to expect when you visit a “going” concern. Anyone who has visited companies in China will know what I’m referring to, I think.
In the West, if a business is unprofitable, in some cases it is sold for scraps. However, while there is no value in the operation itself, there is usually value in the customer base and the brands. This is more true in China, where the state own entities also come with a often captive customer base. In this way, state entities could be privatized and the proceeds going to provide social safety net etc. Not saying that this will happen, but this is certainly one of the ways to transfer wealth to the people.
I guess there is a lot of variety among Chinese state-owned firms. Some may have a captive market. Many others have arisen due to artificial “drives” and “campaigns” to create specific strengths and capacities in the economy. I think it is difficult to assess the income statements and balance sheets of the latter. Among other problems, there are long chains of receivables strung through the economy, and I suspect that a lot of what has been booked as “income” is in fact non-recurring or even non-occurring (haha). It is what goes under the general heading of “overcapacity” in the state press, or more recently, under the heading of supply-demand mismatch. It’s just a fancy way of describing a company that can’t sell what it makes at a profit. I have seen only anecdotal cases, but quite a few such anecdotal cases.
What do you think are the implications of the IMF putting CNY in their SDR basket? If China does liberalize–and it seems like China is starting to liberalize, albeit slowly–is it likely we’ll see something similar to a Bancor system?
On another note, I found this. It was basically Jack Lew saying he wants the USD to remain the world’s reserve currency. From this, I gather that he’s either a fool or a paid shill or some combination of both. The current leadership and the people in charge of the administration have no clue what the actual problems of the US are. Why does it make sense for the most capital rich country in the world to keep importing capital?! And how does the US providing a global public good make the US a stronger economy? It makes no sense.
http://finance.yahoo.com/news/lew-says-u-ensure-dollar-152206374.html
http://finance.yahoo.com/news/lew-says-u-ensure-dollar-152206374.html
Lew talks about risk, but I don’t think he understands risk at all.
https://streaming3.service.rug.nl/p2gplayer/Player.aspx?id=dRPTbF
A great article here and you laid it out in laymans terms pretty much. China is currently growing at 6.9% GDP and you say if they grow at 5% next year with 8% credit growth than this is good. How do we know that they are not growing at 5% or even 3% already because as premier Li said years ago- we can’t trust the figures?
I have the same question. It seems a easy way to re-balance is by stealth. If the GDP numbers are overstated, then would it not have the same effect as advocated by Prof. Pettis?
We are definitely feeling the China slowdown more in Australia. Western Australia (where most of the iron ore comes from) is reeling with very high commercial vacencey rates (around 20%) as companies leave, falling residential property prices (Perth fell 4% in September), state government diving into defecit. In November property prices for Melbourne falling 3.5% and Sydney falling 1.5% (albeit off all time highs) where real estate agents are saying they have noticed a lot less Chinese people at auctions and in western Sydney some properties had no bids at all.
I know this blog focuses on Economics, but Economics always overlaps with Politics.
A lot of Asian countries changed from an authotarian government to a democracy. Why do you think some countries such as Taiwan and South Korea did pretty well wheras some such as Indonesia did poorly in building a democracy?
Thanks
Read Fukuyama, http://www.amazon.com/The-Origins-Political-Order-Revolution/dp/0374533229
Larry Diamond, Stanford, is another’s whose research you might want to review, he would be famous for the notions (memes), common in society, and part of the intellectual inertia. group-think, poor sense-making ability, that posits, that chances for democractic development are more likely to be increased as countries advance in middle income status, from an LDC through Middle Income Country.
Of course this is an issue that is at play in the discussion surrounding countries transiting the middle income trap. the Financial Narrative has repositioned this narrative of late, in support of China, to emphasize advances in ability to absorb technology, and climb the value-added manufacturing ladder, along with growth in serrvices in a society, but of course this has to do also with the advance of institutions. Diamond’s work is behind the notions that support growth in Middle Income dynamics, and changing expectations of the middle class lead to the evolution’s of institutions in a society that lead to, support, the development of democracy. Fukuyama takes a much longer term view of the development of the Political Order on this matter. Both support institutional development. this is of course, one of the reasons, China has been emphasizing a moderately prosperous society, not merely of the altering economic trajectory, but in the re-emphasis upon the Party as the Guardian of the nation (insofar as the HAN ethnicity).
Another interesting addition to this Rodrik, in his globalization Paradox, which looks at the current state of affairs, and its impact on the current status of Democracy. The lack of foresight on the part of international actors, in relation to Rodrik’s perspectives, are a glaring component of the intellectual inertia that Michael mentioned in another response.
Taiwan and South Korea can also be relative to geopolitical considerations of another era.
Intersting in all this, especially as relates to notions of some actors, and their perspectives, is the Bush Administrations discussion of a League of Democracies, which seems so far removed from the present dialogue. This points again, to the oft contrary makeup of actors, and the intellectual inertia mentioned by Michael previously may illustrate the ongoing influence of International cosmopolitanism, rather than mere Laissez-Faire Liberalism, in the current frames that dominate many dialogues, which would not be opposed in many of the centers of high finance globally. Do the ire of Post-Modernist and Marxian Sociological critics, paid newspaper commentators, and left-leaning Academics more generally.
Now, we’re at a point where the trade and economic activity in the Pacific is larger than the Atlantic and we’re only at the beginning of this shift. We’re entering the heyday of the Pacific Ocean trade network. So financial institutions must develop and adapt in such a way as to allow for the integration of the Pacific trade network. Alas, the TPP is just the very beginning here.
This is also where I find Rodrik kind of wrong. He seems to be operating with this nation-state paradigm that’s looking at the past. Nation-states are fine structures for Europe, but trying to impose those structures on Asia won’t work and will probably lead to (and is leading to) blow-ups. Nation-states are, by definition, states with homogenized polities. Countries like India and China are not homogenized. Some “nations” like Indonesia, Malaysia, Vietnam, etc all have similar economic and financial interests, but they will not be ethnically homogeneous. There needs to be financial structures that can adapt to these geopolitical constraints.
What I’m basically saying is that you need empires. I was at a family reunion recently, we were all drinking, so I asked everyone if India will still be united in 150-200 years and everyone cringed. I have a similar view of it as well. Look at what’s happening in the Middle East with its nation-states. The world needs empires. We can say, oh well they can have federal systems, and I’ll say sure, but as Alexander Hamilton seems to have understood, the concept of federalism is the idea of empire.
As for economic development, we must remember that some areas aren’t gonna be materially rich. I’m sorry, but Bihar will not be super wealthy regardless of whatever we do to try and make it so. However, you don’t need to be materially rich to have a functional society where everyone has a sense of dignity and self-respect.
Keep in mind that in the heyday of the Indian Ocean trade network, the entire policy across the entire region really was 100% free markets and 100% free trade (all duties were purely for revenue purposes and the size of the states was very limited). It was the heyday of the Atlantic Ocean trade network where all of this changed, but the Atlantic Ocean is no longer the key zone.
The meaning of “federal system” or “federation” may have been changed by the US usage of these words, so they might not work either. Thanks to Star Wars however maybe “federation” has become a useful name again, although only if you don’t mind the connotations of jedi knights and such.
I take your point on empire, but don’t you think it’s also important to change the underlying philosophy that gives rise to these conceptions? For example, I’ve actually been trying to understand Marx so I’m getting much more into Capital (it’s actually a really easy read and it’s clear to me that Marx doesn’t understand anything about finance, capital, or capitalism) and I’m currently ~25% through Volume I. There’s so many assumptions he makes that he doesn’t realize he’s making. His general approach is completely wrong. He simply mistakes what he doesn’t understand or see as something that shouldn’t be so. The real error is fundamentally philosophical.
I usually don’t watch movies or TV shows, but I LOVE Star Wars. I’ve also really gotten to appreciate the symbolism in it, the plot line is really good and exciting, and the entire series (including the Star Wars TV shows) is really incredible. I actually think the plot line and symbolism shows us the dangers of this leftist (by leftist, I mean Marx-based) thinking.
The typical example of such a person would be Anakin Skywalker in Episode III. Anakin is effectively a social justice warrior (SJW). The typical scene of such an example is the Mace Windu vs Chancellor Palpatine scene where Mace Windu comes in with 3 other Jedi, who get wiped out immediately, takes Palpatine one on one and wins. Anakin shows up at the last minute, Palpatine plays to Anakin’s sentimentality, and “proves” to him that the Jedi are evil because Windu would kill Palpatine immediately instead of letting him go to trial. Mace Windu was a wise Jedi who understood that with horrible people, you have to do bad things to prevent worse things from happening. Anakin wanted to eliminate all pain and suffering, and in this process, ended up as nothing but a self-loathing psychopath.
https://www.youtube.com/watch?v=4ESOrF_u1hg
To be honest, I don’t see much of a difference between what Anakin did in Episode III and people like Lenin. These are people with an elevated sense of self, that claim to fight for justice, have this idealistic world view, confuse the world for something it’s not, and justify the most horrific acts in the name of the people.
https://www.youtube.com/watch?v=Lo4cFViNLes
“This is how liberty dies: with thunderous applause”
https://www.youtube.com/watch?v=vKjuQrHp3A0
Another place where this shows up is in the fight between Obi-Wan and Anakin again, in The Revenge of the Sith.
“I have brought peace, freedom, justice, and security to my new empire”–Anakin
“Your new empire?”–Obi-Wan
“Don’t make me kill you?”–Anakin
“My allegiance is to the republic, to democracy”–Obi-Wan
“If you’re not with me, then you’re my enemy”–Anakin
“Only a Sith deals in absolutes. I will do what I must.”–Obi-Wan
https://www.youtube.com/watch?v=WcUKP1sAto8
http://www.amazon.com/Why-Nations-Fail-Origins-Prosperity-ebook/dp/B0058Z4NR8
Again, stresses Institutions:
https://en.wikipedia.org/wiki/Institutionalism
https://en.wikipedia.org/wiki/New_institutional_economics
Such led me to Marcello de Cecco, and watched his as well.
His INET video’s are worth watching, if he and the reviewer seemed a bit to cynical, generally, their knowledge of different monetary era’s were deep, such left me wanting for more, overall, but they didn’t express anything too earth shattering.
Anyways, Douglass North ALWAYS gets referenced. I’ve heard good things coming from fellow grad students who study politics, but I’ve never read him. He’s clearly very influential.
Since I finished my research early–it should be online for the world to see by the end of the month (hopefully earlier)–I’ve been focusing my most of my time on financial history as of late.
My favorite financial historian would have to be the late and great Charles Kindleberger, who leftists (as usual) always distort to make him support their own ends. To be quite honest, I find his wonderful Manias, Panics, and Crashes to not be that good compared to the rest of his work. His best book, that I’ve read is World Economic Primacy.
The difference is in what the losers of the popular vote or other power struggle do. In a democracy they grudgingly accept being governed by a party they did not vote for and hope to unseat them at the next election. At worst they paint their placards and demonstrate outside the seat of government. In a non-democracy the losers reach for their guns ready to fight the government’s actual soldiers or bureaucrats. Or they may if it is geographically possible demand regional independence.
In essence you must first look at how the opposition to the government behaves, or would behave if it were not repressed. If most of the people feel they are in a land occupied by “foreign” troops, they are likely to seek direct action to oppose the government, not via the ballot box.
In the Chinese political economy deflation is supply-side (aggregate supply curve shifts to the right); increasing output and ffalling prices (negative PPI for 3 years, rising capital output ratio). In this context “a rising debt burden” would mean more of the same – more investment in SOEs; local govt financing platforms, which I assume must be off the table, which leaves only two options.
http://www.project-syndicate.org/commentary/china-leaders-debt-dilemma-by-adair-turner-2015-11
Seems china will in fact attempt “to rely on debt”.
http://www.chinadaily.com.cn/business/2015-12/04/content_22624640.htm
Love Adair. On to your response, while, perhaps, financial products and assets can be viewed on supply and demand curves, I wonder, if that, because they are framed in this respect, we can not clearly separate dynamics. Of course, you are talking aggregates, but maybe aggregating from Micro-economic functions, in this respect, is part of the reason why we have so much trouble in these matters.
When I think of deflation, in China….it is of course in asset prices.
These will have roll on effects for investment, employment, financial stability, the banking and shadow banking systems, government revenues (all levels), people, firms, the global trading system, and so forth, but these can not be captured simply in any model.
Adair speaks of the problem of models assuming far too much.
I have stated a theory can only be two of the following three things, taken from Weick, …………..General, Accurate or Simple
In this case it might only be General, and Simple, but Inaccurate as relates to the topic. As might many Economic models/frameworks.
As for deflation in the price of goods, that has been happening for a long time, formerly vaunted by Finance, as the “China Price”, where we know what goes on support of it (cheap loans, export rebates, mass over-investment in capacity, negative margins, etc).
That leads back to the model, where you noted falling wages, unemployment in the aggregate of deflation, and leads me to the bloat of asset valuations and inequality, in the era before asset deflation.
With that being said, I’m starting to think that a large part of deflationary pressures comes with the structure of a monetary system. When most people think of free banking (including economists, social scientists, etc.), they think that the impact of free banking is this highly inflationary, wild, and crazy banking system that tends towards massive speculation, bubbles everywhere, and leads to an economic system with no sense of stability at all. However, that conception is something I find to be highly flawed.
Free banking leads to an economic system that’s highly deflationary and a financial system that’s very innovative. I also think it’s a mistake to assume innovative financial systems as the most crazy, wild, unpredictable, and unstable financial systems. I’d argue that a tightly controlled financial system or financial systems with huge government control that tend towards inflation are far more unstable than free banking. In my view, the Chinese financial system is far more unstable than the American one, even though (or more realistically, because of) the American financial system having crises regularly like clockwork almost. Crises are necessary correction mechanisms and the financial crisis was really exacerbated by government policies and not market forces. If I remember correctly, more than 50% of all securitized mortgages up until 2008 went through Fannie Mae and Freddie Mac. There were laws on the books that were specifically designed to increase borrowing among the lower classes, but somehow “deregulation” was the cause of the crisis? That really doesn’t make any sense.
It’s interesting because Minsky says that a consumption driven economy with investment being partially socialized is the best development model (I agree), but the best example of that was the 19th century US which was extremely deflationary. For most of the 19th century, there was virtually no financial regulation in the US. Every financial crisis was basically solved by getting a bunch of elites into a room, filling the room up with cigar smoke, breaking a bunch of laws, yelling and rage for days on end, and the procedure continued until the panic was halted. By the end of the 19th century, you had some guy who was basically a financial emperor successfully blackmailing a democratically elected President who had no clue what was going on.
The power structure of the US during the time period (especially after the fall of the Jacksonian system, into the Civil War, and until the creation of the Federal Reserve) was essentially that a winner-take-all free-for-all in the financial system decided who the most powerful people in the country were. Most of the Presidents were merely puppets of these people.
This is why I don’t get why Minsky favors more power to the government. He talks about how the liquidity expansions of the Federal Reserve and Treasury in the 70’s were largely responsible for, and for how they exacerbated, commodity prices (particularly oil prices). This is essentially the exact same as the libertarian/Austrian argument on this regard. When you have democratically elected leaders who either make decisions or appoint people who make decisions about these things while giving lots of “power to the people” (for lack of a better word), what you usually get is some nutcase that uses the masses as a springboard to gain power and then imposes his will on independent actors to really do what he wants. I’m not a libertarian, but you can’t make the world out into something it’s not and expect good things to happen by making horribly incorrect assumptions by assuming it’s gonna operate according to the way you think it should operate. The Iraq War was supported by most of the populace. Even in the current situation, more and more of the people support combat operations in the Middle East. There’s no real understanding of what the problem is and most people don’t seem to understand that if you start blowing up stuff, you may kill a terrorist, but you actually expand terrorism.
http://www.gallup.com/poll/186887/americans-evenly-split-sending-troops-fight-islamic-state-group.aspx?g_source=Politics&g_medium=newsfeed&g_campaign=tiles
The worst thing we can do is to get ourselves caught up in military conflicts overseas and reacting to them by direct force. On top of this, we’ve actively been promoting dangerous ideologies while the same people in charge who support killing terrorists have these promoters of these ideologies as a large portion of their support base.
But the actual policy response in 2009 was the exact opposite, unleashing massive credit expansion to fund the investment-related stimulus program, under quasi unanimous applause from the “experts” who had somehow missed the fact that this strategy had consistently produced poor outcomes in all the countries that had tried it in the last 30 years, with ephemeral impact on economic growth but lasting debt overhang.
Now that the Chinese balance sheet has materially deteriorated as a direct consequence of the 2009 policy response, the rebalancing is even more necessary – and has actually started slowly in the past few years – but the path towards an orderly completion is much more narrow and difficult, as you have shown.
It doesn’t seem so frequent that policymakers of all countries, confronted to the consequences of their erroneous decisions, have the courage to change course. They usually find it more expedient to resort to the famous risk management rule “when in trouble, double!”. Which suggests that the cycle of lowering interest rates, initiated one year ago in China, will continue. Alternatively or in conjunction with lower interest rates, the experiment at currency realignment might also continue after the initial trial of last August. These measures would be a transfer of value from households to borrowers, the reverse of what you suggest.
No doubt Chinese policymakers are facing a largely self-inflicted economic dilemma at the moment (in that, they are in good company). We’ll see which way they eventually find it easier to lean. It would be good news if they choose to pursue the rebalancing. But the pressure and temptation to go the other way and lower interest and exchange rates should not be underestimated.
You say the world needs a new Bretton Woods. You are almost alone saying this. Of course, there is a generally under-appreciated difference between being alone and being wrong. Or between being in a crowd and being right. Not that it makes the smallest difference but I think you are right. Early versus the dominant opinion (sorry for the pleonasm), but probably right. That’s not the most difficult part, however. The real Herculean task is to lift the weight of “established truths”. Good luck for that and thank you for your thoughts.
I am certain that we will eventually win because events will make us right, but the point is to win before that happens. If events force a change in the global monetary system, it will be messy and chaotic. If the change is pre-empted under a hegemon or a coordinated power structure that can impose an orderly transformation, it needn’t be.
Remember that the driving force behind Bretton Woods was to avoid repeating the 1920s and 1930s. We have to do the same.
From a pure financial standpoint, Trump actually understands that one of the most important issues is the negative current account balance. The person who doesn’t know anything about these issues is Hillary Clinton, who’s really nothing more than a shill.
https://research.stlouisfed.org/fred2/series/BPBLTT01USQ188S
His immigration policy of deporting all illegal immigrants and revoking birthright citizenship in the 14th Amendment are batshit insane (and completely wrong IMO). He also wants to build a wall, which is stupid. A wall isn’t gonna work. He’s previously said that he wants to use Predator drones on the Mexican border. Is he insane?! These are weapons of war that’re being used on civilians looking for opportunity at a better life. This is just ridiculous.
Trump is correct on infrastructure and on the current account balance, but he’s not a statesman. I don’t know how long he remains in play here either.
Second, the reason why it is a problem for the US is that 40 years of accumulated current account deficits have been a big factor in pushing total debt from 150% to 350% of GDP. The reason it can not go on like that is quite simply that the US can not find itself with 550% debt to GDP in 40 years time. The same is true for all deficit countries, a fortiori is they don’t have an internationally recognized currency to issue at will or if they have lost monetary sovereignty because in that case the adjustment is by way of economic recession, mass unemployment and wage deflation. Perhaps it will make the issue more tangible for the US if the country was placed under an IMF adjustment program to try to eliminate the deficit. Of course, it’s precisely to avoid such unpleasant experience that the US is obstinately refusing to give up its veto right at the IMF.
Third, the reason why it is a problem for the rest of the world, including surplus countries, is that it makes their development model very unbalanced, hence precarious and unsustainable. Reliant on FX arbitrage rather than genuine comparative advantages. At the first sign of slowing external surplus, the default response from policymakers is to use the accumulated FX reserves from years of external surplus to expand domestic credit, eventually ending up as indebted as the deficit countries themselves, if not more. This has happened to Japan and China. The end result is that there is duplication of credit worldwide in both the deficit and surplus countries and this is the mechanism which has been inflating the global debt snowball relative to global GDP for the past 35 years. To the point where the whole world is at risk of falling into a balance sheet recession. This is the point where we are now, thanks precisely to decades of “why is this a problem?”, also known as “benign neglect”. The staggering and totally unnecessary cost of such attitude is dozens of trillions $ of irrecoverable debts and the rise of potentially serious conflicts over the assignment of the corresponding losses.
This is why it not only matters but it is probably the single most important economic issue of our times.
This, to me, is the most important, and clearly explicated, statement that you have written here.
Exactly….
You provide just enough of the pertinent information to explain what is happening and going to happen. Getting bogged down in perspective rich, data rich, and model rich explanations, while interesting and useful, takes us away from what has happened, is happening and is going to happen.
Now with what you have said to regions attempting to go to surplus…. add in this piece, which I am sure we discussed well before anyone else, I know that I was well concerned with the global development implications of this well before the GFC, but this piece as to Chinese attempts to export their surplus steel production
http://www.ft.com/intl/cms/s/0/7700d728-9e8f-11e5-8ce1-f6219b685d74.html#axzz3tsrNKwvC
Reminds me of Friedan/Petti/Rodrik/Zedillo, After the Fall regarding financial cooperation.
Then look at OBOR and AIIB.
Look at how the Europeans jumped on board.
Look at IMF support for China in IMF SDR.
It is obvious that the ideology of global policy makers, ideology is always the bastard step child of philosophy, the group-think, and poor sense-making of this lot in regard to where we are at, where we have come from, and where we are going.
While vast reams of argumentation have been given to “dichotomized” around ideology as scholarship in the past half century; too many interests, interested only in the narrow values of their particular discipline,we have a state of affairs where the whole development project is being suborned by a severe lack of cooperation at the global level. this is why I repeatedly highlight Laissez Fair Liberalism and International Cosmopolitanism, against the more Realpolitick Westphalian Territorialism we see acted upon by states.
It seems that those who would support International Institutions, that would premise markets, that would support half-measures or merely, and slyly, act upon sheer greed, or upon Malthusian principles have married their utopian, Marxist, brothers and sisters while riding out to Xanadu on their unicorns.
It is truly amazing how information and communication technologies, both lead to an advanced potential of humans and states, while also encouraging the most ridiculous of expectations, driving the most irreal of demons, as we march to the tune of the molochs.
Dani Rodrik is really correct on what is happening, even while new paint is applied to the system. What China has been enabled to do, stops development before the debt dynamics you describe strip the gears of the system.
I am not sure how any could have applauded such a massive overbuild of capacity, such a structuring of growth, when global demographics trend as they do, while there seems to be little time or room to ensure the structures that can support such a capability to supply.
Be careful using gross estimates of debt/GDP because we’re not on a gold standard anymore. Much of the debt is in the financial sector, which is just because of securitization. For example, the total assets of the American banking system are ~85% of GDP. In Europe, that number is closer to 300% of GDP with little securitization. When you account for capital assets, one security often shows up as debt 2-3 times because of the procedure that goes through a firm, but when one debt gets paid off, another does simultaneously.
Gross debt/GDP is not very useful in the current financial structure of the US. It can be useful if the primary mode of financing is bank lending, but if you use capital assets or equity as your primary mode of financing, gross debt/GDP tells us nothing.
I know where the data is from and I actually have the data and charts of the gross debt/GDP in my FRED account. I’m not attacking your source for the data. I’m attacking the idea that the number is even valid when considering the financial structure of the American banking system.
“As we have previously discussed on this blog in the past (with Vinezi Karim but I can’t remember in which article from the top of my head), most if not all financial debt is not double counting but double leverage on the same asset base and absolutely needs to be counted.”
Most of the financial debt in the US must necessarily be double counting because of the structure of the American financial system. These are capital assets that move around in trillions on a daily basis via the repo market. For that to be true, it has to be double counting. Many times the amount of money is moved via the repo market daily than via the traditional bank market in the US.
I can’t emphasize how different the American financial system is compared to the way you’re thinking about it. It requires a completely different way of thinking about it.
It’s funny, because people read Minsky and apply it to our financial system but don’t seem to get that much of what he said can’t really apply. In terms of understanding the structure of the financial system and the pure acumen of thinkers, Murray Rothbard has a more sophisticated and nuanced understanding of the American banking system (especially when thinking in terms of capital assets) than Hyman Minsky.
For example, Rothbard actually cites call money data as a very important piece of information for the US in the 19th century. Rothbard understands the capital asset base of American finance and on a level that’s much more sophisticated and nuanced than Minsky. There’s issues on Rothbard’s economic views and a lot of stuff that I don’t agree with him on, but there’s no doubt of his financial acumen and the details of it as well.
You are not being clear.
First, you tell me the number referenced above is gross. Which it’s not, it’s net.
Then you tell me you know it’s not gross because you have access to the gross number from the Fed but that the problem is actually not that it’s the gross number (which you initially said was the problem) but that the number is not valid. Then you say the reason the number is not valid is because debt securities are traded many times over in a given period of time. Let’s clear a confusion here: it doesn’t matter whether a debt security with a face value of $Xm is sold and repurchased 0 or 100 times during a given time period, it is still a $Xm debt outstanding. You are confusing the amount turned over during a certain period of time with the amount outstanding at a given moment in time.
Take a few minutes to study pages 82-106 of the latest Financial Accounts of the US. It will clarify your understanding of what is and what is not “financial sector debt” in the meaning of the Financial Accounts of the US, which is the meaning in which i use the expression.
Not only must most of that debt be double counting, but in many cases (if not most), it could even be triple counting. For example, if a firm issues asset backed commercial paper (ABCP) to finance some activity, some fund (suppose this is a money market fund although it would probably be some other type of fund, I’m just gonna refer to all of these as MMFs) essentially buys the commercial paper while offering “deposits” in the fund. Then, some origination company else buys that ABCP while buying other ABCP from other places packages it into an asset backed security (ABS). In other words, that firm as ABCPs as an asset and an ABS as a liability wherein the original MMF now has essentially swapped its ABCPs for an ABS that’s backed by a combination of ABCPs with the origination company having essentially no exposure one way or the other. Now someone can take that ABS and use it as collateral to borrow in the repo market.
This is just an example and it probably won’t work out exactly like this way, but the capital markets in the United States work out very similar to this. In other words, double-counting is probably a large understatement and I suspect most of these asset-backed securities are created something like this. When you add in other derivatives like IRS or CDS, then this thing gets even more layered.
Of course, this is basically the way the American capital markets worked up until the creation of the Federal Reserve where stupid bureaucrats mismanaged the system, ran it into the ground, and then proceeded to blame the people who built the system rather than themselves. Using this mechanism in the 19th century, the United States had a larger rail network than the rest of the world combined by 1860, had the world’s highest wages by the mid 1870’s, and had one of the largest sustained increases in standard of living ever seen in the four decades before World War I.
It was really the Woodrow Wilson time period where this thing got fucked up. Then, these leftists have built these narratives saying that it was this market system that’d failed while Wilson and FDR are the Americans most responsible for setting up the dominance of the United States in the 20th century. It’s such horseshit. The stabilization of the short term money market rate of interest after the creation of the Federal Reserve combined with the use of the War Finance Corporation (WFC) as a ward of the state to make loans to small farmers and the like to sustain excess production levels led to catastrophe. Instead of the debts being cleared out like clockwork from consistent and sustained shifts in short term money market rates that usually shifted along with the agricultural cycles, they never got cleared. Then, Wilson decided it’d be a good idea to continue these policies by essentially lending others money to buy our shit after the war instead of writing down inter-war debts.
The people who were primarily responsible for the economic and financial dominance of the US in the 20th century was the structure of American finance and people like JP Morgan and others. What I’m really worried about is that since the 40’s and 50’s, the financial understanding of both the populace and the elites actually fell IMO (especially the populace). I think this has started to shift with my generation, especially considering that we’ve been looking at our financial documents since we were effectively children. Unfortunately, we’re loaded with debt, but if this debt could be cleared, a lot of wonderful things can happen. I’m currently of the opinion that we understand money as well as any generation of the United States in ~100 years and as time goes on, it seems more and more true.
I’m not so sure how often commercial paper is securitized, but all sorts of things are primarily securitized and almost all credit created is securitized today from mortgages to student loans to credit card loans to virtually anything. In other words, there’s probably more double-counting than what either one of us would expect. Keep in mind that much government debt that’s held as an asset by the private sector is also used as collateral to borrow in the repo market, so much of that will be double-counted as well.
http://suvysthoughts.blogspot.com/2015/11/the-decentralization-of-money-and-its.html
I never said anything about what is gross debt or what isn’t, but I’m pretty sure that the repo market does count in the financial sector debt. With that being said, an asset backed security is obviously a liability of someone else. When you use that capital asset as collateral in the repo market, that asset shows up twice even though the originator probably has no exposure to the performance of the asset.
Also, when you have a loan that’s been securitized, that loan counts as a liability as does the security. Then, if the security is being used as collateral in the repo market, that debt shows up again.
The number I referenced above (I assume you meant the 85% of GDP number) was the total assets held by the commercial banking system. It’s not net debt or anything like that. It’s just the total assets of the commercial banking system that includes some ABS along with other bonds.
I assume this is the chart and these are the numbers you’re referring to. I’ve only provided the private sector. The gross would be public+private.
https://research.stlouisfed.org/fred2/graph/?graph_id=92629&category_id=
Why is that total number not valid? According to FRED, it classifies the debts as “credit market instruments” and as a “liability”. If this is the case, then you certainly can’t take the gross debt/GDP seriously.
The mortgages of a person would be securitized into some MBS that shows up as a liability of an origination company, but both the household and the mortgage company have their own equity capital. So how can it be double leverage if you look at debt/equity ratios? That makes no sense.
The useful numbers aren’t the gross debt numbers, but the debt/equity numbers for households, non-financial firms, and financial firms.
This is shadow banking, which means that for a capital asset to exist, it has to show up on several balance sheets as a liability for that capital asset to exist, but there’s only one loan that really impacts the real economy. You’re gonna have firms that have literally no exposure to anything that may happen to such a capital asset being counted as liabilities and then counting another liability if that asset is used on the repo market as cash.
In the shadow banking economy, that 70% mortgage would be securitized into ABS worth 70% of GDP making the gross debt AT LEAST 140% of GDP (probably higher with a repo market) with the origination company having no exposure to the quality of the loan. In a “traditional” banking economy, that 70% mortgage debt would show up as a total debt of 70% of GDP. Yet one capital structure of an economy is no real different from another.
*real structure, not capital structure
But everyone knows that:
1) China’s SOEs are not only notoriously opaque, inefficient behemoths that rely on overly-generous state funding and monopoly positions to survive (with many of them failing to make a profit last year anyway despite these unfair advantages!)
and
2) The financial data they do release is difficult to verify and generally considered to be unreliable (to put it mildly).
So no foreign bank is going to give them loans – at least nothing close to the order of magnitude of money necessary to fix China’s problems at home! And any real loans they would even consider would look incredibly unfair to the SOEs used to being fed the Chinese peoples’ money on favourable terms by the state. In fact, it seems that Mr Xi has just announced $60Bn of aid to Africa. Presumably most of this will be paid to Chinese SOEs to build infrastructure in Africa which of course can potentially benefit the locals who use it (once the Chinese workers who build it have gone home) but at the same time, this is only adding to China’s internal debt burden.
Also, I think the “how do we screw the outsiders to solve this particular problem?” mentality well-captured in your post has been way too obvious from Chinese business for decades now. It’s almost an epidemic sickness within the modern PRC to believe that you can cheat and con your way out of any problem – even if you already have a reputation for cheating and lying and nobody trusts you! It’s a good example of the chickens coming home to roost: for decades, the PRC has been nickel-and-diming companies and partners and telling itself how clever it is to cheat their way in to small and temporary advantages… while all the time, a huge crisis builds up. And now that the regime has finally accepted there is a problem (after a decade of aggressive, politically-charged denial), it seems that the regime’s nature has too much inertia for anyone to fix it.
One final point: Michael Pettis Wan Sui!
The high debt level is relative viz other major economies and China’s debt/GDP level is at the upper boundaries. Markets can pressure a financial crisis such as the considering the RMB to be overvalued. Besides reforms as you correctly pointed out are filled with inertia with dubious impact on the existing moribund financial structure.
Can we really hope for benign markets as China totters along to have confidence in Beijing’s ability to avoid a debt crisis ? Can we underestimate exogenous pressures in today’s concentration of debt laden major economies ?
https://research.stlouisfed.org/fred2/series/BPBLTT01USQ188S
His argument is that the price of oil, and the ramp up of US shale, has wiped out segments, or percentages, off the current account deficit.. The longer term view you provide is useful. Because of two reasons; swelling of the current account deficit during the commodity supercycle story, which particularly hit the US at points, and primary through oil, but also the global impact that had on balance of payment dynamics, which should have impacted the US negatively. The intereseting thing, is the swelling of foreign holdings after the GFC (some switching to US Treasury debt, from other pools of dollar capital achieved over what time frame; Japan keeping pace with Chinese Treasury debt acquisitions).
So, DvD is implying that if it wasn’t for oil the US current account surplus would be much higher.
This is obviously true in some respects.
First, as to oil, the US is producing more of its own. As the price of oil sinks, the US will import more. When the price starts to rise the US will produce more domestically. Noise in the financial media about debt in the sector, etc….are over-blown. Some, misguided pundit casting their net around to hope to be able to claim victory in the future (I predicted the Oil debt bomb back in 201X). More fundamentally, OPEC points of underinvestment in the industry, may see the traditional spike in oil prices globally, but this will see a bonanza domestically in the sector, mitigating rises in US C.A. Deficits in the lower oil price term. Any Builderburger or Free-Mason theorists out there?
Now what DvD needs to consider is this;
what does the “double global gdp” from 1998-2008 world experience, on the back of heightened enthusiasm for global integration, the super-cycle in commodities, and stories of deep untapped potential for consumer demand globally along with the rise of the global middle class, and the vertical rise in global debt levels, along with vast asset bloat, and well too much productive capacity in East Asia, mean/imply/assure?
Well as to the US current account deficit, it implies that rises were do to the confluence of those factors. The current global recession (shallow depression), and alterations, imply that these should be subdued, and will likely be subdued, that attempts by others to continue what is being done, by large prosperous regions, undergoing distress, assure a break to the system. Because it cannot continue to work. It is added more grease to your drain pipes.
So, the current account deficit in the US, if it were to rise, would be nothing more than a signal of a far greater global disaster in the making. Fundamentally, and structurally, this has to do more with the role of the US and the dollar in the global system, than with the status of the US economy itself. This is the US economy as the necessary center/keyhole/switch point of a world economy that is decidedly in bad shape.
Insofar, as current account dynamics being a harbinger of the demise of the US economy. It should be acknowledged by now, that it is far more indicative of a global trading system that has become extremely distorted.
While OPEC may be concerned of US shale, or merely losing market share, it may have been, that US shale, played a far more important place in stabilizing the global system than many might have realized. Without Shale, could you imagine what US austerity would have assured, as political ideologues of all sorts viewed the quarterly date.
As Michael has said repeatedly, or is it just that I have, the US just needs to attach more of its own demand.
DvD, whaddya think about accounts placed, in all our names, in the FED, with helicopter money, that can only be spent on services (barbers, restaurants, masseuses, education, tutors, lawyers, accountants, doctors, health care, physical therapists)?
This at least, would assure one pass through the economy, via consumption, prior to leaking out in the terms of goods purchases.
This passign through, and around, was what was meant to happen in the global system. Not China and others, altering the development trajectory of their peers, by insuring against “financial volatility” and structuring their economies to get asset bloat (ensuring financial volatility), to get high savings, to run up investment, to achieve high growth rates, and structure, current account surpluses, and creating an enormous amount of suspect growth (doubling of global gdp in 10 years), which enables social critics far outside the realm of their expertise, to note the rise of the rest, looped back into the economic discourse, by sell-side financial analysts, while all merrily hum a tune, in their sleep.
Just wanted to make sure because I recall from previous essays that U.S. treasuries/USD can not themselves be used in China on a large scale.
Generically, it works like this:
1. Chinese companies in aggregate sell more goods to the US than they buy from the US, hence they have a trade surplus for which they receive the corresponding amount of USD balances as settlement.
2. Chinese companies convert these USD balances to national currency balances (RMB) at the Chinese commercial banks.
3. Chinese commercial banks convert these USD reserves to RMB reserves at the central bank. Said differently, the PBoC issues domestic currency as counterpart to the USD thus acquired. The equivalent of the USD balances enters China money supply. This is how Wikipedia describes it: “Foreign exchange reserves are assets held by central banks […] used to back its liabilities, eg. the local currency issued and the various bank reserves deposited with the central bank”.
4. The PBoC typically invests these USD balances in the US financial markets. Notice here the round trip of USD from the US to China back to the US, with the effect that the US trade deficit doesn’t result in any monetary contraction, hence doesn’t restrict purchasing power, hence doesn’t trigger any downward adjustment in internal demand to rebalance the external trade account. This is the secret of “the deficit without tears” as Jacques Rueff called it or the “exorbitant privilege” of the USD as it is sometimes referred to in the sense that the US can buy without paying or by always pushing the payment to later. In any case, the USD balances have entered China money supply without leaving the US money supply. This feedback of USD is repeated endlessly on a daily basis. It is the mechanism by which trade imbalances have been allowed to develop and grow unrestricted for so long, accompanied of course by the corresponding rise in claims, ie. debt.
5. The new RMB reserves of the Chinese banks can support new loans for a multiple amount of those reserves, for instance a 10x larger amount of loans if reserve requirements are 10%. This is precisely how China spectacular credit expansion was made possible from 2009-2010: by multiplication of the monetary reserves accumulated after years of trade surpluses. There is duplication of credit between China and the US as the USD balances enter China credit system while at the same time being on-lent back to the US, for instance being lent to the US Treasury if China buys US Treasury bonds. This exact same mechanism was also behind Japan’s credit boom of the late 1980’s after years of Japanese trade surpluses.
The combination of large trade imbalances with fractional reserve banking is the powerful engine that explains the staggering rise in global Debt-to-GDP for the past 35 years, ultimately pushing both debtor (US) and creditor (Japan, China) countries into excess debt situation. The fast increase in global debt relative to global production results from this double mortgaging of future production at each iteration of this duplicate credit structure. Until such time when debt is no longer serviceable from the cashflows generated by future production, even with interest rates at 0%. At that point, the global pyramid of financial claims will collapse, either nominally or in real terms.
“In the current system, a national central bank can issue currency not only against claims denominated in the national currency but also against claims denominated in foreign currency, like USD for instance.” Zimbabwe, like China, can issue any amount of currency it likes with or without “claims denominated in a foreign currency.”
In para 3: “The equivalent of the USD balances enters China money supply.” My understanding is that because the PBoC was worried about inflation, it required the banks to return those RMB in exchange for various central bank IOUs, which paid a very low return. In exchange the PBoC set very favorable loan – deposit rates guaranteeing profits and passing costs on to households.
Then in para. 4: “In any case, the USD balances have entered China money supply without leaving the US money supply.” In addition to US bonds, lets say PBoC also bought Fannie Mae securities or shares in Microsoft with these dollars: are these assets now part of China’s money supply?
Finally (para. 5): there were no “new reserves;” nor were new reserves necessary for the govt to massively increase credit in 2009.
Csteven, I’ve gone back and read every single post on this site, and bookmark insightful comments from you, DVD, and others. The big picture stuff makes sense, almost like a scientific discovery, which is why I enjoy coming here so often. Sometimes I get stuck on the technical details, I imagine because econ/finance are not my field.
That’s one reason I always keep my eyes open for book recommendations here. Reading the Volatility Machine, I felt like I could have used a book or two as background to get the full value. Perhaps a basic finance textbook is the answer.
For those who would like to know more on this topic I’ve published an article about rebalancing in China on my educational website (www.financialcrisismonitor.com). On pages 31-35 I discuss the problems of over-investment and debt capacity constraints caused by China’s investment-driven growth model. Finally, I’m grateful for the comments and useful information provided by Michael Pettis for this article.