Chinese economy update - August 2023

The pile of bad news from the Chinese economy keeps growing - property market defaults are rising, economic growth is slowing, exports are declining, foreign investment is cratering and some like VC and PE are vanishing, bank lending is falling, and youth unemployment is rising. And all this is being exacerbated by the tightening of US-led sanctions. These stories have triggered commentaries offering explanations. 

Adam Posen has declared the end of the end of the Chinese economic miracle and argued that we are now past Peak China. He argues that things were fine as long as the government allowed the private sector to work and attributes the reversal in fortunes to Xi Jinping's turning against the private sector. 

Michael Pettis disagrees and writes a long Twitter thread that's worth quoting almost entirely

China implemented a high savings, high-investment model that was extremely successful when the economy was severely underinvested for its level of institutional development. But once China closed the gap between the investment it had and the investment it could productively absorb, given its particular set of business, legal, financial and political institutions, like every historical precedent, instead of switching to a different model, it continued with the same model of high savings and now-excessive investment, which led – as in every one of the precedents cases – to asset bubbles, especially in real estate, and an ultimately unsustainable rise in debt. 

As this happened, the locus of economic activity automatically shifted from hard budget-constrained sectors to soft budget-constrained sectors. The turn against the private sector, in other words, was a consequence of China's rising imbalances, and not the cause. For certain economists, any rapid growth is by definition a consequence of private sector initiative, while any slowdown, also by definition, is a consequence of government intervention. But this is not at all what happened in China.

China's ferocious growth in the first three decades of reform was the result of heavy government intervention. This included policies that forced up the savings rate and corralled the resulting savings into a highly controlled banking system that was designed to flood the investment and manufacturing sectors of economy with cheap financing. It also included heavy currency intervention, tough labor restrictions, and a whole series of direct and indirect subsidies to the manufacturing sector that led to explosive growth in infrastructure and made Chinese manufacturers the most competitive in the world, albeit at the expense of Chinese households. To say that three decades of some of the most spectacular growth in history came simply from "unshackling" the private sector makes no sense at all...

What perhaps should've been obvious a decade ago has now become obvious to most economists in China: China's biggest problem isn't "government intrusion" (although that certainly doesn't help). It is the distortion in the distribution of income that keeps domestic demand too weak to support domestic business investment. Without resolving weak domestic demand, it is all but impossible for China to maintain high levels of economic activity except by maintaining the high levels of non-productive investment that have caused the very malaise it is supposed to cure. Business investment is weak, in other words, not because of government intrusion but because of weak demand. Government intrusion is the consequence of weak business investment. The way to fix the economy is to fix the demand side of the economy.

Martin Sandbu echoes Pettis and his diagnosis is largely focused on the garden variety debt overhang that invariably hurts.

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

He compares China's present situation to that of Japan in the 1990s, the US in 2008, and the Eurozone in 2010. He argues that all of them waited for too long to act on restructuring of balance sheets, and even when they acted they preferred bailouts that spiked public debt and stifled subsequent growth. Instead, he recommends Beijing acts fast to restructure debts with writedowns so that it will remove the uncertainties about the real worth of assets and liabilities, and allow for lending, investing, and planning projects to restart. 

The news of deflation in July has sparked conversations about possible Japanification. Robin Wigglesworth cites a recent JP Morgan report to highlight similarities and differences with Japan. Japanification is the phenomenon of an economy stuck in an extended period of "deflation, economic sluggishness, property market declines and financial stress as households/companies/governments try to deleverage after a debt binge". A big concern is that China is both poorer and aging more rapidly than Japan was in the early nineties. However, being a much larger country, it also has more sources of growth than Japan.

Some thoughts

1. Michael Pettis, I think, gets it right. The facts support his narrative. The Chinese government got things largely right for a long time with its directed growth model and industrial policy. But it went too far. Worse still, it tried to keep the economy growing at the same level by following the same recipe of directed growth. And a booming real estate market was an essential requirement to raise resources and sustain growth. Thanks to the size of the economy and favourable global factors (and good management), this appeared to work well for longer than it ought to have. This, in turn, lulled Beijing into believing its policies and continuing things for longer. And it meant that the government could gloss over and postpone the trickier challenges like rebalancing the economy toward consumption, services, and domestic demand growth. 

The chickens are now coming home to roost. The greater the misallocation, the worse the problems. It's simple Econ 101 that countries can and should try to grow only at the rate at which the system can support. There are natural limits to growth, dependent on the country's accumulated financial, physical, human, and institutional capital. Any growth beyond this rate triggers overheating and inevitable crises. Only the nature of the crisis varies across contexts. 

Pettis sums it up nicely in an FT oped from 2020

As long as Beijing requires growth that is substantially higher than the economy’s real, underlying growth rate (probably around half reported growth rates) China has no choice but to expand the government’s presence. This will also reduce the market’s role in allocating resources.

This is a teachable moment for India too. It would do well to keep this lesson in mind as it strives to engineer high economic growth rates. Sustained high growth rates require strong foundations of capital accumulation. India is far from having that foundation.   

2. Pettis argues in favour of rebalancing the economy towards consumption and boosting household demand, by redistribution of wealth from local government and elites to ordinary households. This too is easier said than done. Any such rebalancing in practice runs into several challenges. 

One, it's not clear as to how such rebalancing can be achieved. What instruments, to what degree, at what pace, and in which sequence? Two, even if it happens, it'll take time. How long is acceptable enough? Three, any rebalancing will involve significant cooling down of the economy and losses for the entrenched elites, along with all the attendant uncertainties. How much rebalancing is sufficient and how much uncertainty will be enough to avoid any hard landing? Four, the entrenched interests will obviously oppose any efforts that are perceived to be detrimental to their interests or redistributing sources of wealth and power. What would take for the elites and governments to give up their sources of income and power?

The same problem of practicality applies to the prescription suggested by Sandbu,

My view is, therefore, that the sooner you restructure balance sheets through writedowns, the better. The difficult policy and political choice you then have to make is who you force to bear the losses: local governments, banks, investors, or households. In each case you need to have a plan for how to move on. You need to organise what happens to a bankrupt local administration (and its officials). You need new, well-capitalised banks to populate the banking system. You need to compensate innocent victims among households, at least those too poor to bear the losses they face. But if you do, it will be a lot cheaper than a bailout, and unlike the other policy paths it will set China up for renewed growth, perhaps of a higher quality. Investors, lenders, developers and local administrators will have learned they need to choose projects that really create economic value.

Again easier said than done. How many write-downs will serve the purpose? How should the write-downs be distributed among sectors or segments of the economy? How to backstop the write-downs to preempt economic and financial market runs? How can the losers be compensated? Most importantly, how can the political economy be primed to accept and undertake such decisions?

3. While the underlying contributors have been building up the trigger for the current woes has to be placed at the Xi Jinping turn. There are at least four reasons. One, in order to also justify his pitch for the unprecedented third term, he has forced the economy to grow at the same rates for longer than it could have. Two, he has shut down many of the sources of dynamism in the economy for a variety of reasons - to tighten the Communist Party's control, to achieve shared prosperity, to rein in cultural degeneration etc. Three, in his overreach to declare the country's arrival as a superpower, he has junked the wise policy of "hide your strength, bide your time", and opened up several hostile foreign fronts. Finally, by suppressing dissent and centralising powers, he has dismantled the various checks and balances that often prevent or atleast attenuate distortions and closed down feedback channels. 

4. The danger is that now the economy may have fallen into what James Kynge calls a "psycho-political funk", where a self-fulfilling doom loop may have been triggered on consumer confidence. And this is precisely at a time when consumption may be the only economic engine intact and is critical to the country's long-term rebalancing. 

5. It's hard not to feel that Adam Posen is right in assuming we are past Peak China. Or at least that China which grew consistently and effortlessly at five plus percentage points, which was the factory of the world, which contributed an outsized and growing share of the world output in many areas, whose growth formed 40% of the global growth, whose exports and surpluses kept growing at a rapid clip, and so on. China will continue to remain the second largest economy and be an important factor in all these. But its relative importance will only decline with time.