Will China’s New “Supply-Side” Reforms Help China? - Part 2

<< Read More: Will China’s New “Supply-Side” Reforms Help China? - Part 1

What are Beijing’s “supply-side” policies?

What are these reforms? Here is how the People’s Daily describes them, in an article that calls them the “top priority” of this month’s annual Central Economic Work Conference:

The supply-side reform will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system. Public service is set to be improved and new demand created to spur growth.

The country’s top leaders are likely to introduce all-round “supply-side reform” at the annual Central Economic Work Conference, which began on Friday in Beijing. “All signs are pointing in the same direction, that supply-side reform will command center stage next year,” according to a policy review of the conference by China Minsheng Bank, one of the largest non-State banks.

The article goes on to give a little more detail further along, of which perhaps the most important and encouraging comment, at least in my opinion, is the suggestion that the GDP growth target will be de-emphasized:

A Web commentary by People’s Daily called the supply-side reform “a profound change”. It will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system, it said.

In the most immediate move, the commentary said, the government will have to reduce housing inventories, and one way is to subsidize rural migrant workers so they can settle down in the cities where they work. It should also shed excessive industrial capacity, especially in industries with low technology and poor market prospects, it said.

A third thing to do is to deepen reform of the financial system, so as to build a nationwide system of financial service, taxation and multiple layers of insurance, the commentary added. Wang Yiming, vice-president of the State Council Development Research Center, said reform will definitely be the priority at the meeting.

GDP growth will be assigned secondary importance, economists said. Some suggested that next year’s GDP growth target should be lowered from “around 7 percent” this year to between 6.5 and 6.8 percent. GDP growth in the first three quarters reached 6.9 percent year-on-year, down from the 7.3 percent last year. The growth target won’t be published until the National People’s Congress in March.

In its December 22 primer, Xinhua explained what Beijing might mean by supply-side reforms:

Supply-side economics holds that the best way to stimulate economic growth is to lower barriers to production, particularly through tax cuts. The wealth-owners, rather than spending on direct “demand” purchases, will then be more enticed to invest in things that increase supply, such as new businesses, innovative goods and services.

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. …Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

The return of Say’s Law

My understanding of the proposed reforms is that they are only partially described by use of the phrase “supply-side”, whose overuse is already causing some off us the same confusion felt by Inigo Montoya, the vengeful swordsman from The Princess Bride: “You keep using that word. I do not think it means what you think it means.”

The phrase itself was first used in 1976 by Herbert Stein, of the University of Virginia, to discuss a body of policies that had evolved in opposition to demand-side policies, often mistakenly attributed to Keynes, that could not explain or address the stagflation of the 1970s. These policies later became more widely known as “Reagonomics”, the heart of which is usually assumed to be tax cuts as part of a strategy to reduce government involvement in the economy on the grounds that government involvement creates incentives that systematically distort economic behavior and reduce productivity.

The heart of supply-side economics is Say’s Law, sometimes summarized as “supply creates its own demand”, based on the work of Jean-Baptiste Say, a French economist who lived from 1767 to 1832 and whose main work is A Treatise on Political Economy. In that book Say claimed that “a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” Because the full value of any commodity produced is dispersed into the economy in the form of production costs, wages, and profits, insufficient demand for goods can never be a fundamental condition of any free market because the payments involved in creating the supply of goods and services also create purchasing power which will either be used for consumption or will be saved and directed to investment, creating demand that is equal to the value of those goods.

This doesn’t mean that Say and his followers deny that there can be supply and demand mismatches, of course, but that they happen only for two reasons. First, as long as perfect information is impossible, the economy will be subject to bad information, poor judgment or exogenous shocks that can cause these mismatches. These tend to be fairly small in effect and are always temporary. Second, and far more powerfully, institutional distortions can force agents into systematic misalignments of supply and demand (mainly by changing incentives for political reasons) that can get very deep and can persist for very long periods. The main source of these distortions, according to supply-siders, is the government. In that case the best way to increase productivity permanently is to remove the source of these distortions.

According to Say and his followers, policymakers should never worry about inadequate demand as the source of depressions. They should only worry about policy distortions that cause the market to create the wrong mix of goods and services. In what is perhaps the most quoted of all of Say’s passages, he says:

The encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.

But we have to be careful about how we interpret that last clause. At first glance Say and the supply-siders seem to suggest that the whole rebalancing thesis is wrong for China, and that there is no reason to worry about the low consumption share of GDP. If this were true, however we would immediately have to dismiss supply-siders because it only takes a little arithmetic to show that China’s soaring debt burden is a direct consequence of its demand imbalance, and to dismiss the consequences implies both that the country’s debt capacity must be infinite and that there will never be uncertainty about the allocation of debt-servicing costs, neither of which can possibly be true.

A more sophisticated reading, however, would recognize that China’s demand imbalance could never have existed except for very powerful political incentives that created in the past two decades deep institutional distortions. In that case the point of supply side reforms would be to eliminate these distortions so that the imbalances can reverse, and it seems to me that the only possible disagreement among supply-siders must be whether the purpose of reforms is to eliminate institutional distortions as quickly as possible or whether Beijing should take active steps to speed up wealth transfers to the household sector. Which side you support depends, clearly, on how urgent you believe it is to begin to deleverage the Chinese economy and how quickly rebalancing can occur as you eliminate distortions.

The main tenets of China’s supply-side reforms

It is pretty easy to see why this economic theory might appeal to Beijing. China produces far more than it is able to consume or demand domestically, but even with one of the highest current account surpluses in history and with explosive credit expansion to generate demand, inventories are rising and growth rates dropping sharply. Reforms during the past three years have done too little to resolve the problem, and whether China can rely on these reforms depends on how much longer Beijing can afford to allow excessive credit expansion before China runs into debt capacity limits, and on whether Beijing is strong enough to overcome domestic political opposition and speed up the pace of the rebalancing.

Is this new set of supply-side reforms the solution? At least some of the policies that are being bandied about are actually contradictory or mutually exclusive, and clearly there is not nearly enough certainty about what exactly the reforms entail nor, just as importantly, whether they can be implemented, but already analysts have been wrestling with the implications, trying to clarify the reform proposals, and providing their initial evaluations. According to last month’s Economist:

Those who first pushed supply-side reform onto China’s political agenda want a clean break with the credit-driven past. Jia Kang, an outspoken researcher in the finance ministry who co-founded the new supply-side academy, defines the term in opposition to the short-term demand management that has often characterised China’s economic policy—the boosting of consumption and investment with the help of cheap money and dollops of government spending.

Whatever the supply-side reforms imply about earlier reform proposals, I do not think we can easily declare yet either that the new policies will be successful as predicted or that they won’t – with one exception: I am very confident in saying that unless implicit wealth transfers to the household sector rise to 2-3% of GDP annually, which I recognize will be politically very difficult to manage, there is almost no chance that growth over the rest of this decade can remain at 7% or even at 6% or 5%.

Because we are still in the very early stages of this new set of policies, it is hard to discuss them except in very abstract terms, and already so much ink has been spilled describing them that contradictions and confusions have emerged. An article in China Daily seems to set the stage at least as well as any other:

China used to rely on three major forces to drive economic growth – investment, exports and consumption, which are classified as the demand side. As the effectiveness of boosting growth in the demand side wanes, the government has started to reform the supply side, or the supply and effective use of production factors, including funds, resources, skilled workers, equipment and technologies. The reform aims to accelerate economic growth by freeing up productivity and raising supply-side competitiveness. Measures will include cutting excess industrial capacity, reducing housing inventories and cutting production costs with policy support.

The focus on freeing up productivity and raising competitiveness is of course no different than the promises made by the earlier set of reforms, but supply-side doctrine proposes that rather than raising productivity by improving the distribution of demand and letting producers respond, Beijing will take steps to boost production efficiencies, confident that more efficient and profitable producers will trickle down into stronger consumption. Credit Suisse, in its December 21 report, specifies more concretely how Beijing plans to raise productivity:

The central committee of China’s communist party held the annual Economic Working Conference between 18 and 21 December. The conference listed five major tasks for 2016: (1) Reduce over-capacity. (2) De-stocking. (3) De-leveraging. (4) Lower corporate costs. (5) Improve weak links in the economy.

The meeting pointed out that supply-side policy should be given more attention in order to stabilize growth. The conference highlighted that promoting the supply-side structural reform is an innovation to help China to adapt to, as well as to lead, the new norm of the economy. In the coming years starting from 2016, China will promote the supply-side structural reforms on top of appropriate expansion of aggregate demand. China will maintain macro policy stability in order to create a stable macro environment for structural reform. China will enhance the strength of active fiscal policy through tax cuts and the periodic increase of the budget deficit. Steady monetary policy should be adapted with flexibility. China will maintain adequate liquidity and appropriate growth of total social financing. China will increase the degree of direct financing, lower funding costs and further develop the exchange rate mechanism.

An article in Xinhua proposes, similarly, the following policies that are consistent with Credit Suisse’s understanding:

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

Finally, another article, this time in the South China Morning Post, describes the intentions of President Xi for the proposed supply-side policies in the following way and in nearly identical terms:

Xi has listed the four big battles of the coming year as addressing overcapacity, cutting financing costs, reducing property inventory and preventing financial risks, China Business News reported.

The key objectives

As far as I understand these reforms, then, I would list the main objectives very broadly as consisting of the following:

1. Reducing over-capacity. This will include encouraging mergers and acquisitions, as well as preventing bankruptcy. Because of very strong incentives that favor gross production over productivity, including pressure, mainly from local governments, not to fire workers, Chinese companies have been very reluctant to close down capacity even as demand has plunged globally. Because companies that maintain capacity at the behest of local officials can have them pressure banks to finance rising inventories, the obvious consequence is rising debt collateralized by permanently rising inventory, and with no formal mechanism to write down either, wealth will be overstated. It is not clear to me exactly what policies will be implemented to address over-capacity, but policymakers at the Economic Working Conference stressed that the balance between social stability and structural reform should be dealt with carefully. Overcapacity must be reduced, in other words, but not by firing workers to the extent that the resulting unemployment is destabilizing. It will not be easy to do one however without risking the other.
2. Reducing real estate inventory. Xu Lin, director of the Department of Development Planning at the country’s top economic planner, the Central Leading Group for Financial and Economic Affairs, explains in an interview with Caixin in November that “the key step [in reducing the inventory of property] is to help migrant workers in cities to settle down through household registration reforms, thus creating more demand for housing and reducing excess inventory of property. The mega cities of Beijing, Shanghai and Guangzhou are suffering from population pressure, so they have strengthened controls on population growth. But there are many other big and medium-sized cities with little population pressure that should enhance efforts on household registration reforms. But those efforts have been inadequate.” We have already seen tentative “experimental” policies aimed at liberalizing the hukou regime, which determines the residency status of all Chinese, but the biggest problem, as is well recognized, is that the supply of hukous is for lower-tier cities whereas most demand is for the top tier cities.
3. De-leveraging and otherwise strengthening balance sheets. Much of the focus here seems to be on making debt-servicing costs more manageable for heavily indebted entities, especially provincial and municipal borrowers, many of which are struggling. According to an article last week in the People’s Daily, Zheng Gongcheng, a member of the National People’s Congress Standing Committee, said there are a great many zombie companies among State-owned enterprises. “Their existence can only increase financial loss and the pressure to repay debt.” What makes this especially difficult is the highly politicized nature of lending, which the supply side reforms will try to address. As Caixinexplained in another article: “Banks were sometimes strong-armed by local government officials to extend loans to these [zombie] companies because they feared letting them go under would cause social instability, a risk-management executive at one bank said. ‘But these companies are doomed,’ he said, adding that forcing banks to lend to them ‘amounts to dragging down the quality of the loans to non-performing.'”
4. Fiscal expansion, including tax cuts. Fiscal expansion is usually seen as a demand side policy, but in this case tax cuts will be designed and implemented as much to improve business efficiency as to boost demand.
5. Lowering corporate costs directly and by reducing government bureaucracy. Again, according to Xu Lin, “I think the core idea is to reduce transaction costs created by institutional arrangements. Businesses are paying quite high costs in transactions, taxation, financing and social security. High transaction costs in China are mainly created by institutional hurdles. Reforming the supply side will reduce costs and make it easier for enterprises to do business. It will encourage business innovation, boost quality and efficiency of the supply system, and improve the supply structure. Eventually, supply side reform will lead to higher productivity of the economy and improve enterprises’ competitiveness.” There has been a great deal of complaining in the past about the cost of bureaucracy and most of the reformers seem to stress the need for streamlining bureaucracy.

The goals, then, seem to be to take advantage of the urgency generated by recent events to force through a series of difficult reforms that will improve China’s economic efficiency over the longer term, but that must at the same time address the vulnerabilities that China faces in the shorter term that can easily overwhelm any larger reform program. These reforms clearly will not be easy and just as clearly face significant political constraints.

How will the reforms proceed?

I won’t pretend that I can lay out with any subtlety the specific reforms that Beijing must implement in order to improve the long term functioning of its economy, and can only wish the reformers the best of luck in what promises to be an immense task, but I do want to address, perhaps a little abstractly, the kinds of policies that will directly move China towards or away from the optimal adjustment path. Again, I want to make the distinction between the two types of reforms to which I earlier referred:

1. China, like every other economy, has institutional constraints that prevent it from achieving the sort of frictionless system in which incentives, including the design and implementation of economic laws, reward economic behavior that increases social wealth, and in which land, labor and capital resources are exploited as productively as possible. These reforms, which I sometimes refer to as “asset-side” reforms, are not always clear-cut among economists and are no less subject to fashion than men’s hair-styles, but it is pretty normal that at any point in time there is a widely accepted consensus about what constitutes an appropriate set of reforms. The goal of these reforms is to identify institutional or investment constraints that reduce efficiency and eliminate them, with the goal of increasing productivity.
2. In highly unbalanced and heavily leveraged economies in the late stages of a particular growth model, another set of reforms are designed specifically to speed up the rebalancing process and to reduce leverage.

I have already pointed out that historical precedents had always made it easy to predict the sequence of events:

• During the later stages of the period of rapid expansion in economic activity, and in spite of ample evidence that included an overwhelmingly consistent collection of historical precedents, the economic advisors to the Beijing government, along with most of the research analysts covering China, would fail to recognize the relationship between growing imbalances, capital misallocation, and deteriorating balance sheets. Nor would they recognize the symmetrical role of balance sheet inversion, in which what had caused them to confuse speculative profits in a period of expansion with higher-than-expected productivity would necessarily cause the contractionary phase to slow even further because the symmetry of speculation meant that losses would be magnified just as profits were. Just as inverted balance sheets made growth unexpectedly high in the expansion phase, in other words, they would necessarily make growth unexpectedly low during the contraction.
• At some point, however, debt levels would become so high that these same economic advisors would recognize the need for economic rebalancing, and for reforms that would accommodate the rebalancing in a way that lessened the chance of disruption.
• However because of a continued failure to understand the balance sheet component, the proposed reforms were always likely to be the asset-side reforms described above. For that reason it was also fairly easy to predict that the reforms would have very little impact in improving the underlying imbalances in the Chinese economy or in reducing the country’s reliance on surging debt to stabilize growth rates. It was inevitable that barring some major positive shock, debt would rise far more quickly than the economic policy advisors had predicted, and China’s vulnerability would rise to dangerous levels.

So to repeat myself

So far China has followed the same unfortunate path as all its predecessors. The recent announcement of supply-side reforms is no more than an explicit recognition that this is exactly what has happened. Beijing clearly now faces two options. One option is to recognize that productivity growth will not pull China out of its rising debt burden and to focus on liquidating assets to pay down debt and to fund wealth transfers to the household sector.

The second option is to embrace “supply-side” reforms which design improvements in economic efficiency in the elimination of institutional constraints that are dramatic enough to lead to a surge in productivity powerful enough to allow China to grow its way out of its debt burden. China, in this case, will not have to allocate losses directly or indirectly to households, businesses or governments, nor will the PBoC have to monetize the debt, which of course is simply another way of allocating the losses to the household sector. At the same time the household share of GDP will rise so rapidly that investment can quickly decline with no impact on growth or unemployment.

No country in history as ever managed to pull off this second option. This doesn’t make it impossible for China to do so, but it is all the more worrying that no country has suffered from economic imbalances or from debt burdens as deep as those of China today. Frankly I find it difficult to work out arithmetically any such outcome with numbers that are consistent systemically except under assumptions of near frictionless transitions and many years of implausibly high levels of wealth transfer from the state to ordinary households, on the order of at least 3-4% of GDP.

If I am right, the best way for China to avoid a very painful and possibly disruptive adjustment is for the supply-side reforms to be designed and implemented to accommodate rebalancing. Each important reform must be designed either to accommodate or boost a rapid increase in household income or wealth or it must be structured to pay down debt. As I will show it is important to understand that wealth transfers are fully compatible with supply-side reforms, depending on how the reforms are formulated.

How the evaluate the reforms

To return to the main objectives of the supply-side reform plan I listed above:

1. Reducing over-capacity. The purpose of reducing over-capacity must be to reduce the growing gap between the rise in debt that is required by companies to maintain unnecessary production facilities and the declining economic value to Chinese households of what is produced. Inevitably there will be lots of other considerations invoked by the relevant stakeholders and regulators involved in the problem of over-capacity, but they are barely relevant. If the reformers understand that the measures they take should be valued primarily in terms of their impact on reducing China’s debt burden, these reforms will be consistent with a smoother and ultimately less costly economic adjustment.

The difficulty in closing capacity of course is that it also usually means increasing unemployment. This is simply yet additional confirmation that all policy choices for Beijing boil down to choosing among higher debt, higher unemployment, and higher wealth transfers. But closing down unnecessary capacity can pay for itself, even if unemployed workers are temporarily put on the government payroll (causing debt to rise, but usually by less than it had before), but only temporarily as Beijing takes other measures to boost household income through wealth transfers from the state and so to boost consumption, a form of demand which is likely to be more labor intensive than the demand created in the process of over-capacity.

There seems to be a very clear consensus about at lleast some of the targets of the over-capacity drive. On Friday People’s Daily reported a statement released a day earlier by Premier Li Keqiang: “Steel and coal sectors should take the lead in cutting overcapacity, digest unreasonable inventories, reduce costs and improve efficiency.”

Steel and coal have been so universally recognized as problem sectors that it is pretty clear that they will not be able to escape significant cuts, but after a decade or two of extremely cheap credit (often negative in real terms), widespread moral hazard, and corporate governance incentives that prioritized production and employment above all other measures, it would be astonishing if over-capacity and bloated inventories were not a blight on most industrial sectors dominated by the state or by large companies with access to state patronage. Because these are likely to be the key causes of misallocated credit, and because measures that cut back on overcapacity are likely to be painful, and so politically resisted, if the measures do not extend well beyond steel and coal their impacts are not likely to be sufficient.

2. Reducing real estate inventory. Conceptually there is no easier reform to explain than this one, and while I recognize that there may be innumerable legal and political implications, in fact the economics are brutally simple and incontrovertible.

The economic value of an empty apartment to the Chinese economy is exactly zero, minus running costs and depreciation, which are only partially mitigated by the positive economic impact of their role as a secure form of savings. The moment an empty apartment is occupied by a Chinese family, Chinese wealth and income are immediately increased by the value that family attaches to the change in its living standards. China is notorious for the sheer quantity of its empty apartments, and these empty apartments represent an enormous expenditure of labor and resources by the Chinese people of which a large amount of wealth is destroyed every day that the apartments remain empty.

To get a sense of the magnitude of the cost to China of residential vacancies, we would need to begin with an estimate of the number of vacant apartments. I have seen estimates of the number of empty apartments in urban China range from 64 million to as much as 89 million. I have read elsewhere that roughly between one in four and one in five urban apartments in China is empty. I assume these two sets of numbers are consistent. For comparison sake I understand that urban vacancies in China are roughly ten times the global norm – i.e. in the rest of the world one in forty to one in fifty urban apartments are typically empty.

If we assume that there are in fact 60-70 million empty apartments in China, and further assume that the average size of these apartments is 50-60 square meters and the average square meter costs roughly $1,500, then the market value of empty apartments in China is between $4.5 trillion and $6.3 trillion. The real economic value of an apartment is not necessarily the same as its market price, especially if a speculative real estate bubble has artificially boosted prices, so let us assume that the fundamental value of these apartments to Chinese households is actually between one-third and one-half of the market value. If these apartments were actually occupied, in other words, Chinese households would feel wealthier by between $1.5 to $3 trillion dollars, or roughly 12-25% of GDP.

If somehow vacancies in China were immediately to adjust to global norms, these back-of-the-envelope calculations suggest that the annual impact on household wealth would be the equivalent of an annual increase in household income of 2-3 percentage points – which increases the income of households by 4-6%, assuming that the income of ordinary Chinese households is roughly 50% of GDP.

This is not a negligible number. If the supply-side reforms Beijing is contemplating include measures that reverse the institutional distortions responsible for the very high vacancy rate in China, household income would be the equivalent of a 4-6% higher every year, and the household income share of GDP would be raised by 2-3 percentage points, which isn’t much less than has been accomplished over four very difficult years.

Reforms that fill up empty apartments, in other words, are clearly consistent with rebalancing, and are the kinds of reforms that will lower the adjustment costs for China. What kind of reforms can fill empty apartments? That I leave to smarter people than me, but if the carrying cost of an apartment, which is currently very low, were to increase significantly, most obviously by instituting an annual property tax, apartment owners would have very strong incentives either to sell or to rent out their apartments to generate enough income to cover the cost of holding apartments. The risk of course is that by forcing some owners to sell, this could cause the market to drop sharply, and while I would argue that lower housing prices represent, paradoxically, an increase in Chinese wealth, along with a redistribution of wealth from the richer to the poorer (and, not incidentally, might help President Xi flush out additional corruption), it might have a destabilizing impact on the banking system which would have to be addressed.

The point is that by placing real-estate-related reforms in the context of rebalancing, we can quickly tell which reforms are helpful and which are not. We can also see that houkou reforms aimed at diverting population flows to empty apartments in secondary cities, and away from the highly prized Beijing-Shanghai tier of cities, avoids addressing a big chunk of potential rebalancing value – empty apartments in those cities – and so these must be addressed by other policies. Finally building new low cost apartments for the poor represents an increase in debt, unless it is funded by the sale of state assets, and an increase in economic activity, but an increase in debt would only be justified by labor shortages in the relevant lower-tier cities – shortages that constrained the productivity of existing investment facilities, which is unlikely to be the case.

3. De-leveraging and otherwise strengthening balance sheets. The purpose of this set of reforms and its consistency with the appropriate goals of rebalancing is pretty self-explanatory. There is one important point, however, that is often missed.

Debt exchanges that lower debt-servicing costs for provinces, provincial borrowing vehicles, or large corporate borrowers do not advance the rebalancing process or lower China’s adjustment costs in the least, contrary to expectations. All they do is reduce unbearably high debt-servicing costs for insolvent or nearly-insolvent borrowers by transferring part of the debt-servicing costs elsewhere. If a provincial borrower is able to swap out of an expensive loan into a bond with a much lower coupon, its debt-servicing costs will of course have plummeted, and it might finally have additional breathing space which it can put to good reforming use (although it can just as easily abuse the benefit), but every RMB it saves represents an equivalent reduction in the profitability of the bank or of some other lender, and so also a reduction in its retained earnings, and it will increase the contingent liabilities of the central government by the same amount.

The provincial debt swaps, in other words, do not reduce debt and do not reduce debt-servicing costs. They simply transfer debt from China’s provincial balance sheet to Beijing’s central balance sheet. Some economists are sophisticated enough to argue that because of the convexity of financial distress costs, this debt transfer will lower slightly overall financial distress costs for China, but this is only true if the resulting increase in central government debt – in the form of contingent liabilities, in this case – has no impact at all on the perception of central government creditworthiness. It would be extraordinary, however, if it had no impact.

1. Fiscal expansion, including tax cuts. The optimal role of fiscal policy in lowering China’s adjustment costs is another case of reforms whose purpose should be fairly straightforward. If fiscal policy is designed to reduce income inequality, or to raise household wealth and fund this increase in wealth by the liquidation of state assets (and not by increasing debt), it will advance the rebalancing process, lower adjustment costs, and reduce the risk of disruption. Because there are a near-infinite number of ways fiscal policies can accomplish or not accomplish these objectives, it isn’t meaningful to try to list them, but the optimal set of policies involving changes in fiscal expenditures and perhaps a reallocation of tax collection, in which revenues of RMB 11.1 trillion were accumulated in 2015, according to People’s Daily, is quite clear: faster growth in after-tax, disposable household income, in which the lower the income, the faster the growth, and a reduction of outstanding debt.
2. Lowering corporate costs directly and by reducing government bureaucracy. These may seem like the most obviously useful set of reforms, but this is only because economists mis-conceptualize the value of improvements in asset-side efficiency. These kinds of reforms, if done correctly, will benefit China in the long-term by raising productivity growth, but as in the case of the reforms implemented by Mariano Rajoy in Spain, they do not address the rebalancing process, and their net impact on reducing the country’s debt burden takes far too long to matter to China’s adjustment process. The historical precedents indicate that however effectively the reforms are designed and implemented, if China’s economic adjustment is excessively costly or economically or socially disruptive, they won’t even matter in the long term.

A new beginning, or more of the same?

My description of the kinds of supply-side reforms that Beijing may be contemplating may seem overly abstract, but the purpose of my very long essay is not to propose specific reforms that will help resolve China’s rebalancing. It is to warn against falling into the trap of economic orthodoxy. China’s problem is not that a spate of recent exogenous shocks has perturbed the economy from its path of high growth, and so it does not require efficiency-enhancing improvements to the way it manages the asset side of the economy in order to return to that high growth equilibrium.

China’s problem is a systems problem, and it is the same problem every country that has experienced a similar investment-led growth miracle has experienced. China must switch from the current growth model to a completely different growth model as smoothly as possible, and the more debt it has, and the more distorted the structure of that debt, the more difficult it will be to manage this switch smoothly. This new growth model requires that household income comprises a much greater share of GDP than it currently does, and one way or another this new model will be imposed upon the Chinese economy. The first of the only two important questions is whether the higher household income share of GDP is a consequence of a rise in household income or a drop in GDP.

Because the quality and structure of Chinese debt severely limits the options available to Beijing and significantly increases the risk of a shock causing a disruption or a crisis, one way or another debt will eventually become a lower share of China’s GDP. The second of the only two important questions is about the manner and speed with which debt is reduced. Put differently, the only way to reduce debt is to allocate the cost to some sector of the economy, and broadly speaking these sectors are the household sector, the private sector, the state sector, and the various more specialized subsectors within these three – for example households can consist of rich households versus the rest, the state sector can be divided among the central government and the provincial governments, the private sector can consist of SMEs, large corporations, labor-intensive industries, capital-intensive industries, the export sector, etc.

China can choose to avoid reducing debt for as long as possible, as Japan has done, but the cost is a near permanent state of economic stagnation and the risk is that a poor, volatile economy like that of China is unable to last as long as Japan, in which case it’s debt burden will be reduced in the form of a debt crisis or in the form of monetization by the PBoC, which is simply another way of saying that the cost of the debt will be implicitly allocated to household savers, as was the case in the Chinese debt crisis of the late 1990s.

But this would make rapid growth in consumption impossible. Without the ability to boost GDP with explosive growth in investment, as China did following the debt crisis of the late 1990s, this also means that GDP growth must collapse, and could even become negative.

Alternatively China can choose to reduce debt explicitly by allocating the costs to some sector of the economy. As I have discussed many times, including in my 2013 book, Avoiding the Fall, arithmetically and logically the only appropriate sector is the government sector, and given the need for President Xi to further centralize power if Beijing is to implement reforms successfully, it is obvious that debt costs must be allocated to provincial governments.

Of course this is politically easier said than done, but nonetheless these are the options open to China. It must rebalance and it will. It must reduce its debt burden and it will. It can do what many other countries have done in similar circumstances and waste time and resources by implementing the kinds of reforms beloved of academic economists that do not directly address the rebalancing or the debt directly, and so significantly raise its ultimate adjustment cost while running an increasing risk of crisis. Or it can take steps aggressively to direct the rebalancing and reduce the debt.

China has done the former during the past several years but Beijing’s recent announcements about supply-side reforms suggest that its leaders are frustrated by the ineffectiveness of the proposed reforms and are determined to set out on a very different path. Whether or not this very different path ends up being more of the same we will learn only over the next two or three years.

But whatever happens, this year will clearly be an important one for China, apropos of which, happy Year of the Monkey, which begins in two weeks. They say if you’re very smart you’re likely to do well this year, otherwise it’ll be a very tough year.

Footnotes

1. The Chinese growth model is simply a variation on what I call a “Gershenkron” growth model, which has three main characteristics:
2. Rapid economic growth is driven by rapid growth in investment. To achieve this rapid growth in investment, the financial system is structured so as to maximize credit expansion, and credit is directed primarily into infrastructure investment and investment in manufacturing capacity.
3. In order to force up the savings rate so that savings can easily be directed into investment, direct and indirect taxes are used to constrain the growth in consumption by constraining the growth in the household income share of GDP. As households retain a smaller and smaller share of GDP, their consumption also becomes a smaller and smaller share of GDP. Because household consumption comprises most consumption in any economy, total consumption also declines as a share of GDP, and its obverse, savings, rises. Ideally the result is such rapid growth in GDP that even as the household share contracts, household income overall grows rapidly.
4. The institutional settings that maximize credit growth and that constrain the growth in household income are further linked because the direct and indirect taxes on the household sector that constrain growth in household income also subsidize investment. In China’s case these taxes have mostly been indirect and include low wage growth relative to productivity growth, an undervalued currency, environmental degradation, the rights of eminent domain, moral hazard and, most importantly, financial repression.

Many countries have employed variations on the Gershenkron model and have achieves spectacular growth. All of them, however, have ended up with very difficult adjustments and significant debt problems. The sequence is usually the following:

1. At first it is easy to identify productive investments and the system pours credit into these areas, achieving very and unbalanced rapid growth that is both wealth-creating and sustainable.
2. At some point however the economy begins to reach investment saturation, and this is especially a problem in poor countries because most poor countries are poor because they do not have the institutional ability to absorb and exploit resources productively. When they reach this point continued rapid credit expansion results in credit growth that exceeds the growth in debt-servicing capacity, and the country’s debt burden begins to grow unsustainably.
3. At this point the economy must switch to a new growth model that focuses not on continued expansion in investment but rather on implementing the institutional reforms that will allow businesses and citizens to exploit resource more efficiently. These reforms are usually described as a kind of “opening up” or “liberalization”, and require substantial changes in the educational, financial, and legal systems as well as an elimination of the direct and indirect taxes that had constrained the growth in household income and the subsidizing of investment.
4. Because these reforms are always strongly opposed by the elite that grew up around and had benefitted from the Gershenkron model, the reforms are strongly resisted and in every case in history the result has been a dangerously excessive build-up of debt.
5. Ultimately either the reforms are implemented against strong political opposition or, if they are not, the economy suffers from a crisis, usually a debt crisis, in which it rebalances disruptively. Whether or not the rebalancing occurs disruptively, the longer the debt burden is allowed to grow the more painful the adjustment.

And as Albert Hirschman reminded us, all rapid growth is necessarily unbalanced.

The orthodox world seems to be one that approaches that described by Adam Smith, in which we can assume a near-infinite number of economic entities, none large enough to have an impact on input or output prices, and in which there do not seem to be significant institutional constraints. In fact the only variables that operate as institutional constraints, and so the only variables that can prevent rapid adjustment towards equilibrium, are wage stickiness, along perhaps with certain kinds of price stickiness.

I suspect that in many orthodox models household savings preferences are also implicitly a kind of constraint that can occasionally change independently for reasons that are not specified (i.e. if there is a change in the household savings rate that cannot be modeled by demographics, income levels, unemployment, or various kinds of economic uncertainty, we simply assume that households have decided to become more or less thrifty). Efficiency in this world is usually maximized when the economy achieves some idealized equilibrium. Exogenous shocks can move the economy away from this equilibrium, and wage and price stickiness, along perhaps with rigidities in savings preferences, will slow the adjustment process by which the economy returns to equilibrium, but in the long run if left to its own devices the orthodox world always returns to equilibrium, rendering economic policy-making largely useless.

In the short run however the orthodox world accepts that fiscal and monetary policies can speed up the adjustment towards equilibrium, largely it seems by countering these constraints, or by setting interest rates in order to manage investment and consumption. There is a great deal of disagreement between those who seem to think that monetary policy is largely ineffective and those, known as monetarists, who followed Keynes in attaching importance to changes in the demand for money while berating him for not stressing the inflationary impact of money creation. Whether the disagreement between the two is a trivial one or is of major theoretical and practical significance seems mainly to depend on how seriously you take the neo-classical synthesis, but I think both the orthodox and the unorthodox would agree that it isn’t a good idea to confuse anything Keynes might have actually said or believed with any of the various “Keynesian” schools.

I try to describe this “orthodox” world because even though I suspect most mainstream economists would agree that the Chinese economy in no way resembles one that is comprised of a very large number of agents too small to affect output or input prices, in which there no major institutional constraints, in which unsustainable credit expansion cannot persist except over a very brief period, and imbalances return automatically and fairly quickly towards efficient equilibrium. As I have discussed many times, however, this world is very rigidly embedded into most of their models and analyses.

For those who are interested, Hyman Minsky lists the conditions implicit in the world of orthodox economists, with tremendous sensitivity, in the 5th chapter of his book, Stabilizing an Unstable Economy. In my September 1 blog entry I argued that economists typically focus on managing the asset side of the balance sheet, and almost never on the liability side, because they implicitly understand both the extent and the nature of economic growth to be almost wholly a function of the ways in which assets are managed. If you want to increase the growth rate of an economic entity, in other words, you must do so by improving the efficiency with which its assets are managed.

But this is only true under certain specific circumstances. In any economic entity in which either debt levels are high enough to introduce uncertainty into the debt-servicing process or the balance sheet is sufficiently distorted or inverted to transform the incentive structure or exacerbate or otherwise affect the impact of exogenous changes, the relationship between the value of assets and the value of liabilities can in itself increase growth, reduce it, or cause it to collapse.

This very important but surprisingly poorly understood feature of balance sheet fragility was something that Irving Fisher often discussed when he insisted on the distinction between the events that trigger a crisis and the underlying “cause” of the crisis. In the early stages of the GFC, for example, optimists often pointed out that the total outstanding amount of US sub-prime mortgages was too small to matter much to the US economy, but the fact that something so “small” triggered so large a disruption simply means that balance sheets were extremely fragile and increasingly susceptible to smaller and smaller shocks. That is why while it is true that the Chinese stock market is too small to matter in any “fundamental” sense, that doesn’t mean we can completely rule out in the future its impact on a larger disruptive process.

The only clear historical exception I can find in the past 200 years is the case of Romania in the 1980s. Nicolae Ceausescu, worried by political instability in Poland after it had been forced to restructure its debt (Poland was one of the 32 sovereign creditors participating in the “LDC Debt Crisis” of the 1980s), and concerned perhaps about the implications of a debt restructuring for his domestic reputation as a policymaker, chose to repay in full the $13 billion the country owed, which it did ahead of schedule in 1989 by imposing brutal austerity. Few think it is a coincidence that shortly thereafter, when he and his wife were captured quickly executed, there was general jubilation among Romanians.

Colombia and the USSR were technically not among the restructuring countries, although they traded as such (their loans were “voluntarily” rolled over by banks unwilling to add to the pool of formally restructured sovereign debt) and engaged in direct and indirect discounted buybacks. Chile was among the restructuring “LDCs” and was one of the only major restructuring countries, I believe, that did not request or receive a Brady restructuring with a formal discount. It was however among the most active participants in direct and indirect discounted buybacks, especially through its famous “Chapter 18” and “Chapter 19” debt-equity swaps.

A well-known economists suggested to me that the only exception he could think of was England after the Napoleonic wars, and although I am not sure whether it indeed is an exception, it is noteworthy that except for the case of Romania, which is not really an exception because it did not grow its way out of the debt but rather imposed brutal austerity, we would have to go back 200 years to find an exception. It is surprising that this very consistent and remarkable history has not at least been acknowledged by economists who have recommended with great confidence programs aimed at allowing overly-indebted sovereign entities to grow their ways out of their debt burdens.

There is a great deal of confusion about this. In a January 13 panel discussion organized in Moscow at the Gaidar Institute Conference at which both Peking University colleague Lin Yifu and I participated, Dr. Lin proposed China’s experience during the past decade as precisely one case in which a country with an excessive debt burden was able to grow its way out of the debt with no partial forgiveness and no allocating to some other sector a substantial portion of debt servicing costs.

But it turns out that China was not an exception. China during this time had nominal GDP growth ranging typically from 16% to 20% and its GDP deflator was typically 8-10%. Interest rates however were extraordinarily low by any standard. The lending rate was around 7% and the deposit rate around 3.5%. While the standard explanation is that bad loans were resolved by transferring them to the AMCs and liquidating them efficiently, in fact the AMCs purchased most of the loans in two tranches, one at full face value and one at 50% of face value. I believe that they were able to liquidate only a portion of this portfolio, and at less than 25% of face value.

The AMCs received the full funding for these purchases from the banks that sold them the bad debt in the form of 10-year bonds, many or most of which were subsequently rolled over for a second ten-year period. Clearly this did not involve any transfer of value.

However under the nominal GDP growth and GDP deflator conditions described, a lending rate of 7% was clearly concessionary by any standard, and by at least 5-7 percentage points. In that case it is easy to calculate that the amount of debt forgiveness for just the first 10-year period ranges from 28% to 36% on all loans. The costs were borne, of course, by household depositors, who bore an additional cost to recapitalize banks equal to approximately 9% of their savings, in the form of a spread between the lending rate and the deposit rate that was roughly double the standard spread.

China did not simply grow its way out of its loan problem of the late 1990s, in other words. It implicitly passed onto households between an amount equal to between a third and a half of the value of the loans in order to recapitalize the banks and grant debt forgiveness to insolvent borrowers. It was no coincidence, of course, that during this time the household income and consumption shares of GDP plummeted, from already low levels. The impact of lagging consumption growth on GDP growth was countered, obviously, by soaring investment.

While this was a very successful way of repairing the damage caused by bad lending in the 1990s, China of course cannot use the same mechanism again. Rebalancing requires that consumption growth exceed GDP growth, and Beijing fully understands that it cannot use a surge in investment to counter the impact of such a huge transfer of wealth from the household sector.

A recent editorial in Caixin makes the point a little bluntly: “Some officials have recently placed their hopes of avoiding painful reforms on the “belt and road” initiatives, arguing that they will export their way out of excess. But new markets opened by these programs will not be big enough to absorb all of China’s excess capacity. We have already witnessed backlashes in some developing countries against China’s steel exports. Such resistance will become stouter.”