There is increasingly a consensus in Beijing that China’s excessive reliance on surging debt in recent years has made the country’s growth model unsustainable. Aside from the economy’s current path, there are only four other paths China can follow, each with its own requirements and constraints.

The first quarter GDP numbers that China’s National Bureau of Statistics released last week have renewed what was already an aggressive debate about whether or not China would be able to meet the 5.5 percent GDP growth target it set for itself this year. Two weeks ago, for example, for the second time in three months, the International Monetary Fund lowered its GDP growth forecast for the country to 4.4 percent from 4.8 percent in January 2022 and 5.6 percent last October. Given the serious headwinds the economy is facing, many analysts question whether China can achieve even this rate of growth.

But it’s a mistake to view China’s growth in terms of whether it can or cannot achieve a particular GDP target. China’s GDP growth is not a measure of the country’s economic output and performance in the same way the statistic is for other major economies. China’s GDP growth target is an input decided by Beijing at the beginning of the year. Its fulfillment depends on the extent to which the economic authorities are able and willing to use the country’s resources and debt capacity to achieve the required amount of economic activity.

Higher GDP growth for China, in other words, doesn’t mean a better economic outcome than lower GDP growth, as it does for most other economies. It just means that the authorities were more willing to employ resources for creating economic activity, whether or not that activity is productive or sustainable. System inputs cannot indicate anything about the performance of that system. Because GDP growth in China is such an input, it cannot be a measure of how well the economic system performs. Only an output measure can gauge its performance.

That being the case, what matters is not the level of GDP growth China manages to reach in 2022 but rather the way in which that growth, whatever its level, is achieved. Beijing has already long distinguished between “high quality” growth and “other” growth, a distinction that seems to be reflected in an important essay last year by President Xi Jinping in which he calls for more “genuine,” not “inflated,” growth:

I said that we needed to shift the focus to improving the quality and returns of economic growth, to promoting sustained and healthy economic development, and to pursuing genuine rather than inflated GDP growth and achieving high-quality, efficient, and sustainable development.

Broadly speaking, genuine growth can be thought of as sustainable growth generated largely by consumption, exports, and business investment (with the last of these elements aimed mostly at serving the first two), whereas “inflated” growth consists mainly of nonproductive, or insufficiently productive, investment in infrastructure and real estate. The purpose of inflated growth is to bridge the gap between genuine growth and the GDP growth target deemed necessary to achieve the Chinese leadership’s political objectives.

To simplify matters, a better economic outcome for China is not more GDP growth but rather more genuine growth and less inflated growth, whereas a worse outcome is the opposite. In that sense, whether or not China achieves a GDP growth target that exceeds the economy’s underlying genuine growth only reveals how determined Beijing is to achieve that level of economic activity, and how much debt it is willing to allow and how many resources it opts to sacrifice, to achieve a politically acceptable level of economic activity as measured by GDP. This GDP target says little about how healthy the economy is.

The rise in debt itself is not necessarily a problem, but while an accurate measure of the problem of wasted resources in the Chinese economy would be fairly complex, a disproportionate share of Chinese debt goes to fund investment. This means that, in principle, the country’s debt-to-GDP ratio is a reasonable proxy for the amount of inflated growth in China’s GDP numbers. For example, in 2020, when the onset of the coronavirus pandemic caused consumption to collapse, which in turn drove a contraction in genuine growth, more than 100 percent of China’s GDP growth was explained by the consequent surge in investment in infrastructure and property. It is therefore perhaps no surprise that China’s official debt-to-GDP ratio rose that year from about 247 percent to 270 percent.

In 2021, however, there was a major reversal of the previous year’s collapse in consumption, along with a surge in exports, a combination that also caused business investment to rise. At the same time, Beijing came down hard on the property sector and restrained growth in infrastructure investment. The result was that most, if not all, of the growth that year represented genuine growth and, not surprisingly, China’s debt-to-GDP ratio did not rise.¹ This reinforces the idea that the surge in China’s debt burden in the past decade, among the fastest in history, is a result of the economy’s overdependence on nonproductive investment in property and infrastructure to balance out its structurally high savings rate and to bridge the gap between genuine growth and the GDP growth target.

FROM PRODUCTIVE TO NONPRODUCTIVE INVESTMENT

Investment in property and infrastructure doesn’t inherently cause an economy’s debt burden to rise. If the investment is broadly productive—that is to say, if the direct and indirect economic value it creates exceeds the cost of the investment—then any increase in debt will be more than matched in the short term to medium term by an increase in GDP, which is usually a proxy for the value of goods and services produced by the economy. If the created value outweighs the cost of the investment, the country’s debt-to-GDP ratio will not rise.

This was the case in China from roughly the late 1970s until the mid-2000s, when Chinese debt rose sharply, but GDP rose at least as rapidly. The relationship changed between 2006 and 2008, after which there was an observable acceleration in debt and a deceleration, gradual at first, of GDP growth.

While it is possible for productive debt to rise faster than GDP for short periods of time, when the growth benefits associated with the investment are postponed, this is unlikely to be the case when debt surges relative to GDP year after year for many years—as happened for the past fifteen years in China’s case. When that happens, it becomes obvious that the value of resources employed in the investment, for which debt is a proxy, is less than the value of productive capacity generated by the investment, for which GDP is a proxy. This creates a strong case for a claim of systematic malinvestment.

Investment in China can broadly be divided into two categories that mirror the distinction between genuine and inflated growth.

• private business investment: investment by entities that operate under hard budget constraints, activity that tends to be productive because nonproductive investment eventually lead to insolvency
• investment by entities without hard budget constraints: investment by local governments, state-owned enterprises, and, until recently, the property sector—whereby loss-causing activities can be subsidized or ignored for long periods

It is mainly this latter category that accounts for the surge in China’s debt-to-GDP ratio. To the extent that much of China’s investment in property and infrastructure in recent years cannot be justified economically, in other words, it explains the sharp rise in the country’s debt burden.

It is worth repeating that China’s overdependence on investment by entities that operate under soft budget constraints hasn’t always resulted in a rising debt burden. China began its reform period in the late 1970s after five decades punctuated by the Second Sino-Japanese War, civil war, and Maoism, all of which left the country hugely underinvested in infrastructure, logistics, and manufacturing capacity for its level of social development. Until the mid-2000s, while the Chinese economy remained underinvested relative to the capacity of Chinese businesses and workers to absorb investment productively, most investment tended to be productive.

Even with a substantial and rising amount of wasted investment, which showed up in the staggering amount of nonperforming loans in China’s banks that were cleaned up between 2000 and 2010, China’s high investment levels were nonetheless productive in the aggregate and resulted in rapid, sustainable growth. By 2006 to 2008, however, like every other country that has followed a similar high savings, high investment growth model—most notoriously the Soviet Union in the 1950s and 1960s, Brazil during those same decades, Japan in the 1970s and 1980s, and perhaps a dozen other countries—China seemed to have closed the gap between its level of capital stock and the level that its workers and businesses could productively absorb, after which China’s debt burden began to rise rapidly.²

CHINA’S FIVE PATHS

The problem with this stage of the development model—and it is worth repeating that this also happened to every other country that followed a similar approach—is that the continued high levels of growth generated by systemic investment misallocation are not sustainable. Once it reaches that stage, such a country must shift to a new growth model, perhaps a much more bottom-up one in which the authorities abandon their previous supply-side orientation in favor of income redistribution and demand-side support.

Until the country begins its difficult adjustment, it can continue to grow rapidly only with the piling on of more nonproductive investment, creating more inflated growth. Because this fictitious growth isn’t sustainable, it must eventually be amortized, and in every previous case the period of adjustment reversed much of the previous growth. Unfortunately, the more fictitious growth that is created, the more politically difficult and economically costly the amortization of this growth tends to be.

Once it is recognized that China’s surging debt burden is a function of nonproductive investment, and that this investment must eventually be curtailed, it turns out that there are a limited number of ways the economy can continue growing. Any economy broadly speaking has only three sources of demand that can drive growth: consumption, investment, and trade surpluses. For that reason, there are basically five paths that China’s economy could take going forward.

1. China can stay on its current path and keep letting large amounts of nonproductive investment continue driving the country’s debt burden up indefinitely
2. China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with productive investment in forms like new technology
3. China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with rising consumption
4. China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with a growing trade surplus
5. China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with nothing, in which case growth would necessarily slow sharply

These are the same five paths, by the way, faced by every other country that has followed the high savings, high investment model. Each of these paths creates its own systemic difficulties and each, except for the first, implies substantial changes in economic institutions that, inevitably, must be associated with substantial changes in political institutions. This may be why in the end every previous country followed the last of the five paths.

It is nonetheless worthwhile to examine each of the five paths in turn. Doing so will underscore the constraints that Beijing must accept or overcome in pursuing each path.

PATH 1: CAN CHINA KEEP DOING WHAT IT HAS BEEN DOING?

For China to stay on its current path of high-level growth fueled by nonproductive investment, the country would need to allow a persistent, indefinite increase in its debt burden.

There have been many attempts to argue that rising debt isn’t a problem for China. Some commentators argue, rather foolishly, that debt is only a problem if it involves external debt and is not funded by domestic savings. But surging debt funded by domestic savings rather than foreign savings just means that the country accumulating the debt is running a current account surplus. It should be enough to point out that the surge in U.S. debt in the 1920s and the surge in Japanese debt in the 1970s and 1980s—both countries with persistent current account surpluses, high domestic savings, and no external debt—turned out to be among the two greatest debt-related calamities of the past century.

Others argue that as long as China is monetarily sovereign, there is no limit to the amount of debt it can create and absorb. This is basically the same argument as the one above, couched in slightly different terms, but (as I’ve discussed elsewhere) it is based on a naïve misunderstanding of modern monetary theory. An expansion in debt that results in an expansion in demand relative to supply must be resolved by implicit or explicit transfers that, in turn, always undermine economic growth, whether the debt is funded domestically or externally.

More importantly, however, it has become clear that the majority of economic policymakers and economic advisers in Beijing do not believe that a persistent increase in the country’s debt burden is sustainable. They have stated many times that they are determined to get off this particular path and have tried to implement policies seeking to restrict nonproductive investment and the growth in the country’s debt burden, even if none of these attempts have been successful. That is because of how difficult it is, or how unwilling they are, to accept the consequences of any of the four remaining paths.

Continued in Part 2>>

¹ In fact, while the outstanding amount of debt roughly stabilized, it fell as a share of GDP by six percentage points, to 264 percent, mainly because part of that year’s economic activity had been funded by the previous year’s surge in debt.

² It is probably not just a coincidence that China’s debt-to-GDP figure rose especially rapidly in periods during which Beijing had to rely more heavily than usual on property investment and public-sector investment in infrastructure—such as from 2009 to 2010 and in 2020—to achieve GDP growth targets that otherwise exceeded the capacity of the private sector.