<<Continued from Part 1

PATH 2: CAN CHINA REPLACE NONPRODUCTIVE INVESTMENT WITH PRODUCTIVE INVESTMENT?

Beijing could bring debt under control while maintaining high growth rates by replacing nonproductive investment with investment in more productive economic sectors. Chinese authorities have been proposing this for many years as the most likely path to follow, but they have been unable to fulfill these promises.

This shouldn’t be a surprise. Every country that has followed this growth model has, in the model’s later stages, proposed the same solution, but there are at least three important reasons this solution is difficult to implement.

The first hurdle is the sheer size of the required transfers relative to the potential size of the would-be recipient sectors of the economy. China currently invests 40 to 45 percent of GDP every year, the highest figure ever recorded by any country, even if this number is down from earlier levels; a little more than roughly 30 percent of this amount has been channeled into infrastructure investment and a little less than 30 percent has been allocated for property investment.³ In contrast, the Chinese economy’s high-tech sectors, in which so many place their faith, represent less than 10 percent of GDP according to the most generous of definitions.⁴ The idea that there are highly productive sectors in the Chinese economy that can easily absorb even a fraction of the investment in nonproductive or low-productivity sectors is pretty far-fetched.

That leads to the second problem. It is not at all obvious that these presumably more-productive sectors are starved for capital. China’s private-equity and venture-capital sectors have grown explosively in the past two decades, and it is widely mentioned by practitioners that raising capital to fund new ideas is far easier than finding profitable new ventures to fund. This is not just an issue in China—Apollo CEO Marc Jeffrey Rowan recently noted, for example, “Our market sometimes loses sight of what’s in short supply; capital as a general matter is plentiful, and it is assets that offer appropriate risk rewards that are in short supply”—but it has been a bigger concern in China than elsewhere. That being the case, diverting large amounts of additional investment into these sectors is likely to replace one kind of nonproductive investment with another.

The third problem, one that crops up in any discussion of how the Chinese economy is to adjust, is probably the most difficult to resolve. An economy that has invested between one- quarter and one-third of its GDP in property and infrastructure for three decades or more, and one that has seen the amount of wealth accounted for by property and infrastructure investment soar, will have developed social, economic, financial, and—most importantly— political institutions that were constructed around this method of investment. Such a tradition of investment misallocation is also likely to result in a household sector for whom home ownership is a disproportionately large share of total household savings—up to 70 percent by some measures.

Such a radical transformation of a country’s investment process cannot help but disrupt these social, economic, financial, and household institutions. It is hard to imagine that such shifts would not also require or result in fairly radical transformations of political institutions in ways that have historically been extremely difficult to absorb and predict. While economists rarely—with few exceptions, like Albert Hirschman or the dependencia theorists of the 1960s and 1970s—discuss these institutional constraints, historically they have always been the most important constraints that have prevented successful adjustments.

None of this means, of course, that it is impossible for China to follow this path, but it does indicate that doing so would be extremely difficult and would inevitably require institutional changes that are hard to predict. At the very least, such a path would require that the authorities in Beijing have a clear understanding of why other countries that followed this growth model found this form of adjustment so difficult to implement.

PATH 3: CAN CHINA REPLACE NONPRODUCTIVE INVESTMENT WITH RISING CONSUMPTION?

Beijing could bring debt under control while maintaining high growth rates by replacing nonproductive investment with a rising consumption share of GDP. This is what Beijing has been proposing since at least March 2007, when (during his closing press conference at the Two Sessions parliamentary meetings) then premier Wen Jiabao announced that the rebalancing of domestic demand toward consumption would be a top priority of Beijing’s economic policymakers.

Household consumption composed less than 40 percent of China’s GDP as of 2020, versus a global average in other countries of roughly 60 percent. With other consumption (such as government consumption) adding 10 to 15 percentage points, an amount in line with the figures for other countries, China has by far the lowest consumption share of GDP of any economy in the world.

There’s no mystery as to why the Chinese consumption share of GDP is so low. Chinese households retain a very low share—in the form of salaries and wages, other income, and transfers—of what they produce, so they are unable to consume more than a low share of what they produce. Beijing’s new common prosperity policies focus on redistributing income from the wealthy to the poor and the middle class, but even if the program is successful, this will only help at the margins.

That is why there is also no mystery about how to sustainably raise the consumption share of GDP: Chinese households must retain a larger share of what they produce, which of course also means that some other sector of the economy—either businesses, the government, or foreigners (although this last category is too small to matter)—must retain a reduced share.

With businesses in China retaining roughly the same share of GDP as in other countries, it would be costly for Beijing to force businesses to absorb the extent of the necessary transfer, which leaves only the government sector (mainly meaning local governments). The only way to rebalance consumption in China meaningfully and sustainably, in other words, requires substantial transfers from local government to households.

But this is also why it has been so difficult for Beijing to manage the rebalancing process and why, the consumption share of GDP has only risen a few percentage points, even fifteen years after Wen first promised to rebalance demand. It is inconceivable that a transfer of 10 to 20 percentage points of GDP from local governments to households wouldn’t also imply a huge shift in the relative political power of different sectors of the economy and a major transformation in the country’s relevant social, political, and economic institutions.

Again, none of this means that it is impossible for China to follow this particular path, but recall Hirschman’s insight that the constituencies that have benefited disproportionately from the older model—and have amassed a disproportionate share of political power in the process—are likely to block an adjustment to this model that requires them to absorb a disproportionate share of the adjustment costs. Put differently, it is easy to figure out the arithmetic of the rebalancing adjustment, but it is difficult to absorb the political consequences.

PATH 4: CAN CHINA REPLACE NONPRODUCTIVE INVESTMENT WITH A RISING TRADE SURPLUS?

Another way that Beijing could bring debt under control while maintaining high growth rates would be by replacing nonproductive investment with a rising trade surplus. While this option is possible in theory, in practice it isn’t.

China’s trade surplus, at roughly 4 to 5 percent of China’s GDP at the end of last year, was already equal to nearly 1 percent of the GDP of the rest of the world, and by my calculations it would need to increase the surplus every year by at least 3 percentage points of Chinese GDP to replace domestic nonproductive investment. This is a possible strategy for a small economy, but China’s trade surplus is already unacceptably high for such a large economy. The rest of the world would not (and probably could not) accept a system in which China depends for growth mainly on its ability to absorb a larger and larger share of scarce global demand.

PATH 5: WHAT HAPPENS IF CHINA DOES NOTHING TO REPLACE NONPRODUCTIVE INVESTMENT?

Given that investment accounts for 40 to 45 percent of GDP in China, with investment in infrastructure and property accounting for nearly two-thirds of that amount, it is clear that a significant reduction in nonproductive investment—if it is not replaced with another equivalent source of growth—must result in a sharp contraction in China’s GDP growth. My back-of-the-envelope calculation suggests that the upper limit of GDP growth for many years, should that prove to be the case, would likely be 2 to 3 percent.

Unfortunately, historical precedents suggest that such adjustment costs tend to be underestimated. This growth model is highly pro-cyclical, with massive infrastructure spending causing rapid growth, and rapid growth in turn justifying more infrastructure spending. If the adjustment is not carefully managed, an initial slowdown can become—and has become in every previous case—self-reinforcing. That may be because the more the economy slows, the more it undermines the value of previous investment in infrastructure and manufacturing capacity, which only increases the amount of fictitious wealth (bezzle) that must ultimately be written down, a process that in turn depresses growth further.

Historically, there have been two ways (or some combination of ways) in which the adjustment to much slower growth occurs. One way is for this shift to happen rapidly, usually in the form of a financial crisis along with a sharp contraction in GDP. The other way is through lost decades of very low growth. The first way may be more costly in the short run but less costly over the long run, unless it leads to political and social disruption.

Whether the Chinese economy is likely to adjust in the form of a financial crisis or in the form of lost decades of sluggish growth is probably mainly a factor of the stability of the country’s domestic balance sheets and the financial system and the ability of financial authorities to control and restructure systemic liabilities. In my opinion, domestic financial conditions are such that China is still unlikely to have a financial crisis or a sharp economic contraction. It is much more likely, in my opinion, that the country will face a very long, Japan-style period of low growth.

THE OUTLOOK FOR THE REST OF 2022

Beijing is trying to reduce nonproductive investment as rapidly as it can while trying to make progress toward the second, third, and fourth paths outlined above. But for political reasons, Chinese policymakers have never been able to accept the extent of the necessary slowdown, which is why debt continues to surge. As long as increases in fixed asset investment continue to be Beijing’s main lever for maintaining politically acceptable growth rates much above 2 to 3 percent, there is no way to prevent the country’s debt burden from ballooning.

While Chinese economic policymakers and advisers increasingly recognize that China’s existing growth model is reaching its limits, the political importance of the year 2022 for the country’s leadership is likely to mean at least one last year of rapid growth driven by investment excesses, even though the economy has been badly hurt by the March and April 2022 pandemic-related lockdowns of significant parts of the economy.

Once the decision has finally been made, however, to regain control of the country’s balance sheet, eliminate or sharply reduce nonproductive investment, and accept the consequences in terms of slower growth, the question then becomes how much slower growth can Beijing accept? My best guess is that growth must slow to below 2 to 3 percent, but I suspect that even the Chinese policymakers and advisers that most agree with my analysis don’t expect the sustainable growth rate to drop much below 4 percent, in which case they will have trouble accepting the required adjustment and debt will continue to rise for many years even as growth slows sharply.

Whatever Beijing decides, one way or another China will be forced to shift from the first path to one or more of the other four paths listed above, although because of the size of the Chinese economy the fourth path (replacing bad investment with surging current account surpluses) is extremely implausible. But at the same time because the first path isn’t sustainable, this also means that either Chinese policymakers will find some way to overcome the historical difficulties associated with the second and third paths, or they will be forced eventually onto the fifth path. Historical precedents suggest that the longer it takes for Beijing to make this decision, the more economically difficult and politically disruptive the ultimate adjustment is likely to be.

³ These are my own calculations based on data from the National Bureau of Statistics. Given last year’s crackdown on the property sector, the property share has almost certainly declined in recent months while the infrastructure share is rising. See Chinese National Bureau of Statistics, “Statistics Database,” Chinese National Bureau of Statistics, http://www.stats.gov.cn/english/.

⁴ The technology input subindex represents 25 percent of the Caixin New Economy Index, which itself represents less than 30 percent of China’s overall economic input activities. Even then, I suspect that this index overstates the useful new technology sector by including security operations (which comprise the bulk of AI activities) and retail operations that have moved online. In such cases, it will be hard to squeeze extra productivity from increased investment. See Guo Yingzhe, “Shrinking Capital Investment Drives Down Caixin New Economy Index,” Caixing Global, September 9, 2021, https://www.caixinglobal.com/2021-09-02/shrinking-capital-investment-drives-down-caixin-new-economy-index-101767858.html.