There's no doubt that the Chinese economic miracle is real. When you move 500 million people from rural to urban settings, taking them from small farms and putting them in a specialized labor force, the economic dividend is massive. That's how you keep GDP growing more than 7% for 25 years. But along the way, they wanted more.
Beyond building factories and housing for new arrivals, local politicians started building massive, wasteful projects.
Political meeting halls…
Unused apartment buildings…
Empty shopping malls…
Part of it might have been poor economic planning, but a bigger, and more common, problem was at work.
In China, businesses buy off the local politicians for contracts to build in their areas. When that attracts new jobs, the central government rewards those politicians for their contributions to economic growth. However, the buildings serve no purpose other than creating jobs and lining the pockets of businessmen.
In essence, local politicians were forcing construction to bolster their personal political standings.
This might have ended as nothing more than a story of hubris writ large, except for one thing.
Much of that new construction was financed with debt.
Local governments in China issued so much debt over the past 20 years that this category now totals 41% of national GDP. In the U.S., state and local debt combined is only 17% of GDP. Without a productive use for many of the new buildings, there is no way to repay the debt.
Now, national government officials are staring down a couple of bad choices.
Do they let their cities and provinces fail to repay, or do they bail them out?
Letting some of the profligate borrowers fail would make a fine example for others, but there are huge costs. A lot of the debt is held by individual investors. Letting the local government entities default would mean a loss of wealth for consumers, and would likely dissuade them from buying such bond issues in the future.
For the central government, that's not an option. The Chinese savings rate is about 30%. If consumers won't spend the money, the government needs them at least to plow the funds back into investments.
Which leads China to Plan B: issuing national bonds and using the proceeds to bail out local governments.
China can afford to do this because its national debt outstanding is a mere 41% of GDP, well below that of the U.S. at 109%. But that doesn't make it a good idea.
The Chinese are trading one debt for another, moving the pain from one small group (bond holders) to a very large group (all Chinese taxpayers). But nothing in the transaction makes the assets bought with the bonds - the buildings - more productive. There's no change in the basic relationship.
The bottom line is that borrowed money was used to construct useless assets, so some portion of future growth will be used to repay the wasted funds. To the extent that China must carry this deadweight, it will be a burden on the economy for years to come.
Unfortunately for China, the bad news doesn't stop there.
In addition to carrying local governments, the national government must also support state-sponsored businesses, which have total debt outstanding equal to 88% of national GDP. While China's direct national debt as a percentage of GDP isn't so bad, it's much worse when these wards of the state are added to the mix.
Recently government officials have outlined plans for streamlining these traditionally inefficient companies, including firing millions of workers. I wonder if their plans also include assuming the outstanding debt of the companies they intend to shut down?
However the country ends up handling its rising level of bad debt, one thing is clear.
While the miracle of Chinese economic growth is real, the pace of growth in the future won't match the levels of the recent past. Anyone banking on a quick recovery in the Middle Kingdom could be in for a big disappointment.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.