Anyone reading news reports about the Chinese economy a year ago might have thought the country was on the verge of financial collapse. There seemed at the time plenty of evidence supporting those who expected an economic breakdown: debt was surging at unprecedented rates, regulators were in disarray following a stock market collapse the previous summer, and liquidity panics periodically swept through the banking system. In addition, so much capital was fleeing the country that even a huge current account surplus couldn't prevent central bank reserves from eventually declining by nearly a quarter from their June 2014 peak.
But, as I have been arguing for years, China was not on the verge of a financial collapse and was never likely to collapse as long as regulators were credible and able to restructure liabilities in the banking system with relative ease. Financial crises are caused not by insolvency or economic downturns, but rather by highly inverted asset-liability mismatches severe enough to cause a breakdown when evaporating liquidity prevents the rolling over of liabilities. On paper, the Chinese financial system seems plagued by such mismatches, but liabilities in a closed banking system with all-powerful regulators are much more stable than they seem because the regulators have many ways to restructure liabilities through the banking system.
Move forward a year and sentiments have changed dramatically. Reserve levels have stabilized, and economic growth is on track to meet Beijing's 2011 promise to double China's GDP between 2010 and 2020. There is now a growing consensus that the worst of China's adjustment is behind it, and that once Beijing gets debt under control - something banking regulators have clearly set their sights on - China can enjoy another decade or more of 5-6 percent growth. In Tuesday's Wall Street Journal, I explained why I think the new consensus is as wrong as the old, and the article got enough responses and comments that I thought it might make sense to expand on it in a longer blog post.
The new optimism is perhaps epitomized by the release two months ago of a Morgan Stanley Bluepaper tellingly entitled, "Why We Are Bullish on China." The report makes the most cogent version of the bull case for China and predicts that average GDP growth rates over the next ten years will exceed 5 percent, turning China into a high-income country by 2027.
This would be a truly extraordinary feat if China were to pull it off, and unprecedented in history. Excluding a few very small economies whose experiences are not relevant for China - mainly trading entrepôts and oil sheikdoms - if China did reach high-income status, it would be the only poor economy besides South Korea and Taiwan to have done this in the twentieth and twenty-first centuries. And it is hard to believe that the development of these other two cases was not substantially enhanced by their pivotal roles in the Cold War.
What's more, as any mathematician can explain, in any dynamic process in which different entities experience a widely distributed range of outcomes, the smaller, more homogenous entities are far more likely to be outliers than are the larger, extremely varied ones. What was already an extremely unlikely achievement for homogenous economies with 20-40 million people, like South Korea and Taiwan, is even less likely for an economy like China, with a population forty to fifty times larger, represented by a huge variety of economic circumstances.
RECENT DATA CONFIRMS THE NEW OPTIMISM
To return to this new, guardedly optimistic narrative - guarded because all of the optimists, including Morgan Stanley, stress that their forecasts require that Beijing get debt under control - the high expectations seem to have been confirmed by, or at least are consistent with, recent economic data published in the past week. China's exports were reported last week to have increased in March by 16.4 percent, well above the consensus forecast of 5 percent. Imports were up too, by a stronger-than-expected 20.3 percent. This left China with a healthy trade surplus of $23.9 billion in March, compared with February's $9.2 billion deficit, and more than twice what analysts had been expecting. The surplus for the first quarter was $65.6 billion, or 2.5 percent of GDP.
With global trade tensions still high - and, as I have been saying for years, I expect that they will not get better any time soon - there are reasons to worry about China's vulnerability on trade. But Chinese President Xi Jinping's recent meeting with U.S. President Donald Trump seems to have gone relatively well, and trade no longer seems to be as great a source of worry among analysts as it was even a few weeks ago. This may be a little shortsighted. Exports in the first quarter were equal to 18.4 percent of GDP, which is a little higher than their 16 percent share last year, and while they are well below the peak ten years ago of 32 percent, this is a high enough share to indicate that China is still vulnerable to trade conflict.
There also remains the nagging problem of underreported exports and overreported imports as wealthy Chinese take money illegally out of the country, so China's real trade surplus could be as high as 3.0-3.5 percent of GDP. As I have written elsewhere, a forced contraction of the surplus means that more credit expansion is needed for China to meet its GDP growth target, with every one percentage point of GDP contraction requiring roughly one-third more debt.
I find it very useful, by the way, to evaluate the impact of changes in trade or other important economic variables by converting them into credit-expansion equivalents. The way its debt burden is resolved is key to the Chinese adjustment, and debt dynamics set most of the relevant parameters, including how much time Beijing has to implement the most important reforms.
CREDIT EXPANDED
This means, of course, that we cannot discuss China's outlook without discussing changes in debt; last week, credit and monetary data were also released by the People's Bank of China (PBoC). These indicators were more mixed. The good news is that regulators seem to have tightened their grip on China's banks and were able to restrain loan growth in March to 1.02 trillion renminbi - below February's 1.17 trillion renminbi increase, and well below expectations of 1.25 trillion.
The wider and more accurate measure of credit used by the PBoC is known as total social financing (TSF), but it is important to note that TSF is not a complete measure and excludes much of the bond issuance that came out of the recent provincial debt swaps. The news here was a lot gloomier, with TSF - according to the PBoC release - up by 2.1 trillion in March. This came in substantially higher than the consensus forecast of 1.5 trillion.
Finally, on Monday, the National Bureau of Statistics announced that China's real first-quarter GDP rose by a more-then-expected 6.9 percent, above the 6.8 percent achieved in the previous quarter and last matched in the third quarter of 2015. This was comfortably above the 2017 GDP growth target of 6.5 percent. Nominal GDP growth was even more impressive, at 11.8 percent, which is the highest level since the first quarter of 2012.
The data seem broadly consistent with the new optimistic consensus, with Bloomberg describing the Chinese economy as having "stormed back in the first quarter, clocking its first back-to-back acceleration in seven years and bolstering the global growth outlook." After five years of decline, GDP growth seems to have bottomed out, and while debt continues to grow too quickly, regulators have successfully targeted credit growth in certain especially worrying sectors. With the right policies and, more importantly, the necessary resolve, the newly optimistic consensus assumes that Beijing can get debt under control. If it does, when growth has bottomed out, it follows that China will finally put its difficult economic adjustment behind it.
THE ECONOMY AS A SYSTEM
Unfortunately, there is an assumption implicit in this story which, in my opinion, is completely untrue. The assumption is that the underlying drivers of economic activity, that is GDP, are somehow independent of the process of credit expansion, so that it is possible to talk about reining in credit growth and maintaining GDP growth as if these were two separate things.
The new consensus misreads the Chinese economy just as badly as the old consensus did last year, when many analysts expected a crisis; in both cases, the misreading is the result of treating individual pieces of data as separate and discrete instead of as interlocking parts of a system. What looked like extremely fragile balance sheets last year were a lot less fragile than they seemed when we consider the relatively closed nature of the Chinese financial system and the ability of the regulators to shift liabilities among the banks. Similarly, what might look like a bottoming out of growth this year and, separately, an increasingly successful attack on financial irresponsibility, is in fact a single system in which stable GDP growth requires accelerating credit expansion.
It is important to recognize, however, that until now - and contrary to what the new optimistic consensus assumes - Beijing has not been able to control credit growth. It may have done so in targeted sectors, but only by forcing greater credit growth elsewhere within the financial system. That is why even as the growth in direct bank lending has moderated, the growth in TSF has continued to accelerate at a pace wholly unaffected by regulatory attempts to contain credit expansion. Here is how Morgan Stanley explains the process in their Bluepaper:
"In our view, the most recent and arguably the most significant development on the policy front is that policy makers are now signaling a willingness to accept slower rates of growth, and place more focus on preventing financial risks and asset bubbles, indicating that they would not protect growth at all costs, often with the use of investment of a low return nature. This gives us greater confidence that policy makers will be able to slow the pace of rise in debt to GDP and will focus their efforts on setting a more stable environment which will allow China's vibrant private sector and formidably resourced SOE to continue the move towards high value added economic activities."
China's reported GDP growth does not represent fundamental growth in the country's productive capacity, but rather growth in certain accepted measures of economic activity, productive or not. Morgan Stanley seems to agree with me that at least part of this growth is driven by increases in debt. Without this credit expansion, growth must automatically fall to the sustainable growth rate that can be organically generated from rising household income and needed investment. At that rate, GDP growth would correspond with growth in the economy's debt-servicing capacity, and debt would grow no faster than GDP.
HOW MUCH LOWER IS CHINA'S SUSTAINABLE GROWTH RATE?
Where Morgan Stanley and I differ is that I would argue that this sustainable growth today is at least 50 percent lower than the current growth levels, and that over the next ten to fifteen years, China is unlikely to manage growth rates above 3 percent on average, and probably much lower. Morgan Stanley, however, proposes that China can manage to grow at an average annual rate above 5 percent for the next ten years, which suggests that they think this sustainable growth rate today is around 6 percent or a little less.
We seem to agree that any GDP growth above this sustainable rate requires an acceleration in credit growth. This is the only way to generate the additional demand needed to boost economic activity to a level, the GDP growth target, that is politically acceptable. So, how much debt is needed to generate how much additional growth above the sustainable growth rate?
March's 2.1 trillion renminbi increase in debt was part of a 7.0 trillion renminbi increase in debt in the first quarter of 2017, an amount equal to an astonishing 39 percent of the country's first-quarter GDP. Part of this increased lending was used simply to roll over bad debt that is not being recognized. But most of it went to fund a 13.6 percent increase in public sector investment, much of it unproductive (adding to the future amount of bad debt that must be rolled over). It was this debt that drove economic activity in the first quarter above China's sustainable growth rate. This increase in debt - equal to 39 percent of GDP plus credit growth not included in the TSF measure (perhaps an additional 5-10 percentage points) - is what was effectively required to roll over bad debt and boost growth above its sustainable growth rate to the 6.9 percent reported in the first quarter.
I find it worrying enough that this enormous increase in debt was needed to add the 3-4 percentage points that I assume is the minimum gap between China's sustainable growth rate and its actual growth rate. But it seems to me that Morgan Stanley - and anyone else who believes that China can manage a decade or more of 5 percent growth - is claiming something that might be even more surprising: this explosion in debt boosts growth by only one percentage point above the rate China can achieve anyway without relying on debt. This is a mind-boggling amount of debt required to achieve very little benefit, and the only way to make it intelligible is to assume that the amount of bad debt that is rolled over each period is significantly larger than we think-which helps resolve the problem but only by assuming an even more worrying condition.
There is only one other possible explanation consistent with Morgan Stanley's numbers. They might assume that the vast bulk of credit creation over the past few years has occurred purely as speculative froth, has not generated any demand in the Chinese economy, and so can be eliminated overnight without impacting growth at all. This explanation is in my opinion inconsistent with the events of the past five years, which saw the acceleration in credit that Hyman Minsky told us would be needed to maintain a constant growth rate during the late stages of an investment-driven economy. It makes it hard to understand why Beijing has failed so miserably at containing debt during the past five years.
Logically, however, we must accept one or the other of these two explanations. Either credit expansion is necessary to boost growth above China's sustainable growth rate, or it isn't. If it is, just how much extra growth has it contributed? If it isn't, why has it been so hard to prevent what has become among the fastest credit expansions in history?
THAT'S WHY SLOWER IS BETTER
Whatever the current sustainable growth rate, it is dangerous to assume that it is stable. In finance theory, it is widely understood how a rising debt burden can automatically force down the growth rate of the borrowing entity through a process referred to as financial distress. In spite of overwhelming historical evidence that supports the extension of these finance theory insights to economies, there has been no corresponding understanding among economists about how rising debt itself forces down long-term economic growth.1
I have discussed elsewhere how this process works and why the supporting evidence is overwhelming, but the point is that as China's debt burden rises, the accumulated effects of financial distress caused by the debt automatically forces down China's sustainable growth rate. This process - which Hyman Minsky also explained is always present in the late stages of an investment bubble - has locked China into a vicious circle. Rising debt automatically forces down China's sustainable growth rate, and as it declines, the gap between China's sustainable growth rate and its GDP growth target rises. This requires even greater credit expansion to meet the growth target, which, of course, forces the sustainable growth rate even lower.
Long-term prospects for the Chinese economy, in other words, will deteriorate as long as the Chinese economy is forced into relying on debt to grow faster than it can manage organically. For now, China's GDP growth is largely driven by the political calendar. President Xi must consolidate economic decision-making in the run-up to this year's Party Congress if he is to implement the difficult reforms that will break China out of its debt cycle, and higher growth early in the year will make this politically easier to do.
If he is successful in overcoming the vested-interest opposition that has for nearly a decade prevented necessary adjustments in the Chinese economy, GDP growth will probably begin to drop sharply, declining to barely above 6 percent by year-end, and will continue to decline sharply over the rest of this decade. If he is not successful, he may be forced to maintain overly high GDP growth targets for as long as necessary, or as long as the country has the debt capacity.
High growth today does not imply that the growth deceleration of the past five years has bottomed out. It only means that for political reasons Beijing cannot yet abandon its GDP growth target, and so it is willing to let credit expand however quickly it must expand - but the more rapidly GDP growth declines, the better for China in the medium and long term. Whatever path China eventually takes, far from bottoming out, growth still has a long way down to go.
NOTES
1 I should mention that in their book This Time is Different, Carmen Reinhart and Ken Rogoff have in fact introduced into academic economics the idea that excessive debt reduces growth, but they have done so in a much less sophisticated form that ignores many finance theory insights and seem to have convinced very few economists.
