If We Don’t Understand Both Sides Of China’s Balance Sheet, We Understand Neither by Michael Pettis, Michael Pettis’ China Financial Markets
With so much happening in China in the past month it seems that there are a number of very specific topics that any essay on China should focus. I worry, however, that we get so caught up staring at strange clumps of trees that we risk losing sight of the forest. What happened in July this year, and again in August, or in June 2013, or a number of other times, was not an unexpected shock and game changer. China is a dynamic and unbalanced economic system entering into something that we might grandly call a “phase shift”, or less grandly the rebalancing process, and that it is doing so with a great deal of debt structured in a highly inverted way. Anyone who sees China this way would have been able to predict not so much the specific shocks, panics, and credit crunches that we have experienced, but rather that we would of necessity experience a series of very similar shocks.
These debt-related shocks will occur regularly for many more years, and each shock will advance or retard the rebalancing process so that it affects the way future shocks occur. There are only a few broad paths along which the Chinese economy can rebalance, and if we can get some sense of the China’s institutional constraints and balance sheet structures, we can figure what these paths are and how likely we are to slip from one to another.
I would argue that above all we must understand debt, and balance sheet structures more generally, dynamically. Four years ago one of my clients sent me a research report by Standard Chartered in which their China analyst warned that while Chinese debt levels were still negligible, there was a chance, small but no longer insignificant, that credit growth could speed up sharply and debt eventually become a significant constraint for policymakers. Things were fine for now, the analyst seemed to suggest, but it was possible that Beijing could mismanage its way into a debt problem.
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The overwhelming consensus at the time was that China’s growth model was healthy and sustainable, and would generate GDP growth rates for the rest of the decade that were not much lower than the roughly 10% we had seen during the previous three decades. My client sent me the report along with the comment that the sell-side was finally recognizing that the Chinese economy was at risk. A leading analyst who had long been part of the overwhelming bull consensus was, he said, finally beginning to understand the Chinese economy and the problems it faced.
I wasn’t so sure. It seemed to me that those who understood the Chinese growth model would have also understood that its overreliance on investment to fuel growth, combined with the structure of its credit markets, extremely low interest rates, and wide-spread moral hazard, made soaring debt almost inevitable and that debt was already constraining policymaking.
To suggest that this might happen only if the new administration – that of Xi Jinping – mismanaged the process suggested to me that the analyst did not really understand the self-reinforcing relationship between rising debt and slowing growth, and was underestimating how difficult it would be for the new administration to break out of this process. It was going to happen almost no matter what Xi’s administration did. There is a very big difference between acknowledging that China has a lot of debt and understanding how debt and debt creation are embedded within the financial system.
In June the NBR’s journal for Asian economic research, Asia Policy, put together a roundtable to review Nicholas Lardy’s book, Markets over Mao. I was one of the five analysts who were asked to participate. Lardy is one of the best informed and most knowledgeable of the economists covering China. In my review I praised his book for the quality of its analysis, and it well deserves that praise.
But there was a fundamental disagreement in how he and I interpreted the data, and this disagreement extends to the majority of analysts covering China. Lardy believes China is in reasonably good shape economically and concludes with optimistic growth forecasts. Based on the same data and absorbing much of his analysis and interpretation of that data (I have been reading Lardy for many years) I expect growth to slow sharply. The current consensus for China’s long-term growth, I think, is around 6-7%. Lardy thinks this is a low number, and has said “China could grow at roughly 8% a year for another 5 or 10 years.” I believe, however, that without a massive and fairly unlikely transfer of wealth from the state sector to the household sector, the average Chinese GDP growth rate under Xi Jinping cannot exceed 3-4%.
So why do we disagree? I suspect that we disagree for the same reason I disagreed with the Standard Chartered analyst, who saw an unsustainable debt burden simply as an unlikely but possible result of policy mismanagement. We disagree, in other words, not on the fundamental data but rather in our understanding of debt dynamics and the constraints the balance sheet can place on an economy’s “fundamental” operations.
As I see it there are at least two important disagreements here. The first is about the impact of balance sheet structures on exacerbating volatility. Neither Lardy nor the Standard Chartered analyst spent much time discussing how the balance sheet might affect growth. For me, however, this has been and continues to be a key component of the Chinese economic “miracle”, and indeed also of every previous growth miracle. As I said in my review:
Rebalancing is often harder than expected, in other words, not just because of opposition by vested interests, but more importantly because highly inverted balance sheets cause policymakers to overestimate potential growth during the miracle years. But when growth during the rebalancing phase contracts more than expected, the same balance sheet inversion that exacerbated the expansion phase will also exacerbate the slowdown, especially as declining credit quality reinforces, and is reinforced by, slower growth.
I made a similar argument two weeks ago in a Wall Street Journal OpEd about why it is so important that Beijing maintain its credibility, which is the only way of ensuring that China’s substantial balance sheet mismatches can be managed and rolled over:
History suggests that developing countries that have experienced growth “miracles” tend to develop risky financial systems and unstable national balance sheets. The longer the miracle, the greater the tendency. That’s because in periods of rapid growth, riskier institutions do well. Soon balance sheets across the economy incorporate similar types of risk.
…Over time, this means the entire financial system is built around the same set of optimistic expectations. But when growth slows, balance sheets that did well during expansionary phases will now systematically fall short of expectations, and their disappointing performance will further reinforce the economic deceleration. This is when it suddenly becomes costlier to refinance the gap, and the practice of mismatching assets and liabilities causes debt, not profits, to rise.
See full article here.