China’s debt/GDP ratio has reached 257%,2 a level that is likely unsustainable. This debt is the byproduct of a development model that supported domestic saving and exports. Essentially, households faced financial repression which curtailed consumption and boosted saving. The saving supported massive investment but was still large enough to also cause trade surpluses, which are nothing more than the export of saving. Domestic investment used the saving, through borrowing, to develop the economy. We have now reached the point at which (a) malinvestment likely exists, and (b) debt has become unsustainable.
Fixing the problem requires a reversal of China’s development model so that household income and consumption rise, while saving and investment decline. In theory, there are three ways to achieve this outcome. First, one can grow so fast that household incomes outpace overall economic growth.
That has never occurred in history. The second is how the U.S. rebalanced in the 1930s during the Great Depression. GDP collapsed as did household income but the latter fell less quickly, thus allowing for deleveraging. Investment essentially collapsed. The third method is how Japan has handled the problem since the early 1990s. Growth has been very slow for nearly three decades, while household incomes rose a bit faster than overall growth. Unfortunately, too much of the saving in Japan was held by the corporate sector, which has hindered private sector deleveraging.
Although China suggests it can execute the first method, we suspect it will be forced to either use the U.S. or Japanese model. To be really successful, income must shift from the corporate and government sectors to the household sector. This is clearly an economic issue but it is a political one as well. During the Deng reforms, China decentralized the economy, leading to faster growth but higher levels of income inequality.
History shows the political solution to China’s problem is either to (a) democratize, or (b) recentralize. The chosen solution appears to be option “b.” Chairman Xi spent his first term implementing an aggressive anti-corruption campaign, eliminating potential rivals.
At the recent party congress, he was given political status equal only to Mao. We suspect Xi is going to start the process of boosting household incomes and encouraging spending in a myriad of ways, all designed to depress household saving and begin the process of deleveraging. Simply put, if one has done well economically in China for the past three decades, that is about to change. The moves are massive and the potential for a misstep is elevated.