Thinking about China

August 5, 2015

China seems set to take over the world, its rate of growth has been astronomically high in the last couple of decades and it seems to be on course to become the largest economy in the world at some point soon. The Chinese are buying up companies and resources all over the world. China seems unstoppable. But exactly the same things were being said about Japan in the late 1980s right up until the moment that Japan suffered a financial crisis which was followed by years of stagnation.

What happens in the Chinese economy shapes the global economy. I don’t have a crystal ball and I cannot predict the actual course of economic and political events in China but it is possible to understand what the big issues in the Chinese economy are and to use that big picture to try understand events as they unfold. By understanding the big picture about the Chinese economy it is possible to show quite clearly that there are some very big imbalances in the Chinese economy and that it will be the unfolding and correcting of these big imbalances which will shape events in China over the next few years. Taking into account the scale and depth of the imbalances in the Chinese economy it is likely that Chinese growth will slow sharply in the coming decade. How well or how badly that slow down, and the necessary accompanying rebalancing of the economy, are handled by the Chinese government will determine how politically stable China is in the next decade.

A basic Framework: understanding how economies become imbalanced

In order to understand how the Chinese economy is unbalanced and what will be required in order to bring it back into balance it is necessary to understand how economies in general become balanced or unbalanced. Much of the analysis of the Chinese economies below uses ideas about balanced and unbalanced economies which I have explored in much more detail in some articles which are here.

Here is a super concise executive summary of those articles.

In any economy the income generated by economic activity can be spent on either consumption or investment, or it can be saved. In a balanced economy the total national income will be fully spent on on either consumption or investment with nothing left over as this will allow the economy to operate at maximum capacity.

Imagine an economy in a country that has zero trade with the rest of the world. It is a closed economy. In this closed economy a certain amount of the total income is spent immediately (by households and businesses) and a certain amount is saved (by households and businesses). The savings are usually held inside financial institutions which lend out the savings to those who need to borrow to invest (in new factories, new houses, whatever), the borrowers pay a fee for the loan (interest) and some of that is passed onto the savers. In a balanced closed economy the total income not being spent, the national savings, are all loaned for investment. There are no idle wasted savings. The economy is running at full capacity and growing as fast as it is capable of doing because all the savings are being spent on investments. There is no magic plan to make all these things (consumption, saving and investments) balance with each other, although there are policies that can encourage more or less savings, more or less investment, and more or less consumption.

If the national savings, the income not spent on consumption, are higher than investment then there will not be enough demand in the economy to buy all the products created by the economy. There are a number of ways that a lack of demand can be fixed. One way is for the economy to shrink which will cause unemployment to go up and incomes to fall (that is what is happening in the eurozone at the moment), or investment could go up to soak up the spare savings (but it may prove hard to find productive investment in an economy with too much savings and too little demand), or a speculative investment bubble of unproductive investment, such as property speculation, could inflate based on debt (as happened in the eurozone and the US before 2007). Yet another way to find the missing demand resulting from an excess of savings is to export and sell goods abroad. Exporting goods is also the same as importing demand. Of course for one country to export a surplus another country (or countries) have to run deficit.

Bearing in mind this super short summary of how economies become balanced or unbalanced lets now have a look at the shape of the Chinese economy.

Imbalances in the Chinese economy

The key characteristic of the Chinese economy is that it is unbalanced, and unbalanced very significantly. Chinese growth is unbalanced because the very rapid GDP growth, especially in the past decade and a half, has relied too heavily on net exports and investment and too little on domestic household consumption. The big adjustment that the Chinese economy will have to make over the coming years is to readjust the balance of its economy so that much more of its output is consumed domestically and much less is either invested or exported. Given the scale of the imbalances in the Chinese economy the rebalancing will be a big, drastic, and probably a very difficult adjustment which be very socially and politically disruptive. It will pose significant problems for the Chinese ruling elite.

The history of Chinese consumption since the 1978 reforms (following the defeat of the Gang of Four) illustrates the scale of the imbalances in the Chinese economy. In the 1980s household consumption represented about 50 to 52 percent of GDP. This is not an unprecedented number compared to other countries, but it is pretty low. Consumption for most European countries lies in the 60 to 65 percent of GDP range and consumption in many other other developing countries often falls in the 65 to 70 percent range, this is for example the range in much of Latin America. Consumption in the United States has been around 70 to 72 percent in recent years. Chinese consumption rates in the 1980s were not exceptionally low by Asian standards, South Korean and Malaysian consumption is around 50 to 55 percent of GDP (although during and after the Asian crisis in the late 1990s Malaysian consumption did drop to around 45 percent of GDP, before recovering after a year). Other major Asian economies, like India, japan, Taiwan, and Thailand, show consumption in the 55 to 60 percent of GDP range. Nonetheless, even though it started the decade at the low end of the range even for low-consuming Asian countries, as the China grew during the 1990s Chinese consumption declined further as a share of GDP. By the end of the decade Chinese household consumption represented a meagre 46 percent of GDP. This was not unprecedented but the very low Chinese consumption levels by the end of the 1990s was more typical of a country in crisis (such as Malaysia after the late 1990s crisis) than of a country enjoying strong economic growth.

But the story doesn’t end there. By 2005 household consumption in China had declined further to around 40 percent of GDP. With the exception of a few very special and unique cases, this level is unprecedented in modern economic history. Beijing’s response to this very low number, not surprisingly, was a worried one. Chinese policymakers pledged during 2005 to take every step necessary to raise household consumption growth and to help rebalance the economy. Why were they worried? Because, in any economy there are three sources of demand —domestic consumption, domestic investment, and the trade surplus—which together compose total demand. If a country has a very low domestic consumption share, by definition it is heavily reliant on either (or both) domestic investment and the trade surplus to generate adequate demand and thus facilitate further growth.

This meant that as long as domestic consumption remained very low future Chinese growth was vulnerable. One reason it is vulnerable is that although policy makers can encourage a trade surplus, as Germany is doing right now, the continuing demand for its exports depends on the ability and willingness of the rest of the world to continue absorbing China’s deficient demand. With the largest trade surplus ever recorded as a share of global GDP—all the more astounding given that the two previous record holders, Japan in the late 1980s and the United States in the late 1920s, were countries whose share of global GDP was two to three times China’s share—it was clear that China could not expect its trade surplus to increase much more. The way the Chinese trade surplus had been maintained was by a massive export of capital to those countries importing Chinese goods, particularly the USA, where it fuelled demand for Chinese imports by building up debt levels. Its was these accumulating debts from massively unbalanced trade, and the resulting capital flows, that was one of the fundamental causes of the 2007 financial crisis. So lending foreigners money to buy Chinese goods on tick was rightly seen in Beijing as a risky way to finance continuing growth.

The other way to compensate for low domestic consumption was by raising the level of investments in China, but there was also a great deal of concern amongst policy makers that China’s high investment rate would also prove unsustainable. Beijing had engineered (mostly through state control of the banking system and state owned enterprises) extremely high and growing investment rates in China for the previous twenty-five years, and this made a great deal of economic sense at the beginning of the reform process, after 1978, when China was seriously and obviously underinvested for its level of social development. But after so many years of furious investment growth, there were increasing worries that China had become by 2005 over-invested, perhaps even massively over-invested.

In the early stages of economic development when investment is low the diversion of household wealth into investment in capacity and infrastructure is likely to be economically productive. When you have no roads, even a simple dirt road will sharply increase the value of local labor. The longer heavily subsidised investment continues, however, the more likely that cheap state sponsored investment will fund economically wasteful projects. Dirt roads quickly become paved roads. Paved roads become highways. And highways become superhighways with eight lanes in either direction. The decision to upgrade is politically easy to make because each new venture generates local employment and rapid economic growth in the short term, and there are attractive opportunities for fraud and what economists politely call rent-seeking behaviour, while the costs are spread through the entire country through the banking system and over the many years during which the debt is repaid (or not – see below). It is also easy for the Chinese administration, with its roots in the planned economy of yesterday, to implement and manage big investment projects, and politically and intellectually infrastructure investment seems easy to justify (its visible evidence that China is catching up). But each additional step of infrastructural upgrading brings fewer and fewer economic returns and there is an inherent limit to the amount of such investment that is possible. In the long run huge levels of investment are not a sustainable way to soak up demand in an economy where household consumption is a very low proportion of demand.

So with domestic consumption so low, it meant that China was overly reliant for growth on two sources of demand that were unsustainable, possibly unreliable, and in the case of exports, hard to control. Only by shifting to higher domestic consumption could the country reduce its vulnerability and ensure continued growth into the future. This is why in 2005, with household consumption at a shockingly low 40 percent of GDP, Beijing announced its resolve to rebalance the economy toward a greater consumption share.

The decision by Beijing to increase domestic consumption was generally well received by economic commentators around the world. It was widely believed that, given China’s stellar track record of delivering very fast growth, engineering a switch from exports and investment to domestic consumption would be relatively straightforward and deliverable. There was a widespread perception that Beijing had always managed to achieve its economic targets in the past, and this new economic target would also be achieved with the usual efficiency.

But some economists were very skeptical. They pointed out that previous policy successes had almost always involved targets that could be resolved mainly by increases in investment. The real lesson, they argued, was not that Beijing was able to manage the economy efficiently, intelligently and effectively, but that Beijing was able to increase investment whenever it wanted, mostly through the state control of the banks. Given low transparency, limited political accountability, and near total control over national savings and the banking system, it is not surprising that Beijing can control investment activity effectively. Rebalancing the economy towards consumption, however, could not be achieved by mandating higher investment. On the contrary, it would require lower investment. This, the skeptics argued, would make the targets much harder to achieve because when it came to achieving economic targets that could not be met simply by increasing investment, it was not clear that Beijing had ever been very effective. They further argued that a low and declining consumption share of GDP was not an accident; it was fundamental to the growth model. China did not grow quickly, in other words, in spite of lagging consumption growth, rather it had grown quickly because of lagging consumption growth. In that case Beijing would not be able to raise the consumption share of GDP easily because doing so would require abandoning the investment-driven growth model altogether, and there was as yet no political consensuses in China in favour of taking the necessary drastic steps. In fact given the way the wealth and personal power of much of the ruling Communist Party elite, along with the business activities of the still big and powerful state owned enterprise (SOE) sector, were closely bound up with the current export and investment driven growth model it was clear that switching the national economic priority to domestic consumption was bound to unleash intense political tensions within the ruling elite. The skeptical economists warned that consumption would barely grow from the 40 percent level for many years and might even stagnate further.

It turned out that even the skeptics underestimated the difficulty of the adjustment China was facing. For the next five years GDP growth continued to surge ahead of household consumption growth until by 2010, the last year for which there are complete statistics, household consumption declined to an astonishing 34 percent of GDP. This level is utterly extraordinary and no other economy has ever come close to a consumption rate that low in peacetime. For all its determination, in other words, not only was Beijing wholly incapable of reversing the downward trend in the household consumption share of GDP, it could not even prevent a near collapse of consumption rates.

Part of the reason for of the decline in consumption has been the rise in savings, which is simply the obverse of consumption, and a big part of the rise in savings has been the rise in household savings. After bouncing around erratically between 10 percent and 20 percent of disposable income in the 1980s, by1990 Chinese household savings equaled 12-15 percent of disposable income. Around 1992 household savings began rising steadily until 1998, and then stabilised at around 24-25 percent until very recently, when they rose slightly to about 26 percent of disposable income. This rise in domestic savings is bound up with the complete absence in China of any sort of social safety net, it is now largely up to individuals and families to plan and save for a retirement income and for covering the costs of medical care. The investment and export model of growth was partly engineered by a process known as ‘financial repression’ which occurs when a government artificially holds down interest levels on savings so that investment (by either the public or private sector) can be financed very cheaply. The upshot of financial repression is that it is hard for Chinese savers to secure the levels of interest incomes from savings that are required in order to ensure financial security. So they have to save a lot of their income.

Growth miracles are not new

But this is not the whole story because household savings are only part of total national savings. The bulk of the increase in Chinese national savings in recent years was caused by the sharp increase in corporate and government savings, although it is worth pointing out that corporate savings, and even government savings, are themselves caused by the transfer from household savings via low interest rates and other hidden transfers. Corporate and governments savings, in other words, were savings effectively imposed on the household sector.

The rise in Chinese investments is bound up with the rise in the Chinese trade surplus. During the three-decade period since the defeat of the Gang of Four China ran small surpluses or deficits on its trade account from 1978 until 1996, which was when it had its last trade deficit. After 1996 the Chinese trade surplus grew rapidly until 2003, when the surplus was around 5 percent of China’s GDP. After 2003, China’s trade surplus even higher, to reach over 10 percent of GDP in 2007-8, before coming down sharply in 2009 and 2010 as a result of the global crisis in demand. Investment, too, rose steadily during this period as a share of GDP, as indeed it had to if the growth model was going to work. In 1990 investment was around 23 percent of GDP. Investment rose sharply in 1992-94 to around 31 percent of GDP, stabilised at that level, and then began climbing steadily from around 1997-98 to reach an astonishing 50 percent in 2011. The actual investment is in fact even higher if included are imported commodities that are stockpiled (because increasing stored inventories are a form of investment).

In China rising investment, rising savings, and rising trade surpluses are inextricably linked, and nothing suggests how impressive was the increase in China’s national savings rate as the fact that China was able to combine a soaring investment rate with a soaring trade surplus because normally a high, and soaring, investment rate should be associated with a declining trade surplus, or even (and more normally) a large and rising trade deficit. Yet China, with one of the highest levels of investment in history was able to run an extraordinarily high trade surplus. The only way this could happen is if the savings rate was even more extraordinarily high. This massive increase in savings and a resulting big decline in the rate of consumption was the result of many policies, ranging from undervalued currencies, to lagging wage growth, to financial repression, and the weakening of social safety nets. All of these occurred in China to an exaggerated extent, and it was for these reasons that Chinese savings soared. These growth strategies engineered by Beijing forced households to subsidise investment and production, thus generating rapid economic and employment growth at the expense of household income growth.

The rapid and very big drop in the share of Chinese GDP going to consumption was obscured, and social tensions were deferred, because whilst lagging behind the rate of GDP growth consumption levels did grow year on year. Consumption as a share of GDP fell but for most people this period was marked by significant rises in their income, often at around 7% per annum.

There is nothing especially unique about the Chinese development model except possibly its scale. It is a variant of the Asian development model, probably first deployed by Japan in the 1960s, and shares many features with a number of periods of rapid growth, for example Germany during the 1930s, Brazil during the “miracle” years of the 1960s and 1970, and the Soviet Union in the 1950s and 1960s, when at various times it was widely expected that the rapidly growing economies would just continue to grow until they became the biggest and most powerful economies on the planet. It was feared in the 1960s, for example, that the Soviet Union would grow rapidly into the future and overtake the USA, and the same was said of Japan in the 1980s. At the heart of the various fast growth ‘miracle’ models are massive subsidies for manufacturing and investment aimed at generating rapid growth and the building up of infrastructure and manufacturing capacity. These subsidies make it very cheap to increase investment in manufacturing capacity, infrastructure, and property development, generating enormous growth in employment, and they allow investors, whether private or, more typically, the state, to generate great profitability. But of course all subsidies must be paid for by someone, and in nearly every case they are paid for by the household sector.

Guess which country boasted the following characteristics: GDP grew at 11% annually for almost 10 years. The authoritarian, one-party state promoted rapid industrialisation by relocating workers to coastal urban areas. The government welcomed foreign-direct investment and courted companies through tax exemptions and other benefits. Seventy-five percent of the top 100 largest domestic firms assets belonged to the state sector. The governments savings rate doubled in less than a decade, while the agricultural share of employment fell by more than one-third over the same period. The answer is Brazil between 1965 and 1974. There was talk then of a Brazilian miracle. That miracle was achieved by using high levels of income tax to confiscate household wealth and use the proceeds not to improve social benefits but rather simply to subsidise the ferocious spurt of growth. This is not a bad strategy, such growth strategies do work – for a while. But eventually they reach their limits and then an often wrenching adjustment has to take place as the economy is rebalanced and growth slows. The history of every investment-driven growth miracle, including that of Brazil, shows that high levels of state-directed subsidised investment run an increasing risk of being misallocated, and the longer this goes on the more wealth is likely to be destroyed even as the economy posts high GDP growth rates.The difference between posted GDP growth rates and less impressive real increases in wealth caused by non-productive over investment shows up as excess debt. Eventually the imbalances caused by this misallocation and by non-productive investment have to be resolved, and the wealth destruction that has been taking place through unproductive investment has to be recognised as debt levels are paid off and resolved.

The trajectory of Chinese economic reform and the role of State Owned Enterprises

Most of the growth China is experiencing comes from capital fixed investment where the Chinese government supplies massive amounts of money to investment projects. The amounts have been growing since 2005, and in 2008 fixed assets investment was estimated at $2.52 trillion. Most of this is directed by the state, which currently owns 60% of all capital stock. This intense focus on large-scale state directed investment has caused an over-capacity problem with shrinking efficiency. In the 1980s, to create $1 of growth required $2-$3 of investment. In recent years that ratio has risen to $5 of investment for every $1 of growth. The state investment and funding is not distributed evenly across different sector of the economy, at the moment China’s SOEs receive 70% of capital investment even though SOE production accounts for only 30% of the nation’s GDP.

The main banking system in China is state controlled and the various state controlled banks are the main supplier of credit and investment funds to the still large and important state owned enterprises (SOEs) sector. The private sector (i.e non state owned enterprises) which now accounts for the majority of output in China mostly receives credit and funding from the non-state shadow banking system.

The SOEs were the main beneficiary of the post Tiananmen Reforms. Prior to 1989 the main economic liberalisation mechanism had been implemented at the level of local government which were allowed to conduct entrepreneurial activities and become more market oriented. This took place mostly in agricultural areas and involved the creation of what were known as Town and Village Enterprises (TVEs). As a result productivity in agriculture nearly doubled in the years between 1978 and 1995. The economic benefits of moving away from the communist system of state farms and a state controlled planned agrarian economy were clear. TVEs were not really true state-owned enterprises, even though many still received support from the local governments in the form of loans and subsidies, and were mainly a mix of privately and collectively owned firms that performed well because the interests of the local communist leaders were closely aligned with those of the local workers.

In 1989, Jiang Zemin became the head of the Party, and his right-hand man was Zhu Rongji. Both had made their way up the ranks of China’s large state owned enterprises and now that they had secured political power just as there was a major challenge to party authority and political stability. The new leadership began to significantly shift the balance of economic reform and activity. The new post-Tiananmen leadership chose to ignore the local successes of the TVEs and instead stressed large urban SOEs as China’s economic future. This was of course not based primarily on economic thinking, but was mostly a response to concerns that economic and political control was beginning to slip away from the Party. It was time to rein this in and put control of the economy back squarely in the hands of the Party. After Tiananmen, Li Peng, the Premier of China at the time spoke out against TVEs. He discouraged the urban SOEs from working with them and preferred to see TVEs only operate in rural communities. He had the TVE Law passed in 1997 which labeled TVEs as mainly agricultural and defined the TVEs as those enterprises “undertaking to support agriculture.” Li also wanted to see a move away from private TVEs to collective TVEs.

This had devastating consequences for the incomes of rural China. Household income growth dropped from 12% to 4% in only four years and has continued at this lower rate, a factor driving the intense urbanisation process in China. Punishing the rural producers was politically risky for the party, because over two-thirds of Communist Party members were rural workers. Jiang sought to shift this, and in 2001 he encouraged all professionals working in and running private and state businesses to join the party during a speech he made at the 80th Anniversary of the founding of the Party. At the time of his speech the communist party consisted of 70 million members. Private entrepreneurs accounted for only 18% of the Party. In 2005 this number had risen to 23%, and in 2008 their percentage of the Party reached 34%.

Since the late 1970s, profits of SOEs have been in a dramatic decline. From 1978 to 1997, profit per capital unit fell from 22.9% to 0.8%, and per output unit from 15.5% to 1.6%. In 1978 a mere 19% of SOEs were reporting losses. In 2006, that number became 51%. China has dismantled or consolidated hundreds of thousands of SOEs since the late 1970s but the larger SOEs have remained in place and have a huge footprint in the national economy. The central government holds via SOEs a dominant position in the automotive, pharmaceutical, electronics, tobacco, and petrochemical industries. They also own a significant portion of telecommunications and industrial construction such as steel and cement.To these have been added a number of key ‘emerging industries’ in alternative and new energy technologies, new generation IT (e.g., cloud technology and high- end software), biotechnology, new generation automobile technology, high-end equipment manufacturing (especially in aviation, satellite, marine and intelligent manufacturing technologies such as robotics and 3D printing), new energy sectors (such as wind and solar), and new and advanced material sectors.

One way to gauge the extent of the dominance of the ‘super’ SOEs in the broader economy is to look at the balance of revenue and profits. The top three SOEs in China generate more revenues and make more profits than the combined revenue and profits of the largest 500 private firms in China. However the SOE sector itself is divided between a high performing core and a large underperforming rump. Around 80 per cent of all central SOE profits come from around a dozen firms, with the other 100 largest SOEs firms underperforming. There are over 140,000 provincial and local SOEs but the Chinese economy is dominated by a relatively small number of giant SOEs The fact that the majority of SOEs are under-performers means that the SOE system a whole is a drag on national wealth even though the SOE sector is the recipient of the bulk of state banking investment. Given that 80% of the profits of the 150 very large SOEs that the State directly controls come from fewer than 12 SOE it is clear that the SOE system as a whole is a monopolistic power structure supported by the policies and favouritism of the central government. The return on assets of central SOEs is less than their cost of their capital which indicates that these SOEs receive enormous amounts of capital even when they are not deserving of it in commercial terms. That is, in a nutshell, the problem of China’s state-dominated political-economy.

The private sector outperforms these SOEs by a wide margin and it is the private sector which dominates the export sector. Private firms’ rate of return on capital investment is as much as 54% higher than that of the SOEs. However the state continues to favour the SOE sector because it is the main source of wealth and power for big elements of the Chinese ruling Communist Party elite. Senior Chinese communist members (and increasingly their families as informal inheritance systems emerge and become embedded) control big SOEs which is why most government directed loan allocations go to the inefficient SOEs instead of the much more profitable private firms.

But Chinese SOEs have very little incentive to be efficient, to innovate, or to be competitive. The government has given them carte blanche to monopolise, collude, and be fraudulent; all the while praising them for the “growth” they are said to be creating. While banks were desperately writing off bad loans and shuffling them around to AMCs (see below) in the early 2000s, Li Rongrong (the chairman of the State-Owned Assets Supervision and Administration Commission) was praising the profits of SOEs. He claimed that between 1989 and 2002 profits rose from $9.5 billion to $31 billion, which has to be placed in the context of the gigantic Non Performing Loans (NPLs) made to these same SOEs which amounted to hundreds of billions of dollars of bad debt, and independent study clearly showed that productivity was in a tailspin.

Debt and the Chinese banking system

The formal part of the Chinese financial system heavily favours SOEs. SOEs receive over three-quarters of all formal finance (mainly bank loans), which are the cheapest available credit in the Chinese financial system. Because private firms are starved of official credit they are generally forced to rely on the secondary lending market, which includes the so-called shadow banking sector, such as off-record loans offered by SOEs and other cash rich firms, pawn operations, and other ad hoc entities set up to provide secondary finance. Non-formal finance is significantly more expensive and it is a credit to the efficiency and enterprise of China’s private firms that they outperform SOEs, even though they are forced to pay more for credit.

The gigantic sums loaned preferentially to SOEs have led to a large non-performing loan (i.e. bad debt) crisis in China, and lending to underperforming SOEs accounts for 75% of all non-performing loans in China. The finances of the country are dominated by four large banks: Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agriculture Bank of China. These banks are under the control of the State and react more to political forces than economic forces. A non-performing loan is a loan that has not met its payments for at least 90 days, and once a loan is non-performing it is considerably less likely to ever be repaid.These four banks accounted for $358 billion of non-performing loans (NPLs) in China, and the total amount of NPLs were estimated at $911 billion or 40% of China’s GDP. The Chinese Communist Party has always sought to hide the true extent of bad debt in the Chinese banking system and has officially estimated NPLs to be ‘only’ $150 billion, but many independent estimates and surveys places the NPL figure much, much higher. To put the Chinese NPLs estimate of 40% of GDP into perspective, most other Asian economy’s NPLs are between 3% and 5% of GDP. Of course other Asian economies do not prop up large inefficient SOEs with their financial systems.

In 2005, the China Banking Regulatory Commission, which is an agency of the central government, admitted that it was concerned about the number of NPLs. It would not say to what extent NPLs were a problem, but it began to devise a strategy to “fix” the situation. The first course of action was to simply offer large bailouts to the banks from the State treasury. These bailouts have not been effective, due to the continuing of bad practices of loaning to under-performing SOEs. A case in point is the People’s Bank of China. In 1999, the Chinese government estimated that nearly 25% of its loans were NPLs. The government issued the largest bailout in its history, at $36 billion, directly to the State banks. When the People’s Bank of China was reevaluated by outside sources in 2001 after the bail out, it was discovered that 26% of their loans were still NPLs. The level of NPLs may be much higher as the Chinese authorities do all they can to hide the real situation and prefer to focus on the ’success’ of continuing GDP growth.

The other tool the government uses to mask the problem of NPLs is the creation of Asset Management Companies (AMCs). The idea behind these is that the large banks would be able to clear large numbers of NPLs off their books, and the AMCs would be tasked with the job of recovering as much of the NPLs as possible. In 1999 the People’s Bank of China turned over $170 billion of NPLs to these AMCs. From then until 2005 the largest four banks have transferred $330 billion into AMCs. The government claimed that under the attention of the AMCs, NPL recovery would be a minimum of 40% but these numbers were far too optimistic. An analysis by Deutsche Bank showed that NPL recovery was 20% in the best instances. McKinsey & Co. also pointed out that 60% of the reductions in NPLs by the bank were merely a result of transferring them to AMCs. These numbers do not take into account the fact that banks have continued to loan aggressively. If trends continue, $225 billion of these new loans are expected to be non-performing in the future.

Chinese banks have been claiming impressive profits in the past few years. Some have seen this as proof that China is recovering its loan practices and acting more prudently. There are many precarious aspects to this reporting. The percentage of NPLs that Chinese banks are holding is said to have dropped 3.17% since 2008 but this is only due to the three practices discussed above, that is banks continue to transfer NPLs to AMCs, write them off their books, and issue new mostly long-term loans that will take time to go bad, but are counted as assets in the short-term.


So China needs to make some very big adjustments to its economy. Chinese households consume only about 34 percent of GDP, not much above half the global average and far less than the rate in any other country. Such a large domestic imbalance has no historical precedent. The historical precedents for the kind of adjustments required to fix big imbalances are not encouraging, and the adjustment China needs to make dwarfs those of its predecessors. Like it or not, China must change its growth model. Until it does so its economy will be excessively vulnerable to changes in its trade surplus or in domestic investment and the longer the old growth model is pursued the more vulnerable the Chinese economy will become to a wrenching and disruptive adjustment. The old growth model is also building up probably dangerous levels of debt within the Chinese banking system.

The Chinese ruling elite seems to be fully aware of the need for this adjustment, for the need to reign in investment, reduce the dependency on exports and increases the share of household consumption in national GDP. However the Chinese government was acknowledging the need to increase consumption and reduce investment back in 2005 and since then things have moved in the opposite direction, the consumption rate has declined and the investment rate has increased, so changing course will be very hard.

So how will China adjust? Almost certainly it will adjust with much lower growth rates driven by a collapse in investment growth. Over the next ten years policymakers have said that they will work to raise consumption to 50 percent of GDP. Although this represents a substantial adjustment for China, it is worth remembering that 50 percent will still leave China with by far the lowest consumption rate of any major economy. Moreover the global economy is suffering from a severe shortage of demand caused by the excessive savings rates of China and Germany and the ability or willingness of the rest of the world to continue to absorb a large Chinese surplus as the country slowly rebalances (especially as Germany shows no sign of reducing its utterly irresponsible surplus levels) without further financial disruption is limited. China needs to get a move on.

Achieving the stated goal of raising consumption to 50 percent of GDP will be hard because it requires that household consumption grow 4 percentage points faster than GDP. To raise consumption from 34 percent of GDP to 50 percent of GDP in ten years consumption growth must outpace GDP growth by 4 full percentage points every single year of the decade. If China’s GDP grows at 10 percent annually for the next decade, for example, we would need consumption to grow by 14 percent annually in order to achieve the target.

Can the Chinese government achieve these targets? In the past decade, Chinese household consumption has grown by 7 percent to 8 percent annually, while GDP has grown at an very, very high rate of 10 percent to 11 percent. If one expects Chinese GDP to grow by 6 percent to 7 percent on average over the next decade, as increasingly pessimistic policymakers and advisors in Beijing are suggesting, Chinese household consumption would have to surge by 10 percent to 11 percent annually just to permit a rebalancing to 50 percent of GDP in ten years.

Achieving the required consumption growth to rebalance the economy whilst sustaining high rates of growth is unlikely because powerful structural factors work against it. First the global economy will probably not be able to sustain absorbing continued high levels of Chinese exports without serious impacts on capital flows, debt and economic activity. In other words very high levels of Chinese exports will, if it continues as it has done, help destroy the very markets into which it is seeking to sell. Secondly, the Chinese growth model is based on transfers of income from households to the corporate and state sector, mainly in the form of artificially low interest rates, in order to generate such rapid growth. Low interest rates sharply reduce borrowing costs for the state-owned companies that funnel this easy money into the mega-investments that drive growth and the flow of high domestic savings on low rates of interest sustains the banks’ profit margins and allows them to resolve bad loans with relative ease. If there is a surge in nonperforming loans (which is likely as the mega-investment program leads to increased levels of non-productive investment and thus increases the scale of non-performing loans), low interest rates will be the prime mechanism for recapitalising the banks and permitting insolvent borrowers to “grow” their way back into solvency. Without weaning the banks off of dependency on low interest rates cheap borrowing will continue to come at the expense of household depositors. Low yields on deposits will force them to sacrifice consumption in order to raise savings to some target level. This is the opposite of the rebalancing that must occur.

If the economy is to be rebalanced then consumption has to grow faster than GDP grows. If GDP continues to grow fast than domestic incomes has grow even faster. Fast GDP growth in China is built upon the very mechanism that keep domestic consumption so very low. Either way you look at it rebalancing the economy means that Chinese growth rates are almost certainly going to fall, and fall by a significant amount.

The position of the official (state controlled) banking system and of the state owned enterprises with which the official banks have such a symbiotic relationship means that the rebalancing will be very problematic for the whole state sector. This in turn will challenge the vested interest of those sections of the ruling elite whose wealth and power is bound up with the fortunes of state owned enterprises. If the flow of cheap credit is turned off, which it has to be if household consumption is to increase then the entire financial foundation of the state owned enterprise sector could erode and with it the wealth and power of a big chunk of the elite. The ending of cheap credit will also expose the banks to full costs of the non performing loans.

So the coming and inevitable adjustments of the Chinese economy will pose new and uniques problems for the Chinese ruling elite. It will require technical proficiency in new areas of economic policy which cannot rely on expertise gained in driving big investment programs, in fact it has to deliver the exact opposite of what Chinese policy makers have been delivering their entire professional lives. It will expose the weakness of the large state owned enterprise system and the related weakness (and mounting bad debt problems) of the official state banking system. It will significantly erode the economic base of a big section of the ruling elite. And the entire difficult, and probably wrenching, transition away from the export/investment growth model will have to be delivered in a system without the political shock absorbers that exists in liberal democracies.

I don’t know what will happen in China but it appears the Chinese are going to be living in interesting times.

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