Over the medium term I have little doubt that growth will continue to slow, and that at best we have only completed about one third of the journey from peak GDP growth to the trough. As long as it has debt capacity Beijing, or indeed any other government, can pretty much get as much growth as it wants, in China’s case simply by making banks fund local government infrastructure spending.
Most economic analyses of the Chinese economy tend to base their forecasts on the sequence and pace of economic reforms aimed at rebalancing the economy, and on the impact these reforms are likely to have on productivity growth. It may seem contrarian, then, that I forecast Chinese near term growth largely in terms of balance sheet constraints. I am not implying that the reforms do not matter to the Chinese economy. The extent to which the reforms Beijing proposes to implement reduce legal and institutional distortions in business efficiency, eliminate implicit subsidies for non-productive behaviour, reorient incentives in the capital allocation process, undermine the ability of powerful groups to extract rent, and otherwise liberalise the economy, will unquestionably affect China’s long-term growth prospects.
But I expect that any significant impact of these reforms on short-term growth will largely be the consequence of two things. The first is how reforms will affect the amount, structure, and growth of credit. The second is how successfully Beijing can create sustainable sources of demand that do not force up the debt burden — the most obvious being to increase the household income share of GDP and to increase the share of credit allocated to small and medium enterprises relative to SOEs.
To put it a little abstractly, and using a corporate finance model to understand macroeconomics, I would say that most economists believe that China’s growth in the near term is a function of changes in the way the asset side of the economy is managed. If Beijing can implement reforms that are aimed at making workers and businesses utilize assets more productively, then productivity will rise and, with it, GDP.
This sounds reasonable, even almost true by definition, but in fact it is an incomplete explanation of what drives growth. In corporate finance theory we understand that although growth can often or even usually be explained as a direct consequence of how productively assets are managed, it is not always the case that policies or exogenous variables that normally change the productivity of operations will have the expected impact on productivity growth. When debt levels are low or when the liability structure of an economic entity is stable, then it is indeed the case that growth is largely an asset-side affair. In that case for GDP growth to improve (or for operating earnings to rise), managers should focus on policies aimed at improving productivity.
But when debt levels are high enough to affect credibility, or when liabilities are structured in ways that distort incentives or magnify exogenous shocks, growth can be as much a consequence of changes in the liability side of an economy as it is on changes in the asset side. At the extreme, for example when a company or a country has a debt burden that might be considered “crisis-level”, almost all growth, or lack of growth, is a consequence of changes in the liability structure. For a country facing a debt crisis, for example, policymakers may work ferociously on implementing productivity-enhancing reforms aimed at helping the country “grow” its way out of the debt crisis, but none of these reforms will succeed.
....
Clearly it is extremely risky for local governments, who are highly dependent on land prices for their revenues, to increase their exposure to land prices by buying up land at auctions. This is an obvious case of balance sheet inversion at the local government level. Some economist might argue that while it may increase risk at the local level, it does not do so at the national level. It simply represents a transfer of wealth from one group of economic agents to another. If real estate prices fall, for example, local governments will be even worse off than ever, but property developers will be better off because they are less exposed than they otherwise would have been.
There are at least two reasons why this may be totally mistaken. The first reason is that by propping up real estate prices local government may be helping powerful local interests who only want to sell their real estate in order to fund disinvestment or flight capital. The second, and far more important, reason has to do with the fact that financial distress costs are concave, not linear. If there is a transfer of wealth from one indebted entity to another, the latter benefits at the former’s expense. But the reduction of financial distress costs for the latter must necessarily be less than the increase for the former. Taken together, there must be a net increase in financial distress costs for China and a net increase in volatility within China. This is not the place to explain exactly why this must happen (I will do so in my upcoming book), but if it were not true, then it would not be the case that a country could suffer from excessive domestic debt.
My main point is that orthodox economists have traditionally ignored the impact of balance sheet structure on rapid growth, but liability structures can explain both very rapid growth and very rapid growth deceleration. It is unclear to what extent balance sheet inversion explains part of the Chinese growth miracle of the past decade, but it would be unreasonable to discount its impact altogether, and I suspect it’s impact may actually be quite high. To the extent that it has boosted underlying growth in the past, for exactly the same reason it must depress underlying growth in the future.
What is more, because we are in the late stages of China’s growth miracle, we should recognise that historical precedents suggest that balance sheet inversion will have increased in the past few years, and may continue to do so for the next few years, which implies that a greater share of growth than ever is explained not by fundamental improvements in the underlying economy but rather by what are effectively speculative bets embedded into the national balance sheet. Besides commodity stockpiling and real estate purchases by local governments, we have clearly seen an increase in speculative financial transactions by large Chinese companies (the so called “arbitrage”, for example, in which SPEs have borrowed money in the Hong Kong markets and lent the money domestically to pick up the interest rate differential as well as any currency appreciation), which is the Chinese version of what in the late stages of the Japanese growth bubble of the 1980s was referred to as zaitech.
We have also seen growth in external financing, which is the classic form of inverted debt for developing countries. The main thing to watch for, I think, is one of the most dangerous kinds of balance sheet inversion, and is especially common when growth has been driven by leverage, and that is the tendency for borrowers to respond to credit and liquidity strains by effectively doubling up the bet and shortening maturities. I don’t know if this is happening to any worrying extent, but when we start to see a dramatic shortening of real maturities, it should be a warning signal.
Most economic analyses of the Chinese economy tend to base their forecasts on the sequence and pace of economic reforms aimed at rebalancing the economy, and on the impact these reforms are likely to have on productivity growth. It may seem contrarian, then, that I forecast Chinese near term growth largely in terms of balance sheet constraints. I am not implying that the reforms do not matter to the Chinese economy. The extent to which the reforms Beijing proposes to implement reduce legal and institutional distortions in business efficiency, eliminate implicit subsidies for non-productive behaviour, reorient incentives in the capital allocation process, undermine the ability of powerful groups to extract rent, and otherwise liberalise the economy, will unquestionably affect China’s long-term growth prospects.
But I expect that any significant impact of these reforms on short-term growth will largely be the consequence of two things. The first is how reforms will affect the amount, structure, and growth of credit. The second is how successfully Beijing can create sustainable sources of demand that do not force up the debt burden — the most obvious being to increase the household income share of GDP and to increase the share of credit allocated to small and medium enterprises relative to SOEs.
To put it a little abstractly, and using a corporate finance model to understand macroeconomics, I would say that most economists believe that China’s growth in the near term is a function of changes in the way the asset side of the economy is managed. If Beijing can implement reforms that are aimed at making workers and businesses utilize assets more productively, then productivity will rise and, with it, GDP.
This sounds reasonable, even almost true by definition, but in fact it is an incomplete explanation of what drives growth. In corporate finance theory we understand that although growth can often or even usually be explained as a direct consequence of how productively assets are managed, it is not always the case that policies or exogenous variables that normally change the productivity of operations will have the expected impact on productivity growth. When debt levels are low or when the liability structure of an economic entity is stable, then it is indeed the case that growth is largely an asset-side affair. In that case for GDP growth to improve (or for operating earnings to rise), managers should focus on policies aimed at improving productivity.
But when debt levels are high enough to affect credibility, or when liabilities are structured in ways that distort incentives or magnify exogenous shocks, growth can be as much a consequence of changes in the liability side of an economy as it is on changes in the asset side. At the extreme, for example when a company or a country has a debt burden that might be considered “crisis-level”, almost all growth, or lack of growth, is a consequence of changes in the liability structure. For a country facing a debt crisis, for example, policymakers may work ferociously on implementing productivity-enhancing reforms aimed at helping the country “grow” its way out of the debt crisis, but none of these reforms will succeed.
....
Clearly it is extremely risky for local governments, who are highly dependent on land prices for their revenues, to increase their exposure to land prices by buying up land at auctions. This is an obvious case of balance sheet inversion at the local government level. Some economist might argue that while it may increase risk at the local level, it does not do so at the national level. It simply represents a transfer of wealth from one group of economic agents to another. If real estate prices fall, for example, local governments will be even worse off than ever, but property developers will be better off because they are less exposed than they otherwise would have been.
There are at least two reasons why this may be totally mistaken. The first reason is that by propping up real estate prices local government may be helping powerful local interests who only want to sell their real estate in order to fund disinvestment or flight capital. The second, and far more important, reason has to do with the fact that financial distress costs are concave, not linear. If there is a transfer of wealth from one indebted entity to another, the latter benefits at the former’s expense. But the reduction of financial distress costs for the latter must necessarily be less than the increase for the former. Taken together, there must be a net increase in financial distress costs for China and a net increase in volatility within China. This is not the place to explain exactly why this must happen (I will do so in my upcoming book), but if it were not true, then it would not be the case that a country could suffer from excessive domestic debt.
My main point is that orthodox economists have traditionally ignored the impact of balance sheet structure on rapid growth, but liability structures can explain both very rapid growth and very rapid growth deceleration. It is unclear to what extent balance sheet inversion explains part of the Chinese growth miracle of the past decade, but it would be unreasonable to discount its impact altogether, and I suspect it’s impact may actually be quite high. To the extent that it has boosted underlying growth in the past, for exactly the same reason it must depress underlying growth in the future.
What is more, because we are in the late stages of China’s growth miracle, we should recognise that historical precedents suggest that balance sheet inversion will have increased in the past few years, and may continue to do so for the next few years, which implies that a greater share of growth than ever is explained not by fundamental improvements in the underlying economy but rather by what are effectively speculative bets embedded into the national balance sheet. Besides commodity stockpiling and real estate purchases by local governments, we have clearly seen an increase in speculative financial transactions by large Chinese companies (the so called “arbitrage”, for example, in which SPEs have borrowed money in the Hong Kong markets and lent the money domestically to pick up the interest rate differential as well as any currency appreciation), which is the Chinese version of what in the late stages of the Japanese growth bubble of the 1980s was referred to as zaitech.
We have also seen growth in external financing, which is the classic form of inverted debt for developing countries. The main thing to watch for, I think, is one of the most dangerous kinds of balance sheet inversion, and is especially common when growth has been driven by leverage, and that is the tendency for borrowers to respond to credit and liquidity strains by effectively doubling up the bet and shortening maturities. I don’t know if this is happening to any worrying extent, but when we start to see a dramatic shortening of real maturities, it should be a warning signal.
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