China Running Out of Room to Restructure EconomyMichael Pettis
Sept. 26 (Bloomberg) -- If we accept the argument that China must, and will, rebalance its economy by reducing its reliance on investment, what happens if it proves politically impossible to cut investment rates sharply? Gross domestic product growth rates would remain very high, but debt levels would also grow unsustainably. At some point, China will reach its debt capacity limits and no longer be able to fund investment.
At this point, the country would fall into the self-reinforcing process of chaotic adjustment that characterized the U.S. in the early 1930s or Brazil in the mid-1980s. As investment falls and GDP growth grinds to a halt, rising financial distress causes businesses to fire workers. Unemployment causes consumption growth to drop, and GDP growth falls even further, resulting in more distress.
This is the worst-case scenario of rebalancing. In the U.S., for example, between 1929 and 1933, real gross investment fell by 91 percent, real consumption dropped by 19 percent, and real GDP dropped by 30 percent. The result was catastrophic for the economy and for households. But the U.S. did rebalance: Investment dropped sharply, and even though consumption dropped, too, the consumption share of GDP rose sharply at the expense of the investment share.
A less damaging strategy would be for China to rebalance either by raising real interest rates sharply, forcing up the foreign-exchange value of the currency by 10 percent to 20 percent overnight and raising wages, or by lowering income and consumption taxes. This would fairly quickly reverse ongoing transfers of wealth from households to the state sector.
The advantages of this approach are straightforward. By adjusting very quickly, the Chinese government would immediately put a stop to the worsening of the domestic imbalances. It also would immediately eliminate the strong incentives within China to waste money on a stability-threatening scale by raising the cost of capital and forcing investors to generate real returns on their investment. This, of course, would also allow the government to finally get a grip on its ballooning debt.
But the disadvantages are straightforward, too. Eliminating the hidden subsidies abruptly would cause a large increase in financial distress as exporters struggle with a more expensive currency, borrowers are unable to service their debt, and employers, especially those in the labor-intensive sector, become suddenly uncompetitive. This would almost certainly lead to a surge in unemployment as exporters and borrowers are forced to close operations.
In the short term, under these conditions, we would probably see household income decline because the negative impact of rising unemployment would exceed the positive impact of reversing the wealth transfers. This would cause household consumption to decline, forcing the economy into a downward spiral. Needless to say, this would also result in difficult political conditions.
Policy makers might be tempted to eliminate the transfers slowly enough to give exporters, borrowers and employers time to adjust. But this strategy accomplishes its objectives too slowly, and it may already be too late to implement it.
Remember that the total value of these subsidies is enormous: Gradually removing them at a pace the Chinese economy can handle would result in worsening domestic imbalances for many years before there has been enough of an adjustment to reverse the imbalances. During this time, the impact of those distortions -- declining consumption relative to GDP, misallocated investment, and above all, rising debt -- would continue to grow.
The more bad investment China accumulates, the more costly the eventual adjustment will be, and the more the adjustment process must be slowed. Gradual adjustment would increase the risk of China’s reaching debt capacity limits to a near-certainty.
A different way for China to cushion the blow would be to hire unemployed workers for various make-work programs, paying their salaries out of state resources. But if wage costs for unproductive workers are paid for in the form of a fiscal deficit, debt will continue to rise too quickly. If the costs are paid for in the form of direct or hidden taxes on the household sector, aggregate household consumption would remain unchanged as a share of GDP.
Only if wage costs for unproductive workers are paid for by the liquidation of state assets will there be a real increase in the household income and consumption shares of GDP. In fact, the most effective and efficient way to increase household wealth quickly as a share of GDP would be for China to directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.
This would necessarily come at the expense of the state sector. A contraction in the state share of GDP, however, is almost inevitable. The only question is whether it will occur in the form of an actual contraction in state assets or in the form of much slower growth in the state sector than in the overall economy. Contraction is far more efficient but also far more difficult to accomplish politically.
There are many ways in which state wealth can be transferred to the household sector. Farmers can be granted full title to their land. Migrants can be granted hukou residency, which, because it gives them legal status and rights to urban services, would act as a substantial one-time increase in their wealth. The government could strengthen the social safety net by transferring ownership of state-owned enterprises to the pension funds.
Other measures could directly or indirectly increase households’ perceptions of their own wealth. The government could eliminate or erode monopoly pricing power through greater competition, for instance. It could impose significant charges for environmental degradation (remember that a worsening environment imposes future health and production costs on households, which must respond by increasing their savings rate). It can increase the protection of property rights, or it can make it easier, quicker, and less costly to start a business.
State-owned enterprises can be sold either to foreigners or to citizens, with the proceeds being distributed directly or indirectly to households. The money, for instance, can be used to reduce future claims on household income. The most efficient way of doing this would be to use the proceeds to pay down corporate and state debt, thus allowing the central bank to raise interest rates sharply without causing a surge in financial distress.
For all of the efficiency in transferring wealth in this way, however, there is an enormous constraint on China’s ability to pull it off. Martin Luther King Jr. once described history as the story of the refusal of the privileged few to give up their privileges. Transferring assets from the state sector directly or indirectly will require the forgoing of important privileges. There is tremendous resistance to the loss of power and control this would impose on many important and powerful sectors and families within China.
Given this, the Chinese leadership might be tempted to take the easy way out, indirectly transferring wealth from the state to the private sector by absorbing private-sector debt. This is what Japan did as a fundamental part of its rebalancing after 1990, when government debt rose from about 20 percent of GDP to more than 200 percent now. The government effectively absorbed the bad loans in the banking sector. Government debt expanded rapidly, while private-sector debt contracted.
The great advantage of this form of rebalancing is that it is very easy to do politically. But as we saw in the case of Japan, after a decade or so, this strategy leaves the government struggling with too much debt. The debt burden itself becomes the biggest impediment to growth, because the direct or hidden taxes required to service it reduce consumption-driven growth, and the size of the debt limits policy choices for the government.
China has no choice but to follow one or more of these paths. If privatization isn’t an option, then a collapse of the economy caused by a rapid adjustment in interest rates and the currency might be. If that is ruled out, then perhaps the outcome will be a surge in government debt, and so on.
These are the economic constraints that limit the choices China can make. It doesn’t matter what anyone thinks the government will do or what anyone wants it to do; if the plan violates the economic constraints, it simply cannot be done.
(Michael Pettis is a senior associate at Carnegie Endowment for International Peace and a professor of finance at Peking University’s Guanghua School of Management, specializing in Chinese financial markets. This is the last of three excerpts from his new book, “Avoiding the Fall: China’s Economic Restructuring,” published this week by the Carnegie Endowment for International Peace. Read Part 1 and Part 2.)
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