Two Wrong Ways to Think About China's Slowdown
Western observers struggle to make sense of what’s happening to the Chinese economy. Since China is slowing, dragging down commodity prices and forcing a number of other countries into recession, this in an important problem to puzzle out. But how should we evaluate China’s economy? I find that Western writers tend to subscribe -- explicitly or implicitly -- to one of two folk theories of China. Both have serious deficiencies.
The first of these folk theories is “rebalancing.” This is the idea -- promoted by Michael Pettis of Peking University -- that China has been investing too much in infrastructure and factories, and needs to switch to services and to consumption. The theory says that this adjustment is natural and inevitable, but will lead to slower growth.
It is probably correct that rebalancing is necessary. Advanced economies are heavy on services and consumption, lighter on investment and manufacturing. There is no obvious reason to think that China's development will turn out any different. As for whether this necessitates slower growth, that question is less clear. After World War II, the U.S. shifted from manufacturing to services, but growth remained at about the same rate throughout. Maybe China’s shift will force growth to be slower than it would have otherwise, but it seems far from certain.
But where rebalancing theory really falls apart is when we rely on it to explain recent developments in the Chinese economy. China’s slowdown is forcing the shuttering of a large number of factories, throwing people out of work and forcing many to return to rural areas where they will be semi-employed and much less productive. This is a clear sign of economic distress, and is a reason we should be a bit skeptical of official Chinese gross domestic product numbers (they have fallen only slightly, to about 7 percent). It is wrong to interpret this as a positive sign, as some do. Economic shifts should be slow and gradual, not rapid and disruptive.
We also should be cautious about the growth in the Chinese service sector. Much of that has come from the expansion in financial services, much of which just represents banks helping floundering companies roll over their loans. Some part may even represent fake activity. This isn't the “rebalancing” Pettis talks about, but the sign of a sick economy that will take years to work through its problems.
The second folk theory that people use to understand China is based on debt levels. The idea here -- which is rarely articulated, but seems to inform much of the writing about China -- is that lending drives growth, but entails the buildup of bad debt that ultimately causes slow growth. This is sort of a “sin and punishment” view of the economy.
This idea probably describes some episodes and time periods in some countries, but this isn't generally true. If it were, you could use debt levels -- or the change in debt levels, or the acceleration of debt levels -- to predict recessions. But you can’t. Though there are some debt-related variables -- such as interest-rate spreads and debt quality -- that really do help predict downturns, absolute debt levels have almost no predictive power. So looking at the amount of debt in China is probably a bit of a distraction.
Because the folk theory of debt-driven growth is in the back of people’s minds, there is a lot of contradiction in the way we talk about Chinese lending and what it means for the economy. For example, I read bullish articles saying that the increases in Chinese lending are good news. And I read bearish articles trumpeting the exact same lending surge as a sign of impending doom.
Focusing on debt levels distracts people from the real issue, which is the quality of that debt. If loans are being made to finance sustainable economic activity, that’s good. If they are being made at below-market rates because the government wants to support GDP growth, that might be OK in the short term. But if new loans are being issued to roll over old loans to companies that invested in unsuccessful projects and are now refusing to recognize their failure and go bankrupt, it is very bad. The eternal rolling-over of bad debts would hold down Chinese productivity in the future, the way it saddled Japan with zombie companies after that country’s bubble burst in the early 1990s.
As of now, credit quality in China doesn’t look so good. Exactly how bad it is, we can’t say, but it’s almost certainly worse than is being reported. So the pessimists are probably right. But it is wrong to see China’s debt problems as inevitable -- it isn't the buildup of debt that poses the big danger, but the distortions caused by bad lending. And getting the Chinese economy out of its slump won't be about cutting debt levels or increasing debt levels -- it will be about making sure that the financial system lets bad companies die and allocates capital to the good ones.
So when we talk about China’s economy, we should be wary of these folk theories. Without them, it will still be hard to get a grasp on what’s happening in China, but that’s better than convincing ourselves we understand things that we don’t.
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