Global Imbalances and the Chinese Economy
Sep 17, 2015
Let me issue a bit of a warning: the last month or so the essays in Outside the Box have been relatively brief and pretty easy to grasp, I think. This one is not in that vein. You will need to don your thinking cap on and focus a bit more than is normal for an Outside the Box.
George is nothing if not entertaining. I enjoy watching Meredith try to keep him on track. They make a remarkable team, whether writing about geopolitical events or working for the CIA in Africa back in the day. Great stories that I wish I could write about. You’ll just have to track him down one night and agree to an off-the-record conversation.
John Mauldin, Editor
Outside the Box
Global Imbalances and the Chinese Economy
September 1, 2015
Financial distress can be worse than a crisis
- It is possible to structure an economy in such a way that excessive debt creation is not a “choice”, not even a bad choice, but is instead the automatic consequence of institutional constraints within the economy, and in fact it is very rare that a country experiencing many years of “miracle” growth hasn’t created such constraints. This is why it should have been possible to see well over a decade ago that China’s excessive indebtedness was inevitable. Economists who warned of the possibility of a deterioration in the balance sheet, but who thought nonetheless that China could avoid this outcome without a major restructuring of its growth model and a significant reduction of its growth rate, were always fundamentally mistaken. Excessive debt levels were never a “possibility”. They were a necessity as long as the growth model had not been fundamentally transformed.
- The structure of the balance sheet, by which I mean the types of mismatches between assets and liabilities when debt levels are high enough, can systematically enhance volatility, so that periods of expansion, real productivity growth, or benign global conditions can result in many years of growth that exceed expectations. This comes however at a cost. First, the same balance sheet structures that enhance growth during the expansion phases will cause growth to slow much faster than expected during the contraction phases, and second, enhanced volatility always reduces value, although not always perceptibly at first, because it increases gapping risk. This process is perhaps counterintuitive to those who think all economic activity is driven by fundamentals, but is well understood by traders and investors, who know how it works in margin buying, leveraged positions, and derivatives that directly quantify leverage and gapping risk.
- Apart from enhancing volatility, high debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be resolved, i.e. to which sectors or groups they will be explicitly or implicitly allocated. This uncertainty will affect the behavior of any sector of the economy to whom the costs might be allocated, in the form of either direct taxes, indirect taxes (e.g. inflation or depreciation), appropriation or expropriation, or wage and consumption suppression. These sectors, all of whom will alter their behavior in order to protect themselves from bearing the costs of debt, comprise most of the economy, including foreign creditors, small business owners, savers within the banking system or in other forms of monetary assets, workers, wealthy owners of financial and non-financial assets, the agricultural sector, importers and exporters, the mining sector, and many others. The wealthy might take their money out of the country, for ex ample, and creditors might shorten maturities and raise interest rates, business owners might disinvest, the middle class might dis-intermediate savings, workers might organize, local policymakers may engage in protectionist activity, borrowers might invest in riskier projects, banks might reduce the scope of their lending to the most protected sectors, etc. The point is that it is a mistake to assume that the only or main cost of excess indebtedness is a financial crisis.
- The balance sheet can embed strong feedback mechanisms within the economy that make it almost impossible to predict the growth of debt. The balance sheet mismatches that during the expansion phase could be refinanced in ways that created unexpected profit, can easily lead to rising debt instead as the mismatches become harder to refinance or require government guarantees.