Does It Matter If China Cleans Up Its Banks?
It has been a while since we have taken a close look at China. After the dustup with Chinese “depreciation” about this time last year and all the hysteria, all eyes have been trained on the rest of the world. It has been only a little more than a year since we published the book I co-wrote with Worth Wray on China, which we called “A Great Leap Forward?” The title was meant to be ironic, because the original Great Leap Forward imposed by Mao in the ’60s was one of the most economically disastrous times in all of Chinese history. Chinese food production increased, yet 30 million people starved and the country underwent a true financial and economic crisis due to the utter insanity of central control of markets.
China is now attempting something that is different in texture but as powerful in scope as Mao’s Great Leap Forward. China has amassed an enormous amount of debt in its drive to pull itself into the modern world. That China has been successful in remaking itself into a major force in the world is self-evident. But those who are paying attention see the country’s debt growing at a phenomenal rate, much higher than the economy’s rate of growth; and that rate of growth is shrinking, so the ability to service that debt is shrinking, too. And we are talking about massive, humongous amounts of debt in relation to GDP.
There is a lot to like and appreciate about China, but it is not altogether clear what they are going to do about their current circumstances, including the inevitable shift from being a manufacturing powerhouse to being a consumer powerhouse. It is not an easy transition to make.
This week’s Outside the Box is from my friend Michael Pettis who is a professor at the Guanghua School of Management at Peking University in Beijing. I think it is safe to label him as a long-term China insider. He spoke at my conference the year before last, and I will have to have him there again. He is possibly the most knowledgeable person I know on China’s inner workings.
We are going to visit his latest posting (which hit my inbox this morning) on the nature of Chinese debt and the problems the resolution of that debt are going to create. Let me give you just a brief preview:
If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), then for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:
1. Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or
2. Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.
I want to assure you that Michael is extremely understated and probably the least hyperbolic person both in print and in person that I know. I enjoy sitting at dinner with him and pressing him when he arrives at conclusions about the ramifications of events in China. He really gets a little uncomfortable about saying “They and we are in a real world of hurt,” but the situation he describes in those few sentences above and in the rest of this week’s Outside the Box really does lead me to wonder, how can they possibly hope to pull this miracle off? Seriously, is there any place and time in history where, magically, new debt began to generate 18 times as much GDP growth as it did the previous year? Buehler? Anyone?
We are going to pick on China today, but as longtime readers know, I am an equal-opportunity debt-o-phobe. (Seriously, I have been called debt-phobic by none other than Paul Krugman. I am not certain whether that’s a psychological condition; but it is a basic fact of my economic condition that when debt, whether public or private, balloons to extremes like we are seeing all over the developed world and now increasingly in much of the developing world, I begin to have cause for serious worry, not to mention multiple reasons to quietly look for the exit.)
Michael Pettis’s post is called “Does It Matter If China Cleans Up Its Banks?” The answer is, “maybe,” but then somebody has to take that debt off the backs of the Chinese banks. Somebody is going to have to clean up the mess from the tickertape parade of massive debt-fueled Chinese growth.
Those of you of a certain age might think of the image of the little sweeper who came along after the parade at the beginning of the Mr. Peabody & Sherman cartoon show back in the late ’50s and ’60s.
Things are back to normal here at Mauldin Universal Headquarters (my home office), which means I am busier than a one-armed paper hanger. But at least my computers and phones and everything is working and I am working out from under an inbox that had 500 emails – down to 407 as I write, with the intention of having it below 350 and maybe even approaching 300 before I go to bed tonight.
For those of you who have asked about the major muscle pull in my leg, after two months I am finally able to walk without looking like an old man and am relatively free of pain; and I think in another few weeks I will begin to actually slowly – emphasis very slowly – rehab it with some mild workouts for a few months before I can get back to whatever it was that was normal for me. When you are limited to upper-body, when you walk into the gym there is only so much you could do at my age. I mean, if you work a major muscle group you really cannot go back to that group for about two or three days. I will admit that leg days are my least favorite, but at least they broke up the routine. I will certainly appreciate them a great deal more in the future and will probably pay more attention to stretching and the other relaxation exercises.
It is getting late for the deadline to send out an Outside the Box, so without any further comment I am going to hit the send button and wish you a great week!
Your wondering if China could be the first domino to fall analyst,
John Mauldin, Editor
Outside the Box
Does It Matter If China Cleans Up Its Banks?By Michael Pettis
Originally published on Michael Pettis’ China Financial Markets, August 31, 2016
Debt matters, not merely its location
Can China “grow out” of its debt burden?
- Causes each unit of new debt to
generate more than 5-7 times as much GDP growth as it does now, or
- Causes all of the assets backed by the total stock of debt (which we assume to be equal to 240% of GDP) to generate 25-35% more GDP growth than they do now.
- Causes each unit of new debt to
generate 18 times as much GDP growth as it is doing now, or
- Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.
- In some cases, as in Mexico in
1989, after many years of struggling unsuccessfully to implement
productivity-enhancing reforms and suffering from low growth and economic
stagnation, governments finally obtained explicit write-downs of the debt
when the debt was restructured with partial debt forgiveness (35% of the
nominal amount, in the case of Mexico). In this case the cost of the
write-down was allocated to foreign creditors, although during the many
years of stagnation workers paid for financial distress costs through
unemployment and suppressed wage growth.
- In some cases governments never restructured their debt, and so never explicitly obtained debt forgiveness, but they did monetize the debt and so obtained implicit debt forgiveness through high levels of inflation (as was the case of Germany after 1919) or through financial repression (as was the case of China’s banking crisis at the end of the 1990s), or both (as was the case of the UK after 1945), in which the cost of writing down the debt was mostly absorbed by household savers. This last point is important because it creates a great deal of confusion among analysts who think that China can resolve its debt problem the same way it did fifteen years ago. China effectively forced the debt-servicing cost onto household savers mostly during the first decade of this century. With nominal GDP growth ranging between 16% and 20% and a GDP deflator between 8% and 10%, lending rates should have probably been at least 13-15%, but instead they were set much lower, betwee n 6% and 7%, and deposit rates even lower, between 2.5% and 3.5%. Negative real lending rates effectively granted insolvent borrowers debt forgiveness every year equal to at least 6-9 percentage points for a decade or longer. Depositors effectively paid for the full amount of the debt write-down as well as to recapitalize the banks. Forcing the cost of the write-down onto household savers worsened China’s imbalances significantly, however. The household consumption share of GDP fell from a very low 46% in 2000 to an astonishing 35% in 2010. This was not a coincidence.
- In other cases in which governments never defaulted or restructured their debt, and so never explicitly obtained debt forgiveness, they implicitly wrote down the debt not by monetizing it but by means that involved allocating the costs to the wealthy in the form of expropriation or to workers in the former of wage suppression.
- Finally in other cases, the most obvious example being Japan after 1990 and now parts of Europe after the 2009 financial crisis, governments never explicitly or implicitly wrote down the debt, and have instead spent many unsuccessful years attempting to implement reforms that will allow them to grow their ways out of their debt burdens. They have failed so far to do so, and after so many years it is hard to see how they will succeed.
Resolving the debt burden
- Creditors. Creditors are forced to absorb the losses associated
with writing down the debt when the borrower defaults on its debt and
restructures it with a principle or interest reduction. Much of China’s
debt burden has been extended through the banking sector, however, and
because the debt that must be written down exceeds the banking industry’s
capital base, ultimately the cost will be passed on to some other economic
sector – for example Chinese households ultimately absorbed the cost of
the banking sector losses generated in the late 1990s.
- The external sector. To pass on costs to foreigners requires that they
have significantly larger exposure to China than they actually do, and
would also probably require defaulting on debt, a path Beijing is unlikely
to choose to follow.
- Ordinary households. Most banking crises, like the recent US and European
crises and the Chinese banking crisis at the end of the 1990s, are
resolved by hidden transfer mechanisms that pass the cost of writing down
debt to households. China today however must increase household wealth,
not reduce it, if consumption is to rise fast enough to allow investment
to decelerate. This process will be explained in more detail further on
but it means ordinary households cannot be allowed to absorb the cost.
- Wealthy households. Given high levels of income inequality, and the low
propensity to consume of the wealthy, forcing them to absorb the costs of
writing down debt – in the form of highly progressive income taxes, for
example – is likely to be among the less costly ways economically for
Beijing to pass on the costs of paying down debt. As their income or
wealth is reduced, the wealthy are likely to convert most of that
reduction into lower savings and very little of it into lower consumption,
thus minimizing its adverse impact on domestic demand.
- Small and medium enterprises. Chinese SMEs are among the most efficient economic
entities in China and are likely to be the main source of innovation and
value creation in the future. Their long-term success is vital to China’s
long-term growth. Like ordinary households they should be protected from
absorbing the costs of Beijing’s debt-management policies.
- Local and provincial
governments. These have amassed a
considerable amount of assets whose liquidation would most efficiently
absorb debt write-down costs and would entail the lowest medium and
long-term costs. As their assets are liquidated, total Chinese savings
will decline and Chinese consumption will remain largely unchanged, thus
minimizing the adverse impact on domestic demand.
- The central government. Beijing too could pay for the cost of writing down debt by liquidating central government assets, although this may conflict with other economic policy objectives, including overcoming vested-interest opposition to the reforms.
- Chinese borrowers can default
or otherwise restructure debt such that the cost of the write-down is
allocated to creditors in the form of a haircut on the debt. Because the
creditors for the most part are the banks, which are insufficiently
capitalized to bear the full brunt of the losses, these losses will still
have to be allocated to some sector of the economy.
- If the regulators avoid
defaults, there are three further potential outcomes. First, the
authorities can implement efficiency-enhancing reforms that cause economic
productivity to surge to the point at which excess debt-servicing costs
can be covered by the additional productivity.
- Second, the authorities can
implement reforms that specifically assign excess debt-servicing costs to
targeted economic sectors in order to minimize the economic or political
costs. For example it can force local governments to liquidate assets, or
it can use taxes to appropriate the wealth of the economic elite, the
proceeds of which are then used to absorb excess debt-servicing costs.
- Finally, if the authorities do not move quickly enough, excess debt-servicing costs, along with financial distress costs, will be allocated to those least able to protect their interests once debt-capacity limits are reached. There are many ways these costs can be allocated in an unplanned way. One way, and among the most likely, is if the debt is effectively monetized by continuous rolling-over of principle and accommodative monetary policy. While part of the cost may be paid out of an increase in productivity, this is likely to be a small part and can only happen to the extent that unemployment is already very high and the costs of increased production are low. Otherwise eventually either financial repression or unexpected inflation (with the former more likely than the latter because of the structure of debt in China) will force most of the costs onto household savers and others who are long nominal monetary assets, while unemployment and real wage suppression will force additional financial distress costs onto workers.