Last year ended with slightly higher forecasts for global growth and inflation. In part, that reflects expectations of a big new fiscal stimulus measures in the US when US president-elect Donald Trump takes office. However, equally important is the strength of the Chinese economy, with buoyant industrial production fueling a sharp rise in global commodity prices.
That strength has confounded expectations that China’s seven-year credit boom, during which the debt to GDP ratio rose from 150 percent to 250 percent, would inevitably end last year. Some Western investors foresaw a banking crisis, owing to enormous bad debt; others expected that Chinese President Xi Jinping (習近平), having consolidated his political position, would introduce structural economic reforms. However, almost all non-Chinese economists anticipated a significant slowdown, which would intensify deflationary pressures worldwide.
In fact, the opposite happened. Central and local government borrowing in China has soared. Bank and shadow-bank credit has grown rapidly and the People’s Bank of China (PBOC) has increasingly issued direct loans to state-owned banks in a maneuver closely resembling monetary finance of government spending.
In addition, these policies are increasingly justified by assertions that China has policy options not available in Western economies. In an article in July, PBOC statistics division director Sheng Songcheng (盛松成) argued that “the macro framework in a socialist market economy is superior to the Western economy,” because “the Chinese government has significant power in terms of both monetary and fiscal policy, and is able to seek the optimal combination.”
Meanwhile, Xi might have endorsed in 2013 “the decisive role of the market,” but that has not diminished his Marxist-Leninist reliance on the leading role of the state.
Chinese Banking Regulatory Commission Chairman Shang Fulin (尚福林) reminded bank leaders in September last year that they “are primarily party members and party secretaries, and secondarily bank chairman and presidents.”
It seems that in a hybrid socialist market economy, credit-driven growth need not be constrained by concerns about debt sustainability.
In some senses, that is true. Rising Chinese leverage would not produce a 2008-style financial crisis. Most of the debt is owed within the state system — for example, by state-owned enterprises to state-owned banks — and the government could simply write off bad debts and recapitalize banks, financing the operation with either borrowed or printed money. Alternatively, the banks could perpetually roll over existing debt, forever extending new loans to repay old debt.
Of course, that would produce wasted investment. Indeed, with banks failing to impose hard budget constraints on financially unsustainable businesses, and with the planning system incapable of imposing alternative effective discipline, China is already awash with apartment blocks in third-tier cities which will never be occupied and with huge overcapacity in heavy industry.
However, as some Chinese policymakers respond, all growth processes involve waste.
Nineteenth-century railway booms in Britain and the US created huge overcapacity and investor losses, even as they spurred economic transformation. In China huge waste could also be compatible with rapid growth.
Suppose that a full quarter of Chinese capital investment — now running at about 44 percent of GDP — is wasted. That would mean Chinese are unnecessarily sacrificing 11 percent of GDP in lost consumption. However, if the remaining 33 percent of GDP is well invested, rapid growth could still result. Alongside obvious waste, China makes many high-return investments — in the excellent urban infrastructure of the first-tier cities and in the automation equipment of private firms responding to rising real wages.
There are limits in China’s socialist market economy, but they lie on the liability side of banks’ balance sheets, not on the asset side. If bank assets amount to more than 300 percent of GDP — more than US$30 trillion — so, too, must the combination of bank deposits, bank bonds, wealth-management products or other bank liabilities held as assets by companies and individuals.
What these investors do with their holdings is crucial. If they shift their money abroad, the managed exchange rate would become unsustainable. Even China’s US$3 trillion of foreign-exchange reserves, down from close to US$4 trillion in 2014, look small next to US$30 trillion of financial assets. Every Chinese is legally entitled to take US$50,000 out of the nation each year and if just 1 percent of adults have the wealth to do so, that could mean annual capital outflows of US$500 billion.
In addition, in an economy open to trade and direct investment, both inward and outward, there are multiple opportunities to disguise short-term flows of financial capital as current-account and long-term-investment operations. Rapid credit growth was therefore matched last year with tightening restrictions on capital flows, with more likely this year.
The alternative policy would be to let the exchange rate fall. However, that risks an aggressive response from a protectionist Trump administration and it could produce self-reinforcing inflation as savers seek to spend their money before it loses value.
Even a hybrid socialist market economy faces constraints if it also wishes to be an open economy. Sharp contradictions between different strands of Chinese policy are becoming ever more obvious.
The root of these contradictions is the absence of hard budget constraints — of either a market or a planned-economy form — on state-owned enterprises and local governments.
The barriers to reform are political — unwillingness to face public-sector job losses, particularly in China’s northern rust belt, and radical decentralization of economic decisionmaking to competing city and provincial governments.
What will happen next is uncertain. The optimistic scenario is that private-sector job creation and rapid population aging would cause the labor market to tighten, which would make employment protection a less pressing concern — and make reform more politically palatable. The pessimistic scenario is that political power structures would forever frustrate reform.
From outside the Chinese power system, it is impossible to know which approach policymakers will pursue. However, the longer the credit boom continues, the less likely that China can achieve a smooth transition to a sustainable economic path.
Adair Turner, a former chairman of the British Financial Services Authority and former member of the British Financial Policy Committee, is chairman of the Institute for New Economic Thinking.
Copyright: Project Syndicate
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