China and a Balance-Sheet Recession

This is a topic I’ve been thinking about a fair bit recently, and to the extent that it is possible to do so, I want to spend some time in thinking about this in greater detail throughout this week. What’s up with China, and how should we think about

  1. What got China where it is today?
  2. Where does China go from here?

There are other things to think about in this regard, particularly as an Indian, but that takes me into the realm of geopolitics, and I know very little about it. One day, maybe. But for now, the question of what got China where it is today.

And lots of things have gotten China where it is today. But one of the many strings that we need to pick up on and see where it takes us begins with a country and a person. The country is Japan, and the person is Richard Koo. Koo is most famous, of course, for having coined the phrase “balance-sheet recession”:

After its stockmarket bubble burst in 1989, share prices plunged by 60% in less than three years. Property prices in Tokyo fell for over a decade. Deflation, by some measures, persisted even longer. Even the price of golf memberships—tradeable on organised exchanges in Japan—tumbled by 94%. Many companies, which had borrowed to buy property or shares in other firms, found themselves technically insolvent, with assets worth less than liabilities. But they remained liquid, earning enough revenue to meet ongoing obligations. With survival at stake, they redirected their efforts from maximising profit to minimising debt, as Mr Koo put it.

How should you think about this? Well, here’s a very simplified example. Imagine that every single household in your locality decides to not spend more in the month of September 2023, but instead save more. That may be good news for each household, but can you imagine what the local grocer, the neighborhood restaurants and the local movie-theater might feel about such a move? Exactly the same thing happened in Japan, but at a national level:

In post-bubble Japan, things looked different. Instead of raising funds, the corporate sector began to repay debts and accumulate financial claims of its own. Its traditional financial deficit turned to a chronic financial surplus. Corporate inhibition robbed the economy of much-needed demand and entrepreneurial vigour, condemning it to a deflationary decade or two.

The question that The Economist article asks and answers is whether China is “going the Japan way”. Note that this has been covered on EFE before, by the way.

And the answer they come up with is yes, but only kinda-sorta. And there’s (of course) more to it than just that. Yes, Chinese firms have accumulated insane amounts of debt, yes China’s house prices are undergoing a massive correction, and yes credit growth has slowed sharply.

But most of the debt is held by SOE’s, and they will borrow more, if that is what the Chinese government desires. And Chinese households drawing down their debts has more to do with the peculiarities of the Chinese market for mortgages than with households having stressed balance sheets. In fact, if anything, Chinese household debts are reasonably low. On the whole, the article argues, Chinese businesses don’t seem to be behaving the way Japanese businesses were in the 1990’s.

So yes, debt reduction is a thing in China, but it’s not quite Japan all over again, not yet. There is a problem, in other words, and it kind of looks like the Japan problem, but only in some ways. Still, it is a problem, there is no getting around that fact.

So how should this problem be solved?

Richard Koo says that the government should spend its way out of this problem. If the private sector is running up fiscal surpluses (saving more), than those savings need to be deployed somewhere. Where? The government should borrow and spend that money, according to Richard Koo.

If you accept that this is a good solution, there is only one problem. It would seem the Chinese government is not willing to play ball:

The country’s budget deficit, broadly defined to include various kinds of local-government borrowing, has tightened this year, worsening the downturn. The central government has room to borrow more, but seems reluctant to do so, preferring to keep its powder dry. This is a mistake. If the government spends late, it will probably have to spend more. It is ironic that China risks slipping into a prolonged recession not because the private sector is intent on cleaning up its finances, but because the central government is unwilling to get its own balance-sheet dirty enough.

And if you’ve got a mild headache thinking through all of this, I’ve got worse news for you. There are other economists who would argue that it is a good thing that the Chinese government is not willing to play ball. Fiscal policy, they argue, is not the way to solve this problem.

So what is their solution?

We’ll find out tomorrow.