Although I should note that I have given up on trying to figure out if it is the best or worst of times. Who knows?
But rhetoric aside, today’s blogpost continues our attempts at trying to understand just what the hell is going on in China. And we do so by reading an excellent report written by Michael Pettis (here are previous EFE posts where Michael Pettis has been mentioned):
In the United States and China, rising debt is structural, and necessary to the way in which their economies currently operate. While it is indeed likely that part of the debt in both countries is due to profligacy, irresponsible behavior, and even fraud, these do not explain the bulk of the increase in debt. Even with the strictest controls, until more fundamental changes are made to the two economies, either debt must continue to rise or growth must slow to politically unacceptable levels—levels that cause unemployment to rise.https://carnegieendowment.org/chinafinancialmarkets/90358
Michael Pettis makes the claim (and in my opinion it is a convincing one) that investment in China is not going to come down anytime soon. Which means, we know by now (see the first two posts of this week), that investment by government will not come down anytime soon. And why will it not come down anytime soon? Because China needs to grow, and growth can’t come from anywhere else but government led investment.
Think of three questions:
- Why does China need to grow?
- If we accept that China needs to grow, how can China ensure that it continues to grow?
- So what happens next? This question I can answer right away, actually. It is, currently, anybody’s guess!
Question 1: why does China need to grow?
Well, because growth is good – is that not a good enough reason?
Sure, it is, but more importantly, a lack of growth is not politically acceptable. How can low growth be possible when it is Xi himself at the helm? And so China Must Grow. Or be seen to be growing. Or don’t see the fact that China is not growing. But preferably, China Must Grow.
Question 2: How can China ensure that it continues to grow?
Well, let’s have China consume more! Except that this is easier said than done:
China suffers from two forms of income distortions that limit demand for Chinese businesses. The one most discussed is income inequality: rich Chinese individuals (like rich Americans) retain a disproportionately high share of household income. But the second, more important form of income distortion is the very low share Chinese households retain of the country’s GDP—roughly 60 percent versus the roughly 80 percent typical in the United States. The low household share of GDP has the same effect on demand as income inequality.https://carnegieendowment.org/chinafinancialmarkets/90358
OK, then how about getting China to invest more?
Well, that pretty much describes the twenty year period between 1995 to 2015 (more or less). But that party ended a while back:
In fact, in more recent years, they have actually reduced investment in response to stagnant domestic consumption. In both the United States and China, the biggest constraint to productive investment by private businesses is weak domestic demand.https://carnegieendowment.org/chinafinancialmarkets/90358
So OK, China has to continue to grow rapidly, but that can’t happen via consumption. Because inequality, and because Chinese households get a very low share of China’s GDP. It can’t happen via private investment either, because faced with weak domestic demand, private investment prefers to stay out of the game. So what comes next? Government led, non-productive investment.
The problem is that around the mid-2000s, investment in infrastructure, property, and government-owned projects in the aggregate began to create less economic value than it cost. The result was that China responded to the high savings of wealthy individuals and the government with a surge in nonproductive investment, which led to a surge in the country’s debt burden. This is the reason that China is forced to encourage a rapid rise in debt as the only way to prevent a rapid rise in unemployment.https://carnegieendowment.org/chinafinancialmarkets/90358
Or, alternatively, if domestic demand is weak, cater to global demand:
China’s trade surplus allows it to externalize a part of the domestic demand deficiencies caused by low consumption, and so reduces the amount of nonproductive investment (and debt) needed to balance Chinese supply and demand. The American trade deficit forces it to absorb foreign demand deficiencies and so increases the amount of debt needed to balance American supply and demand. But while the countries’ different trade positions exacerbate U.S. debt and reduce Chinese debt, it leaves China overly sensitive to changes in external demand and to trade conflicts, while the United States actually benefits from trade conflict.https://carnegieendowment.org/chinafinancialmarkets/90358
But now, post the pandemic, and post the world’s reluctance to remain overly dependent on China, “externalizing domestic demand deficiencies” is no longer possible. And China has done more than its fair share of government-led, non-productive investment. And so China is now faced with two choices:
- Don’t accumulate debt, and therefore grow more slowly. But hey, Great Helmsman, so China Must Grow.
- Accumulate debt, and grow rapidly, but by making stuff nobody wants. But even this has run its course in 2023, it would seem.
There is secret option 3: liberalize markets, let investments be market driven, and let consumption grow organically and therefore eventually more rapidly. This is the theoretically correct answer, if you ask any economist. This is the politically impossible answer, if you ask any political scientist even remotely familiar with China.
Which boils down to the all-important question:
In a fight between good economics and bad politics, who wins?
My answer to this question is another question:
What time horizon do you have in mind?