Markets

The Denouement: China Enters Lost Decade

You can download a pdf version of this research note here.

China’s asset price bubble is rapidly unraveling despite Beijing’s frantic efforts to stem the tide. Before long, China is likely to enter a full-scale financial panic; followed by secular stagnation that may last as long as Japan’s lost decade. The Chinese panic marks the third round of crises since 2007; the first being the panic of 2007-2008 centered at the US; the second, the eurozone crisis of 2010-2013. All three have been driven by the systematic unraveling of global imbalances.

We have previously argued that global imbalances are the result of the high-savings strategies pursued by Germany, Japan, and China. What is unfolding in China and global markets in the summer of 2015, is nothing short of the denouement of China’s high-savings strategy. In what follows, I will show why this is to be expected and argue that China is entering into its lost decade; with vast implications for global markets and the balance of power in Asia.

Theory of large open economies

In an isolated economy without a financial sector, equilibrium national income, {y_*}, is implicitly determined by equating desired saving and investment,

{\large I(y)=S(y)}

Introducing a money market, we obtain the familiar IS-LM equations with two endogenous variables: national income and the interest rate.

{\large I(r,y)=S(r,y)}

{\large L(r,y)=M(r,y)}

where L and M are the demand and supply of loanable funds. In other words, the LM curve, equation (3), shows the combinations of national income and the interest rate for which the money market clears. The simultaneous solution of equation (2) and equation (3) determines the equilibrium interest rate {r_*} and national income {y_*}.

The Mundell-Fleming model is an extension of the IS-LM model for a small open economy in an international order with perfect capital mobility; and hence, a single global interest rate. The economy is small in the sense that developments in the economy have no perceptible effect on the global interest rate. This assumption effectively means that the interest rate {r_w} is given exogenously. Assuming that there is a single currency in the national and international economy, one obtains the governing equation for national income,

{S(y) = I(y) + X(y),}

where {X(y)} is the net capital outflow (“net exports” or “excess savings”).

Now consider an isolated bipolar system consisting of two open economies trading with each other. Assume again for the sake of brevity that both use the same currency. We then have a set of three equations that determine the national incomes of the two poles as well as the global interest rate.

{\large S_{1}(r,y_{1},y_{2})=I_{1}(r,y_{1},y_{2}) + X_{1}(r,y_{1},y_{2}),}

{S_{2}(r,y_{1},y_{2})=I_{2}(r,y_{1},y_{2}) + X_{2}(r,y_{1},y_{2}),}

{\large 0=X_1(r,y_1,y_2)+X_2(r,y_1,y_2)}

where {y_{i}} is national income of country {i=1,2} and {r} is the global interest rate. The first two equations require the difference between domestic desired savings and investment to be equal to net exports of the country. The last follows from the balance of payments identity under the bipolar assumption.

Figure (1) displays the comparative statics of an exogeneous upward shift of the savings in one country (“China”) on the equilibrium interest rate and the balance of payments in the bipolar system described by the above equations. The left panel shows China’s saving and investment at given levels of the global interest rate; the middle one shows the saving and investment in the United States; and the right panel displays the excess savings of China and the United States trade deficit.

Savings Investment and Trade balance in a bipolar system

An outward shift of China’s savings curve is reflected in the balance of payments, the figure on the right. The savings shock pushes out China’s excess savings curve to the right. The new equilibrium features a larger current account surplus in China (equivalently, a larger current account deficit in the United States). The larger the shift, the large the trade imbalance. China has effectively pushed its unwanted savings out to the United States and imported demand. This is the essence of China’s high-savings strategy.

The equilibrium interest rate is determined by the intersection of the excess savings curves. The new equilibrium interest rate is lower than before the exogeneous savings shock. This is the source of Greenspan’s conundrum—the failure of long-term rates to rise despite monetary tightening—that Ben Bernanke called the “global savings glut.” The lowering of the global interest rate causes an expansion of investment in both the United States and China, both of which are higher than before the exogeneous savings shock.

China’s high-savings strategy

There is nothing particularly novel about China’s high-savings strategy. Other states, most notably Japan, have followed essentially the same strategy. Namely, push down consumption and channel the high savings into growth enhancing investments. The basic weapons in the underconsumptionist arsenal are financial repression, wage suppression, and underpricing of the national currency. Since 2000, Beijing has deployed all three with gusto.

China practices a strong form of financial repression. The People’s Bank of China (PBoC) administers ceilings for interest rates on deposits and floors for lending rates. This ensures comfortable interest rate spreads for banks and keeps the cost of capital low for firms. In 2000-2009, the average loan in China was taken out at 5.84 per cent, compared to 9.41 per cent in the nineties. The repression of interest rates is effectively a tax on households and a subsidy for borrowers—the state and state-backed firms, exporters, and real estate developers. The low rates have allowed an investment boom of unprecedented proportions.

China has a vast reserve army of workers, around 320 million strong, who are underemployed in the traditional sector. This has naturally kept wages from growing rapidly; in accordance with the familiar Lewis model. However, China’s wage supression is also the result of concious draconian policies. For example, migrant Chinese workers from the interior, who work illegally in the coastal areas, have no legal recourse against their employers. And Beijing is always quick to respond with police power at the first sign of labor unrest. The result is that real wages have grown slower than productivity.

When a central bank intervenes to keep the currency undervalued, it accumulates the reserve currency. China’s stupendous pile of 4 trillion dollars in official reserves attests to the scale of the PBoC’s efforts to keep the renminbi down. The appreciation of the renminbi is no more than what would be natural of a developing country—the so called Balassa-Samuelson effect. Because the PBoC has not allowed the renminbi to appreciate at anywhere near the market-clearing pace, China has continued to accumulate foreign exchange reserves at a rapid clip.

China’s high savings strategy has driven its consumption rate down to a mind-boggling 36 per cent of GDP, if the World Bank numbers for 2013 are to be believed. By comparison, the United States consumes 69 per cent of GDP; while Germany and Japan, both high-savings countries, consume 56 per cent and 61 per cent of GDP respectively. Meanwhile, China’s gross investment rate is 48 per cent of GDP; another record. The gross investment rate in the United States is 19 per cent, while the German investment rate is 19 per cent and the Japanese is 21 per cent. However, unlike the other poles in the center of the world economy, China is a developing country. Its rate of investment ought to be higher. Still, a country investing nearly half its national income is likely to be misallocating capital on a massive scale. This is indeed the case, as we shall see presently.

The bottomline is that China’s savings rate far exceeds its investment rate. This means that China has been pushing its unwanted savings onto its trade partners—the United States above all—and importing demand; in accordance with the theoretical analysis of the previous section. This crucial observation means that while China’s growth model may be called export-led or investment-led, in terms of its impact on the global economy, it is more properly called a high-savings strategy.

Denouement

The collapse of global demand in the aftermath of the Western financial crises meant that China could no longer rely on importing demand from its major trade partners; especially Europe. Beijing’s immediate response was to cut interest rates and launch a six-hundred billion dollar stimulus channeled through state-owned enterprises (SOEs). Money poured into infrastructure and housing; exacerbating the overinvestment in these sectors. While the fiscal stimulus may have been enough to buoy up investment demand in the short run, a one-off injection was always unlikely to solve China’s demand deficit problem even in the medium term.

The real solution hit upon by China—and here again it was following in Japan’s footsteps—was to expand debt. Between 2007 and 2014, China’s overall debt grew from 158 per cent to 282 per cent of GDP, or about 28 trillion dollars. An estimated 30 per cent of it is held by shadow banks. Lending by shadow banks has grown at 36 per cent since 2007; compared to 18 per cent for bank lending. Meanwhile private debt-to-GDP ratio rose from 100 per cent to 180 per cent. By comparison, US private debt-to-GDP peaked at 170 per cent in the depths of the Great Recession. The unprecedented expansion of debt yielded a supermassive asset price bubble; most especially in real estate. More than half of China’s ballooning debt, about 45 per cent, is tied to property.

Before the Chinese financial panic began this summer, China’s stock market had more than doubled in value in the preceding twelve months. The Shanghai Composite Index rose from around 2,000 in July 2014, to above 5,000 in June 2015. But the real bubble was not in the stock market—it was centered on real estate. Since 2008, land prices have increased fivefold. In 2013 alone, real estate prices rose 27 per cent. The scale of overinvestment in China’s real estate is truly stupendous. In just two calendar years, 2011 and 2012, China produced more cement than the United States did in the entire twentieth century. China has 75 billion square feet—five years’ worth of annual demand—of new property coming online. With demand falling instead of rising, the real estate bubble began to pop at the beginning of 2015. Proceeds from land sales plunged 30 per cent compared to the year before. New home prices fell for four straight months and are down 6 per cent year on year.

In China, unlike in all other polar economies, the government owns almost all the land and two-thirds of its productive assets. Local governments enjoy a monopoly over the supply of land by controlling the opening of agricultural land to urban development. Proceeds from land sales account for the bulk of the revenues of local governments. For instance, land sales accounted for 46 per cent of local government revenues in 2013. But most of the cash in the coffers of local governments comes from loans secured through shell companies using public land as collateral. There is an obvious limit to debt expansion on the backs of overvalued marginal land: It can only go on so long as the real estate bubble keeps inflating.

Once land prices started falling, local government borrowing and debt settlement became difficult; to put it mildly. Beijing’s response was to push a massive debt swap. Local governments would issue nearly half-a-trillion-dollars worth of long-term bonds and retire an equivalent amount of risky short-term debt. While this is a step in the right direction, the scale of the toxic debt hidden in opaque off-balance sheet vehicles is unknown.

In 2013, China announced that private investors may take minority positions in the roughly one hundred and fifty thousand state-backed firms. This has exacerbated the distortion of the economy in favor of the inefficient state sector. The borrowing costs of state-backed firms is significantly lower than private firms so that they have cornered the capital that would otherwise flow to the more productive counterparts in the private sector.

Beijing’s trilemma

Beijing wants to avoid a full-blown financial crisis, rebalance the economy away from dependence on exports, and keep up growth rates. The hard truth is that there is no way to achieve all three objectives. Indeed, Beijing will be hard-pressed to accomplish even one of the above.

The immediate problem facing policymakers in Beijing is the slow-motion bursting of the asset price bubble. Beijing has already tried direct intervention in the stock market. Less well-known is the manipulation of land prices by local governments—by getting pairs of state-backed firms to buy and sell at inflated prices. Both efforts have largely failed so far. Even if these and other measures do succeed in propping up asset prices, they will exacerbate the deeper problems facing the economy—the build-up of toxic debt in the shadow banking system, the massive overinvestment in property, and the misallocation of resources with the attendant slowdown in productivity—which will further lower growth rates.

Many observers suggest that China has enough firepower—4 trillion dollars—to hold the tide in a financial panic. However, China cannot deploy its reserves at any appreciable scale without considerably strengthening the renminbi and absorbing a large negative demand shock through the external account. As the panic continues to built this autumn, Beijing might very well be forced to take this route. A massive appreciation of the renminbi would indeed accomplish a rebalancing and perhaps even avoid a full-blown financial crisis. But it would be do so at a considerable cost: Growth rates under this scenario will be sharply lower; perhaps even negative.

Some have argued that Beijing has demonstrated considerable skill in managing economic shocks. The central government has indeed moved deftly to deal with demand shocks. As a rule, this has been accomplished by directing state banks to expand lending and pushing state-backed firms and local governments to expand investment. But expanding investment is not a solution to a crisis of overinvestment. All that can hope to accomplish is to perhaps postpone the day of reckoning. And when the crash finally comes, it would be even bigger than otherwise.

Maintaining high growth rates in the medium term will be especially hard. The chief obstacle to maintaining high growth rates is the considerable misallocation of resources. The overinvestment in property is likely to take years to work itself out. State-backed firms have cornered the lion’s share of resources at the expense of more efficient private firms. This distortion is unlikely to unwind by itself due to the backing of the state. Indeed, it is getting worse as of writing. Both of these distortions will have to reverse for growth prospects in the medium term to brighten. Growth will also be harder to maintain unless the build-up of toxic debt is taken care of. This is best done in one fell swoop. It would require Beijing to transfer these debts onto its own balance sheet. The central government debt is thereofore likely to balloon—yet again, following in Japan’s footsteps.

The 800-pound gorilla in the room is of course rebalancing the economy away from its dependence on external demand. This would require an unwinding of China’s high savings strategy. As argued in Section 2, China’s high savings are the result of financial repression, wage supression, and an undervalued exchange rate. In order to rebalance the economy, China must liberalize interest rates, raise wages, and let the renminbi appreciate. Rebalancing would significantly reduce growth rates down to perhaps 3 per cent per annum. But on the bright side, real household income would rise at a faster clip; leaving people actually better off despite the slowdown in the economy. 

The ideal strategy for Beijing is to therefore to avoid a full-blown financial panic and rebalance the economy at the expense of growth rates. However, it is hard to see policymakers in Beijing pursuing this strategy for the simple reason that all the heavy-weights in the Party have very close ties to the beneficiaries of China’s high savings strategy. The rank and file of the Party is also unlikely to be anywhere close to being enthusiastic about a strategy that promises a growth rate of 3 per cent per annum. Beijing’s policy response is therefore likely to be muddled and rudderless.

China is unlikely to sustain high growth rates for the foreseeable future. Given the weight of China in the world economy, the implications for global markets are dire. The ride ahead will be bumpy. Despite the recovery in the United States, the Fed will find it impossible to exit the zero lower bound in September and perhaps even December. US primacy in Asia will endure for much longer than expected hitherto. The party is officially over.

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