For the past ten years much of what I have written about debt in China was aimed mainly at trying to convince analysts and policymakers that the Chinese economy was structurally dependent on an unsustainable increase in debt in order to generate GDP growth rates above some level. This level might have been around 5-6% ten years ago but it has steadily declined with the rising debt burden and is currently probably not much above 2-3%.

Michael Pettis Pettis, an expert on China’s economy, is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. More >

Today it no longer seems necessary to explain that Chinese debt levels are far too high. On May 9 thePeople’s Daily published a major front-page interview with an “authoritative figure”, thought to be very close to Xi Jinping, warning that the Chinese economy was in much worse shape than many believed largely because debt had risen far too quickly. Here is the South China Morning Post:

A People’s Daily article published yesterday showed that China’s leadership is trying to make a grand shift in the nation’s economic policies in a bid to say goodbye to debt ­fuelled growth. In a sign of distaste for the credit-pumped growth in the past couple of months, the Communist Party mouthpiece cited an unidentified “authoritative” figure as saying that boosting growth by increasing leverage was like “growing a tree in the air” and that a high leverage ratio could lead to a financial crisis.

“The whole world”, according to the China Daily the next day, “seems to be talking about the People’s Dailyinterview on May 9.” It went on to say:

The People’s Daily article is good for all local officials to study and to follow. The message cannot be clearer. If it is from the top leadership, as some readers speculated, then what it represents is a requirement on the policy level – cut the debt level, by whatever means. Deleveraging, or cutting down indebtedness, is in fact listed as one of the five tasks of China’s supply-side reform for 2016. Now that half a year already has passed, at least some action should be taken during the remainder of the year, as the interview suggests.

Probably the real indication that the argument over whether or not China has a debt problem has been resolved is a May 7 article in the Economist. For years I had been extremely frustrated by the magazine’s coverage of the Chinese economy as being far too credulous and altogether too willing to assume away problems that other countries in similar circumstances had been unable to resolve.

Not all periodicals were so frustratingly cheerful. The Financial Times had long been writing about China’s balance sheet risks, with the FT Alphaville blog in particular zooming in on the key monetary and balance sheet vulnerabilities that by now have become so familiar to everyone else. Every time new evidence came out that suggested debt levels in China were becoming worrisome and needed to be addressed, however, the Economist responded by dismissing concerns over the debt as overblown. It consistently seemed to argue that China could easily manage it rising debt burden.

Last month, however, in a much-commented departure, the Economist suddenly reversed positions, warning that debt levels had become so extreme that “it is a question of when, not if, real trouble will hit in China.” In an alarming, but not alarmist, piece, the magazine acknowledged how serious China’s balance sheet distortions had become:

China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.



China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.

The article ended with what all of us should have been saying for nearly a decade: China’s debt burden would have been relatively easy to manage had Beijing started doing so much earlier, under Hu Jintao’s presidency. It is no longer easy to manage, but the longer Beijing waits to begin the deleveraging, the more difficult it will be:

One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.



Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.

Finally there is consensus

This, I think, is really the key point. There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.

Not that most analysts understand how important it is to constrain credit growth, the task is to explain exactly why debt is a problem, how it will undermine growth, and why many of the “solutions” that economists propose are simply not solutions at all. These “solutions” include a number of especially treacherous ideas: China’s rising debt can be managed for quite a long time before it becomes a serious constraint, countries have near-infinite capacity for domestic debt when it is “backed” by even greater amounts of savings (this is an especially foolish conceit), China can easily monetize the debt at no significant cost, or the right solution is to improve productivity to the point at which economic growth can outpace credit growth (it is nearly impossible to find a trained economists who doesn’t think this last is self-evidently the only way to approach the problem of debt management).

A little over a year ago in the newsletter I send out to my clients I tried to explain how debt constrains growth. In that issue of the newsletter I discussed debt generally, as it affects any kind of macroeconomic balance sheet, but of course the focus was on China. In the newsletter I posited a number of rebalancing scenarios in order to try to work out the implications fro debt. I have made some small adaptations to these scenarios but most of the rest of this blog entry is taken from that newsletter. One obvious consequence or revisiting this one-year-old exercise is to make clear just how optimistic were the assumptions I made in designing the various scenarios.

Economists are trained with models in which the structure of the balance is barely relevant to growth except to the extent that fear of a debt crisis undermines confidence. Of course this completely circular reasoning cannot be true except if we assume that the fear of a debt crisis is totally irrational – as it must be if growth is not otherwise affected by the structure of the balance sheet. Still, the implications of these totally unrealistic models seem to dominate the kinds of reforms that policy-making advisors have proposed even since Xi Jinping has come to office, and if my suspicions are right, and Xi and those closest to him have become intensely frustrated by the advice both Chinese and foreign advisors have proffered, we may be in for a much needed change.

The first implication of the balance sheet approach to reforms is that given extremely high debt levels there really is no easy way to rebalance the Chinese economy. It is foolish to think that China’s adjustment will be anything other than extremely difficult, and it is in the best interest of China that the challenges facing the Xi administration are not minimized.

Examining China’s debt scenarios

To show why, I thought it might be helpful to summarize the various scenarios for rebalancing and non-rebalancing that I presented to my clients over a year ago. In the table below I look at three possible scenarios in which China is able to maintain current GDP growth rates of 6-7%, with three different amounts of government transfers to the household sector expressed as a share of GDP. This is followed by three possible scenarios in which GDP growth rates drop to 3-4%, with the same three different amounts of government transfers to the household sector expressed as a share of GDP.

I divide each of these scenarios into two time frames. The first is the next three years under President Xi Jinping, and the second is the last three years of his administration (assuming, of course, that Xi, like his predecessors, serves two five year terms).

These scenarios are very rough, and I have tried to select the most optimistic and least disruptive conditions and assumptions. I assume that debt is easily refinanced, that rising debt imposes no financial distress costs, that the amount of unrecognized NPLs is too small for their refinancing to have a significant impact on the growth in credit, and that the growth in household income is not highly correlated with investment growth. I think these assumptions are very optimistic, to the point of seriously underestimating the difficulty of the rebalancing, but they nonetheless help us frame the set of possible outcomes by pretending that all those costs that are hard to quantify are negligible, even zero.

In the first of these three scenarios I will assume that it is politically very difficult for the Xi administration to transfer significant amounts of wealth from the state sector to the household sector – either directly, in the form of transfers of assets to household or to the social safety net, or indirectly in the form of houkou reform, the sale of assets to pay down debt, and so on. In this scenario in other words I assume total transfers are negligible.

Growth remains at 6-7%

No government transfers

2016-2019

Debt growth is steady at 12-14%

Investment growth is steady at current levels

Consumption growth is steady at current levels

Growth in household income is steady and household share of GDP is unchanged

No rebalancing

2020-2023

Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP

Debt growth rises to 15-18%

Investment growth is steady at current levels

Consumption growth is steady at current levels

Growth in household income is steady and household share of GDP is unchanged

No rebalancing

This scenario posits no consequent changes in any of the main variables. Investment and consumption continue growing at current rates, with no change in overall GDP growth (I am ignoring possible changes in the current account). For this to happen, debt must continue growing at current levels of roughly 12-14% annually. I have argued many times before that China is now in a stage – similar to that of the late stages of every other country that has experienced a growth “miracle” – in which so much bad debt remains unrecognized within the banking system that credit growth must accelerate simply to maintain current levels of debt financing for economic activity.

This means that even maintaining current levels of investment, consumption and GDP growth implies accelerating credit growth. Since I sent out the newsletter last year I have already been proven vastly optimistic on this assumption because the latest data just one year later suggest that debt has been growing by 15-17% to maintain 6-7% GDP growth. I suspect that within another year debt will be growing by much closer to 20%.

But I want to be extremely conservative so as to give the optimists every chance for the arithmetic they implicitly use (but don’t seem explicitly to recognize) to work. I will assume, then, that there is no need to accelerate credit growth from levels at the beginning of last year and I will assume that the acceleration we have already seen this year was somehow an aberration that can be reversed (I assume this fir the sake of conservatism. Of course, and not because I think it is remotely likely). I also ignore the financial distress effects I discuss above, even though there is an overwhelming amount of evidence that suggests that as debt levels grow and create increasing uncertainty about their resolution, economic growth slows fairly automatically and rapidly.

The key point about this scenario is that if we maintain current levels of consumption, investment and GDP growth, at the end of three years even conservative assumptions imply that China’s already high debt levels rise, as the table shows, by at least a quarter (i.e. if debt is currently equal to 200-240% of GDP, it rises to 250-300% in 3 years). I don’t show in the table that at the end of six year, debt would rise again by at least one-third, so that it would amount to perhaps 330-400% of GDP.

Debt probably already amounts to more than the 200% of GDP recorded in the June 2015 release of the World Bank’s China Economic Update (pp. 23), with many claiming that it is closer to 250%. Whatever the actual debt ratio, it is hard to imagine that the growth in Chinese debt, already among the fastest ever recorded in the developed or the developing worlds, can be maintained at anywhere near current levels for more than two or three years. The same World Bank report suggests (pp. 6) that there may already be strains in Beijing’s ability to maintain credit growth:

Policy interventions are increasingly focused on unlocking new funding sources. Besides promoting public–private partnerships (PPPs) as a new funding model for infrastructure funding, there have been efforts to intensify use of policy banks. Further, in April the State Council expanded the use of the Social Security Fund to buy local government bonds and other financial instruments. The new rules allow it to invest up to 20 percent of its portfolio in local government debt and corporate bonds.

It may very well be that Beijing’s credibility is so strong that even substantially higher debt levels won’t matter, but I would argue that it will not be easy to manage another three years of debt rising much faster than debt servicing capacity, let alone six, and if this happens it must undermine confidence, even without more credibility setbacks, like the stock market panic earlier this month.

The new normal with government transfers

The “muddle through” scenario, in other words, in which current investment and consumption growth rates are maintained, and with them current GDP growth rates, is an extremely risky one and, in my opinion, makes the possibility of a hard landing as China runs into debt capacity limits very high. Debt capacity limits are reached, as I have long maintained, when debt cannot grow fast enough to cover its two main functions: First, it must grow at a geometric rate to roll over old bad debt as well as new bad investments whose principle and interest cannot be met by increases in productivity, and second, it must grow at a linear rate to invest into new projects that generate the targeted growth in economic activity. This will be made worse if rising debt uncertainty causes wealthy Chinese residents to disinvest locally and send money abroad at even faster paces than they have in the past, but as I point out above, I am ignoring this possibility so as to present the most optimistic scenario.

But Beijing can tray another strategy. Instead of simply muddling through, Beijing might try to maintain current growth rates while transferring wealth to the household sector to force up consumption growth. I posit two scenarios, one in which Beijing is able to transfer 1-2% of GDP every year, and a second in which Beijing is able to transfer 3-4% of GDP every year. The first scenario will be hard enough to pull off politically, and the second extremely implausible, but I include both to give a sense of the range of outcomes.

In the two transfer scenarios I assume that the decline in investment has no adverse impact on household income because its impact on employment is more than counterbalanced by the rise in consumption. With household income at a little more than half of GDP, the transfers would cause household income growth to rise by 2-3 and 6-7 percentage points respectively, and I assume that this translates directly into equivalent increases in the consumption growth rate (i.e. I assume, perhaps very optimistically, that rising debt does not create enough economic uncertainty in the minds of Chinese households to cause them to raise their savings rate).

Growth remains at 6-7%

Annual government transfers of 1-2% of GDP

2016-2019

Debt growth drops to 9-10%

Investment growth declines by 2-3 percentage points

Consumption growth rises by 2-3 percentage points

Growth in household income rises by 2-3 percentage points and household share of GDP rises slightly

Minimal rebalancing

2020-2023

Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

Debt growth rises to 11-13%

Investment growth declines by another percentage point

Consumption growth is steady

Growth in household income is steady and household share of GDP rises

Gradual rebalancing

The key point to which I would want to draw attention is the impact on the country’s balance sheet. In both cases the surge in household income would allow Beijing to bring down investment growth much more aggressively and so to rein in debt growth.

Growth remains at 6-7%

Annual government transfers of 3-4% of GDP

2016-2019

Debt growth drops to 8-10%

Investment growth declines by 6-7 percentage points

Consumption growth rises by 6-7 percentage points

Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher

Material rebalancing

2020-2023

Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

Debt growth rises to 6-8%

Consumption growth declines by 1-2 percentage points

Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher

Material rebalancing

In both scenarios debt continues to grow, but in the second scenario it is now almost in line with the growth in GDP, which we are assuming is no higher than the growth in debt servicing capacity. While the first scenario implies that the debt-to-GDP ratio has increased by 10-15% (or, if debt is currently equal to 200-250% of GDP, it will rise to 220-290% of GDP in three years and 260-340% in six years), the second scenario implies a gradual rise in the debt-to-GDP ratio. The lower end of the estimate, I think, might be sustainable, although no developing country has managed to sustain such high levels of debt as the higher end, and it requires an implausibly high annual transfer of wealth from governments to households of 3-4% of GDP.

Adjustment with slower growth

What happens if Beijing reins in credit growth and forces down the investment rate much more aggressively, so that GDP growth rates drop to 3-4%? The decline in investment growth will cause growth in consumption to decline too, but not by as much, given that the decline in investment would affect the more capital-intensive public sector. I will assume that there is no significant rise in unemployment because Beijing will allow debt to rise to keep unemployment down while it manages the transition to a more consumption-driven economy, in which demand tends to be more labor-intensive.

Again I will consider three scenarios, the first of which involves no transfers of wealth from the government sector to the household sector. The second two will include a manageable transfer of 1-2% of GDP annually and a highly implausible transfer of 3-4% of GDP annually.

Growth remains at 3-4%

No government transfers

2016-2019

Debt growth drops to 6-8%

Investment growth declines by 4-6 percentage points

Consumption growth declines by 2-4 percentage points

Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher

Material rebalancing

2020-2023

Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

Debt growth is steady at 6-8%

Investment growth is steady at current levels

Consumption growth is steady at current levels

Growth in household income is steady at current levels and household share of GDP is materially higher

Material rebalancing

As in the first three scenarios I would argue that the key point is what happens to debt, as this, more than anything else, determines the sustainability of the growth model and how much time Beijing has to manage the rebalancing. In this scenario the debt burden continues to rise, but after three years the debt-to-GDP ratio is likely to be only 10-15% higher than it is today.

Growth remains at 3-4%

Annual government transfers of 1-2% of GDP

2016-2019

Debt growth drops to 5-6%

Investment growth declines by 7-9 percentage points

Consumption growth is flat

Growth in household income is flat and household share of GDP is higher

Material rebalancing

2020-2023

Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

Debt growth is steady at 5-6%

Investment growth is steady at current levels

Consumption growth is steady at current levels

Growth in household income is steady at current levels and household share of GDP is materially higher

Material rebalancing

If Beijing is able to combine lower growth with government transfers equal to 1-2% of GDP annually, the growth in debt will barely exceed GDP growth (under admittedly optimistic assumptions), and finally, if Beijing transfers 3-4% of GDP annually, the debt-to-GDP ratio begins to fall almost immediately.

Growth remains at 3-4%

Annual government transfers of 3-4% of GDP

2016-2019

Debt growth drops to close to zero

Investment growth is zero

Consumption growth rises from current levels

Growth in household income rises from current levels and household share of GDP is materially higher

Substantial rebalancing

2020-2023

Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

Debt growth drops to well below GDP growth

Investment growth is steady at current levels

Consumption growth is steady at current levels

Growth in household income is steady at current levels and household share of GDP is substantially higher

Substantial rebalancing

Clearly the more wealth is transferred to the household sector, or the more Beijing is willing to allow the economy to slow, the more stable is China’s economic adjustment and the less painful economically over the long term. Greater transfers and slower growth, however, both come at the expense of the vested interests who oppose the reforms, and so it is politics, more than economic logic, that will determine the success of China’s rebalancing strategy.

I should note that there are so many moving parts to this analysis and so many simplifying assumptions, that the scenarios listed above should not be taken as predictions. There are important points, however, that I think emerge from this scenario analysis.

First, even after overwhelming the analysis with implausibly optimistic assumptions – discounting the disruptions caused by shifting strategies, for example, assuming financial distress costs are close to zero, and ignoring the impact on debt sustainability that results from rolling over a significant share of total loans that cannot be repaid – it is pretty clear that without a major change in policy or a tolerance for slower GDP growth it will be hard to prevent debt from becoming unsustainable. At some point, and my guess is that this would occur within the next two to three years at current growth rates, China runs the risk of a very disruptive adjustment as it reaches debt capacity limits, perhaps even the risk of negative GDP growth rates.

Second, any analysis of future growth that doesn’t tie changes in the growth rates of investment, consumption and government transfers to changes in debt levels misses out on perhaps the most important constraining factor. I think failure to understand this point explains, by the way, why over the past few years very few economists had expected GDP growth to slow as sharply as it has, and debt to rise as quickly, or allowed for either in their projections.

My guess is that the same economists will continue to make the same mistakes. To avoid doing so, as we continue to make projections about growth in GDP or in any of the drivers of GDP, we must estimate their impact on debt and how this further constrains our assumptions about growth in GDP or in its drivers. This requires a deeper understanding of how balance sheets affect growth.

What is inevitable and what is possible

Unfortunately, much of the analysis we have seen on China in the past two decades almost completely ignores the balance sheet. Four years ago one of my clients sent me a research report by Standard Chartered in which their China analyst warned that while Chinese debt levels were still easily manageabble, there was a chance, no longer insignificant, that credit growth could speed up sharply and debt eventually become a significant constraint for policymakers. Things were fine for now, the analyst seemed to suggest, but it was possible that Beijing could mismanage its way into a debt problem.

The overwhelming consensus at the time was that China’s growth model was healthy and sustainable, and would generate GDP growth rates for the rest of the decade that were not much lower than the roughly 10% we had seen during the previous three decades. My client sent me the report along with the comment that the sell-side was finally recognizing that the Chinese economy was at risk. A leading analyst who had long been part of that consensus was, he said, finally beginning to understand the Chinese economy and the problems it faced.

I wasn’t so sure. It seemed to me that those who understood the Chinese growth model would have also understood that its overreliance on investment to fuel growth, combined with the structure of its credit markets, extremely low interest rates, and wide-spread moral hazard, made soaring debt almost inevitable and that debt was already constraining policymaking.

To suggest that this might happen only if the new administration – that of Xi Jinping – mismanaged the process suggested to me that the analyst did not really understand the self-reinforcing relationship between rising debt and slowing growth and was underestimating how difficult it would be for the new administration to break out of this process. There is in other words a very big difference between acknowledging that China has a lot of debt and understanding how debt and debt creation are embedded within the financial system.

I think this was exemplified last year when the NBR’s journal for Asian economic research, Asia Policy, put together a roundtable to review Nicholas Lardy’s very detailed and carefully argued book, Markets over Mao. I was one of the five analysts who were asked to participate in the reviews. Lardy is one of the best informed and most knowledgeable of the economists covering China and so I was honored to be invited to review the book. In my review I praised his book for the quality of its analysis, and it well deserves that praise.

But there was a fundamental disagreement in how he and I interpreted the data. Lardy believes China is in good shape economically and concludes with very optimistic growth forecasts. Based on the same data and absorbing much of his analysis and interpretation of that data (I have been reading Lardy for many years) I expect growth to slow sharply. The current consensus for China’s long-term growth at the time, I think, was around 6-7%. Lardy thinks this is a low number, and has said that with the right reforms “China could grow at roughly 8% a year for another 5 or 10 years.”

I believe, however, that he is wrong. The reforms he means consists largely of productivity- or efficiency-enhancing reforms aimed at boosting growth by implementing what I refer to as “asset-side management”. But to me these asset-side reforms are barely relevant at this stage, although had they been implemented a decade ago China might not be in the difficult balance-sheet position it is in today. I have argued instead that without a massive and fairly unlikely transfer of wealth from the state sector to the household sector, the average Chinese GDP growth rate under Xi Jinping cannot exceed 3-4%, no matter how aggressively Beijing implements the standard grab-bag of orthodox reforms offered by orthodox economists.

These are the same reforms offered not just in the case of China today but during nearly every debt crisis in modern history, including to policymakers in peripheral Europe following the 2009 crisis. As far as I can tell there is not a single case in modern history in which the reforming country was able to grow its way out of its debt burden. Instead the debt burden has always increased until the country either engineers or is forced into explicit or implicit debt forgiveness.

That is why we disagree so strongly in our forecasts even though I largely accept his analysis of the Chinese economy. We disagree for the same reason I disagreed with the Standard Chartered China strategist who saw an unsustainable debt burden simply as an unlikely but possible result of policy mismanagement rather than an inevitable consequence of a structural dependence on debt. We disagree, in other words, not on the fundamental data but rather in our understanding of debt dynamics and the constraints the balance sheet can place on an economy’s “fundamental” operations.

As I see it there are at least two important disagreements here. The first is about the impact of balance sheet structures on exacerbating volatility. Neither Lardy nor the Standard Chartered analyst seem to recognize how the balance sheet might affect growth in the future and how it affected growth in the past. For me, however, this has been and continues to be a key component of the Chinese economic “miracle”, and indeed also of every previous growth miracle. As I said in my review:

Clearly the more wealth is transferred to the household sector, or the more Beijing is willing to allow the economy to slow, the more stable is China’s economic adjustment and the less painful economically over the long term. Greater transfers and slower growth, however, both come at the expense of the vested interests who oppose the reforms, and so it is politics, more than economic logic, that will determine the success of China’s rebalancing strategy.

I should note that there are so many moving parts to this analysis and so many simplifying assumptions, that the scenarios listed above should not be taken as predictions. There are important points, however, that I think emerge from this scenario analysis.

First, even after overwhelming the analysis with implausibly optimistic assumptions – discounting the disruptions caused by shifting strategies, for example, assuming financial distress costs are close to zero, and ignoring the impact on debt sustainability that results from rolling over a significant share of total loans that cannot be repaid – it is pretty clear that without a major change in policy or a tolerance for slower GDP growth it will be hard to prevent debt from becoming unsustainable. At some point, and my guess is that this would occur within the next two to three years at current growth rates, China runs the risk of a very disruptive adjustment as it reaches debt capacity limits, perhaps even the risk of negative GDP growth rates.

Second, any analysis of future growth that doesn’t tie changes in the growth rates of investment, consumption and government transfers to changes in debt levels misses out on perhaps the most important constraining factor. I think failure to understand this point explains, by the way, why over the past few years very few economists had expected GDP growth to slow as sharply as it has, and debt to rise as quickly, or allowed for either in their projections.

My guess is that the same economists will continue to make the same mistakes. To avoid doing so, as we continue to make projections about growth in GDP or in any of the drivers of GDP, we must estimate their impact on debt and how this further constrains our assumptions about growth in GDP or in its drivers. This requires a deeper understanding of how balance sheets affect growth.

What is inevitable and what is possible

Unfortunately, much of the analysis we have seen on China in the past two decades almost completely ignores the balance sheet. Four years ago one of my clients sent me a research report by Standard Chartered in which their China analyst warned that while Chinese debt levels were still easily manageabble, there was a chance, no longer insignificant, that credit growth could speed up sharply and debt eventually become a significant constraint for policymakers. Things were fine for now, the analyst seemed to suggest, but it was possible that Beijing could mismanage its way into a debt problem.

The overwhelming consensus at the time was that China’s growth model was healthy and sustainable, and would generate GDP growth rates for the rest of the decade that were not much lower than the roughly 10% we had seen during the previous three decades. My client sent me the report along with the comment that the sell-side was finally recognizing that the Chinese economy was at risk. A leading analyst who had long been part of that consensus was, he said, finally beginning to understand the Chinese economy and the problems it faced.

I wasn’t so sure. It seemed to me that those who understood the Chinese growth model would have also understood that its overreliance on investment to fuel growth, combined with the structure of its credit markets, extremely low interest rates, and wide-spread moral hazard, made soaring debt almost inevitable and that debt was already constraining policymaking.

To suggest that this might happen only if the new administration – that of Xi Jinping – mismanaged the process suggested to me that the analyst did not really understand the self-reinforcing relationship between rising debt and slowing growth and was underestimating how difficult it would be for the new administration to break out of this process. There is in other words a very big difference between acknowledging that China has a lot of debt and understanding how debt and debt creation are embedded within the financial system.

I think this was exemplified last year when the NBR’s journal for Asian economic research, Asia Policy, put together a roundtable to review Nicholas Lardy’s very detailed and carefully argued book, Markets over Mao. I was one of the five analysts who were asked to participate in the reviews. Lardy is one of the best informed and most knowledgeable of the economists covering China and so I was honored to be invited to review the book. In my review I praised his book for the quality of its analysis, and it well deserves that praise.

But there was a fundamental disagreement in how he and I interpreted the data. Lardy believes China is in good shape economically and concludes with very optimistic growth forecasts. Based on the same data and absorbing much of his analysis and interpretation of that data (I have been reading Lardy for many years) I expect growth to slow sharply. The current consensus for China’s long-term growth at the time, I think, was around 6-7%. Lardy thinks this is a low number, and has said that with the right reforms “China could grow at roughly 8% a year for another 5 or 10 years.”

I believe, however, that he is wrong. The reforms he means consists largely of productivity- or efficiency-enhancing reforms aimed at boosting growth by implementing what I refer to as “asset-side management”. But to me these asset-side reforms are barely relevant at this stage, although had they been implemented a decade ago China might not be in the difficult balance-sheet position it is in today. I have argued instead that without a massive and fairly unlikely transfer of wealth from the state sector to the household sector, the average Chinese GDP growth rate under Xi Jinping cannot exceed 3-4%, no matter how aggressively Beijing implements the standard grab-bag of orthodox reforms offered by orthodox economists.

These are the same reforms offered not just in the case of China today but during nearly every debt crisis in modern history, including to policymakers in peripheral Europe following the 2009 crisis. As far as I can tell there is not a single case in modern history in which the reforming country was able to grow its way out of its debt burden. Instead the debt burden has always increased until the country either engineers or is forced into explicit or implicit debt forgiveness.

That is why we disagree so strongly in our forecasts even though I largely accept his analysis of the Chinese economy. We disagree for the same reason I disagreed with the Standard Chartered China strategist who saw an unsustainable debt burden simply as an unlikely but possible result of policy mismanagement rather than an inevitable consequence of a structural dependence on debt. We disagree, in other words, not on the fundamental data but rather in our understanding of debt dynamics and the constraints the balance sheet can place on an economy’s “fundamental” operations.

As I see it there are at least two important disagreements here. The first is about the impact of balance sheet structures on exacerbating volatility. Neither Lardy nor the Standard Chartered analyst seem to recognize how the balance sheet might affect growth in the future and how it affected growth in the past. For me, however, this has been and continues to be a key component of the Chinese economic “miracle”, and indeed also of every previous growth miracle. As I said in my review:

I made a similar argument a few weeks later in a Wall Street Journal OpEd about why it is so important that Beijing maintain its credibility, which is the only way of ensuring that China’s substantial balance sheet mismatches can be managed and rolled over:

History suggests that developing countries that have experienced growth “miracles” tend to develop risky financial systems and unstable national balance sheets. The longer the miracle, the greater the tendency. That’s because in periods of rapid growth, riskier institutions do well. Soon balance sheets across the economy incorporate similar types of risk.



…Over time, this means the entire financial system is built around the same set of optimistic expectations. But when growth slows, balance sheets that did well during expansionary phases will now systematically fall short of expectations, and their disappointing performance will further reinforce the economic deceleration. This is when it suddenly becomes costlier to refinance the gap, and the practice of mismatching assets and liabilities causes debt, not profits, to rise.

Financial distress can be worse than a crisis

The second misunderstanding is about why “too much” debt matters. For most economists, the main and even only problem with too much debt is that it might lead to a financial crisis, and that the fear of crisis undermines confidence and so can cause spending to drop. But while these are important problems, these analysts are mistaken in limiting their concerns to these two issues. While a financial crisis is certainly a risk, the damage debt does to an economy occurs long before any crisis, and for debt to be terribly damaging to an economy’s long-term growth doesn’t even require a crisis.

In fact one can easily make a case that while a financial crisis may be spectacular, it nonetheless limits the damage caused by excessive debt by forcing a recognition of the losses, only after which does the system begin to allocate capital efficiently. Until this happens, the adverse impact of debt on growth can persist for decades. A case in point is Japan. Japan never had a financial crisis or a banking sector collapse, but from 1990 to 2010 the amount by which its share of global GDP has declined far exceeds the damage caused to any other country by a financial crisis. Or consider the heavily indebted countries of Europe, like Spain, Italy and Portugal, who have avoided crises without showing convincingly that they are better off economically today and over the rest of this decade than they might have been had they suffered a financial crisis in 2009 or 2010.

In my review of Lardy’s book I try to explain why debt constrains growth, whether or not it leads to a crisis:

The second way liability structures can constrain growth, while often poorly understood by economists, is actually well understood in finance theory. An economic entity will suffer from “financial distress” if debt has risen so much faster than expected, or growth is so much lower than expected, that economic agents become uncertain about how higher debt-servicing costs will be assigned to different sectors of the economy. This uncertainty forces these agents to react in ways that unintentionally but automatically intensify balance sheet fragility and reduce growth. This uncertainty is intensified if the debt burden rises and falls inversely with debt-servicing capacity, which almost always happens when economic growth is highly credit-intensive, and which seems to be happening in China.

Because this seems so counter-intuitive for many people, it bears repeating. The problem with too much debt is not just that it might cause a crisis. The problem is, first, that debt may be structured in a way that systematically enhances volatility, which means good times appear better and bad times worse. This automatic leveraging-up of volatility has seriously adverse impacts on long-term growth. Second, when debt levels are higher than expected and growth lower (one of the nearly inevitable consequences of highly volatility-enhancing balance sheets), if this divergence causes uncertainty about how the debt servicing will be resolved, the uncertainty itself forces agents to behave in ways that automatically reduce growth and increase balance sheet fragility further.

Lardy’s response to my discussion of debt indicates, I think, just how much confusion there is here and how easy it is for most economists to misunderstand the relevant issues – although in fairness it should be noted that he is responding to five separate reviews, and so this is unlikely to be his full response:

Contrary to Michael Pettis’s assertion, the book does give some attention to the liability side of the Chinese economy. I note the huge buildup of debt starting in the fourth quarter of 2008 and analyze the challenges this debt poses for financial stability. But in Markets over Mao I point out that China differs in several critical respects from other countries where rapid debt buildups have precipitated financial crises.



To begin with, China’s national saving rate, reflecting the combined savings of households, corporations, and the government, approaches 50% of GDP, significantly higher than any other economy in recorded history. Like households, countries that save more can sustain higher debt burdens. Second, the vast majority of this debt is in domestic rather than in foreign currency…Thus, its debt does not involve any significant currency mismatch, a major contributor to many financial crises. Third, the majority of this debt has been extended by banks, and China’s systemically important banks are financed entirely by deposits rather than through the wholesale market…Finally, the government has enormous scope to further increase bank liquidity should that become necessary. Other factors, too numerous to list here, also suggest that a banking crisis is far from certain in China.

But Lardy is not actually disagreeing with anything I said. In fact I fully agree with him that a banking crisis is unlikely, and have written many times that while it is possible, and the risk of its happening should not be dismissed out of hand, I do not think China is likely to have a banking collapse, any more than Japan in the late 1980s and early 1990s was ever likely to have a banking collapse. This doesn’t mean however that China’s debt burden is irrelevant.

A system of interlocking balance sheets

Japanese GDP growth, after all, did indeed collapse as it was forced to rebalance its debt-laden economy, and this collapse in growth has lasted an astonishing 25 years, with, as I see it, still no end in sight. During the first wave of excitement over “Abenomics”, for example, I wrote in this newsletter and elsewhere that just trying arithmetically to work through the consequences on the country’s debt burden of the success of Abenomics made it hard for me to see how Abenomics could possibly succeed in generating inflation and real growth without an explosion in its current account surplus that the world would not be able to absorb.

It was precisely because of China’s debt dynamics that I began arguing in 2006-07 that China’s growth model was unsustainable, that its debt was rising too quickly and could not be reined in without a significant drop in growth, and that China had urgently to rebalance. The same logic made me argue in 2008-09 that China’s adjustment was going to be brutally difficult and would entail at least a decade of GDP growth that could not exceed 3-4% on average. And yet I have always also argued that China’s banking system is very unlikely to collapse, and if one excludes things like the credit crunch in June 2013 or this month’s stock market panic, we are unlikely to see a financial crisis unless GDP growth – and with it credit growth – remains at current levels for another 3-4 years at most.

It is neither enough to note the amount of debt a country has or to speculate on the probability of a debt crisis. What matters is the systemic role of debt in generating economic activity, the feedback processes that are embedded in debt structures, and the uncertainty that may arise about the resolution of debt-servicing costs. To summarize, there are at least four important issues to consider:

It is possible to structure an economy in such a way that excessive debt creation is not a “choice”, not even a bad choice, but is instead the automatic consequence of institutional constraints within the economy, and in fact it is very rare that a country experiencing many years of “miracle” growth hasn’t created such constraints. This is why it should have been possible to see well over a decade ago that China’s excessive indebtedness was inevitable. Economists who warned of the possibility of a deterioration in the balance sheet, but who thought nonetheless that China could avoid this outcome without a major restructuring of its growth model and a significant reduction of its growth rate, were always fundamentally mistaken. Excessive debt levels were never a “possibility”. They were a necessity as long as the growth model was not fundamentally transformed. The structure of the balance sheet, by which I mean the types of mismatches between assets and liabilities when debt levels are high enough, can systematically enhance volatility, so that periods of expansion, real productivity growth, or benign global conditions can result in many years of growth that exceed expectations. This comes however at a cost. First, the same balance sheet structures that enhance growth during the expansion phases will cause growth to slow much faster than expected during the contraction phases, and second, enhanced volatility always reduces value, although not always perceptibly at first, because it increases gapping risk. This process is perhaps counterintuitive to those who think all economic activity is driven by fundamentals, but is well understood by traders and investors, who know how it works in margin buying, leveraged positions, and derivatives that directly quantify leverage and gapping risk. Apart from enhancing volatility, high debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be resolved, i.e. to which sectors or groups they will be explicitly or implicitly allocated. This uncertainty will affect the behavior of any sector of the economy to whom the costs might be allocated, in the form of either direct taxes, indirect taxes (e.g. inflation or depreciation), appropriation or expropriation, or wage and consumption suppression. These sectors, all of whom will alter their behavior in order to protect themselves from bearing the costs of debt, comprise most of the economy, including foreign creditors, small business owners, savers within the banking system or in other forms of monetary assets, workers, wealthy owners of financial and non-financial assets, the agricultural sector, importers and exporters, the mining sector, and many others. The wealthy might take their money out of the country, for example, and creditors might shorten maturities and raise interest rates, business owners might disinvest, the middle class might dis-intermediate savings, workers might organize, local policymakers may engage in protectionist activity, borrowers might invest in riskier projects, banks might reduce the scope of their lending to the most protected sectors, etc. The point is that it is a mistake to assume that the only or main cost of excess indebtedness is a financial crisis. The balance sheet can embed strong feedback mechanisms within the economy that make it almost impossible to predict the growth of debt. The balance sheet mismatches that during the expansion phase could be refinanced in ways that created unexpected profit, can easily lead to rising debt instead as the mismatches become harder to refinance or require government guarantees.

This is why I would argue that once a country’s balance sheet reaches a certain critical point, any analysis is fundamentally mistaken if it simply acknowledges the existence of a great deal of debt, or sees a debt buildup as unlikely, or as the consequence of bad policy, when already institutional constraints make it a necessary corollary of growth.

Debt was already a problem in the Chinese growth model more than ten years ago (and is a problem in several advanced economies too, who are going to find it nearly impossible to grow out of their debt burdens without debt forgiveness). Those analysts who do not understand why this is the case probably do not understand why the balance sheet will continue to be a heavy constraint on Chinese growth and will underestimate the difficulty of the challenge facing Xi Jinping and his administration, which means among other things that they will be too quick to criticize Beijing for failed policies when growth drops below their projections.

Transforming the financial system

Related to the failure to understand the balance sheet constraints, there is another argument that has made the rounds in the past year or two as economists covering China slowly have come to recognize just how misdirected investment allocation has been. This argument remains optimistic about growth prospects while nonetheless warning of ways in which things can go wrong, but I think it is based on a similar kind of misunderstanding.

It is well understood that Chinese growth relies excessively on investment, and that consumption is too low a share of GDP to drive demand mainly because household income is too low a share of GDP. But with so much misallocated investment driving the surge in bad debt, China must bring investment growth down as rapidly as it can. I have long argued that the only sustainable way to do this without a surge in unemployment is to transfer wealth from the state sector to the household sector. If this is done forcefully enough, continued consumption growth can drive enough demand to prevent a rise in unemployment as Beijing gets its arms around credit growth.

The main constraint is likely to be the political difficulty of transferring wealth to the household sector from the state sector, where it is managed and controlled by the so-called “vested interests”. Historically for the many developing countries that have faced a similar rebalancing problem, this constraint is a powerful one.

But according to this new, and optimistic, argument, China doesn’t need to rebalance nearly as quickly as we might think. China’s soaring debt burden is not caused because investment levels are high, according to this argument, but rather because Chinese banks systematically channel credit to SOEs, municipal and provincial governments, and infrastructure projects, and that these are no longer able to generate debt servicing capacity in line with debt servicing costs.

All Beijing has to do, consequently, is to implement the right financial sector reforms that will result in a significant re-channeling of credit away from the old recipients and towards new recipients who are able to use this credit to fund productive investment. These new borrowers include China’s very efficient small and medium enterprises (SMEs), and as credit is redirected towards them they will invest it in projects that generate more than enough debt servicing capacity to stabilize or even reduce the country’s debt burden and so give it far more time to rebalance its economy.

Would redirecting credit to more efficient users solve China’s credit problems and give Beijing more time to manage a very difficult rebalancing? Of course it would, but it is completely absurd to expect that this will happen. There is no question that if the Chinese financial system were reformed so substantially and quickly that is was able to channel savings into productive investments, and not into nonproductive ones, there would no longer be any urgency to rebalance. But for Beijing to pull this off would require too profound a transformation of the way the financial system allocates credit to make this a very likely outcome. Many countries have tried to do so and none have come close to succeeding.

Such a dramatic reform of the financial sector is politically almost impossible to pull off without first implementing very rapidly extremely implausible politically reforms. In that context I have regularly cited a line from a book Fragile by Design, co-authored by Charles Calomiris and Stephen Haber. According to the authors, “a country does not choose its banking system: rather it gets a banking system consistent with the institutions that govern its distribution of political power.”

The point is that banking systems do not allocate credit on the basis of a set of well-understood rules that can easily be manipulated or redirected. The credit allocation process is the outcome of a complex set of institutions that are at least as much political as economic in nature. To transform this process requires a long and difficult transformation of these political institutions.

It would also require, in China’s case, the creation almost from nothing of a credit culture, replacing a banking culture in which loan officers paid very little attention to credit risk because money was mostly lent directly or indirectly to government or government-related entities (most or all of which enjoyed implicit or explicit guarantees). Beijing would have to transform this banking culture into one that is driven by the credit evaluation of businesses that are often not very transparent and that operate in complex systems of ownership. But it is not easy to build a credit culture, and it is a virtual certainty that any attempt to do so quickly will, very soon after it began, generate large amounts of NPLs.

The political challenge

Even assuming that in a world of declining demand, falling profits, and excess capacity, Chinese SMEs and other potentially productive investors were willing to borrow and invest at nearly the scale necessary for China to postpone rebalancing, the process of reforming the banking system would be incredibly complicated and would require far too long for anyone to propose this realistically. Offhand I cannot think of any country in history that was able to implement a similar transformation of its banking system, with the possible exception of Chile perhaps in the early 1980s, and even that took a decade and included a political crisis followed by a severe financial and economic crisis in which nearly the entire banking system collapsed as GDP declined by 14%.

To suggest that this is a viable path for the Xi administration would, once again in my opinion, severely understate the challenges that Beijing faces. To imply that only poor policymaking on the part of Xi Jinping’s administration could explain Beijing’s failure to pull it off would be extremely unfair, and would blame Beijing for failing to implement a wholly unprecedented level of financial sector reform.

China, in that case, would essentially be expected to do something that I think no other country has ever been able to do, and certainly no large one, and while this does not mean that China cannot do it, it does mean that at the very least we should be well aware of how difficult it is to accomplish and rather than simply recommend that Beijing do it we must specify what the conditions are that make us so confident that Beijing can do what no other country has been able to do. A massive debt burden significantly reduces the options available to policy-makers and a severely unbalanced structure of demand forces policy-makers to choose between rising unemployment, rising debt, or rising wealth transfers. Economists who do not understand how this fairly simply trade-off dominates all policymaking simply will not be able to provide useful policy advice.

This article was originally published on Seeking Alpha.