The Pandemic Depression
The Global Economy Will Never Be the Same
China’s ballooning corporate debt remains the number one systemic risk to global economic recovery. If the bubble bursts, it will drag down the rest of the world while compromising Chinese Premier Xi Jinping’s grip on power ahead of the Chinese Communist Party congress late in the year. Beijing understands that the debt is hardly sustainable, so over the last two years it has engineered a sophisticated macroeconomic strategy to artificially boost factory prices, increase profits, and ease loan repayments for the most troubled companies. But as economist George Magnus put it, “you can’t resolve a debt problem peacefully.”
Chinese corporate debt is approaching dangerous levels by both historical and cross-country standards. At around 170 percent of GDP, China’s corporate debt rate is the highest in the world. Moreover, the so-called credit gap, which measures how fast credit is growing with respect to the economy, currently stands at 30 percent—well above the eight percent threshold that, in past crises, marked an imminent crash. Not surprisingly, Moody’s has recently downgraded China to A1 from Aa3 for the first time in thirty years. “Western rating agencies,” said a government-affiliated newspaper in response, “often look at China through a telescope.” In the eyes of Chinese bureaucrats, domestically financed debt, a high savings ratio, and healthy public finances should be enough to ward off financial risks.
But the problem is further aggravated by the fact that three-fourths of China’s corporate debt belongs to highly inefficient state-owned enterprises (SOEs) in traditional industries. In mid-2015, when the industrial sector was barely growing and producer prices were declining, thus weighing on profits, Chinese manufacturers struggled to stay afloat and make payments on their mountainous corporate debt. To boost profits and avoid bankruptcy, they needed higher prices, which the government ultimately delivered through a combination of “Beijing-style” supply-side reforms (restrictions on production) and demand-management policies (ultra-cheap credit).
A HAZARDOUS MIX
Xi’s supply-side reforms have little to do with the pro-market reforms implemented by U.S. President Ronald Reagan in the 1980s, when supply-side economics made its appearance for the first time, only to fall into disgrace soon thereafter. Rather than increasing the supply of goods and services and letting the market allocate resources efficiently, as Reagan tried to do, the Chinese government has simply curtailed production in sectors such as coal, steel, and iron. But it has shut down very few “zombie” companies. The goal was to drive out low-quality supply, leaving the remaining players with increased pricing power.
China’s ballooning corporate debt remains the number one systemic risk to global economic recovery.
These policies have mostly stabilized production rather than cutting it substantially to the benefit of the most efficient firms, but they were effective enough to support prices and avoid a deflationary spiral. The adjustment process has been slow as sub-national governments struggle to find funds to relocate, compensate, re-train, and re-employ redundant workers. With SOEs numbering some 155,000 firms and dominating network sectors, retail, construction, and wholesale trade, any major improvement would take a long time to materialize. And it is not in Beijing’s interest to accelerate the process. Getting rid of inefficient SOEs would trigger major job losses, generating enormous socio-political tensions.
On the demand side, with the old players (SOEs) and the old economy (heavy industry) in trouble, Beijing has opted for an old instrument (credit growth) to rescue them. Over the last couple of years, the People’s Bank of China has injected a huge amount of liquidity into the economy, with credit growing at around 13 percent annually. This led to a housing boom that has, in turn, boosted demand for commodities, construction equipment, and materials—sectors dominated by state-controlled actors. According to the IMF, it could take over three years to work off housing inventory in China’s smallest cities, even absent new residential construction.
In addition, the issuance of sub-national government bonds in 2015 and, more recently, the surge in special bonds to support infrastructure projects, have expanded the bond market, providing new lifeblood to state-controlled entities. Although the three main issuer types (government, financial institutions, and the non-financial corporate sector) account for approximately equal shares of the bond market, most issuers are government-related. Policy banks are the largest issuers of financial bonds, whereas SOEs, alongside local government investment vehicles, are the largest non-financial corporate issuers.
As a result of this highly interventionist stance, the state has regained its leading role in the economy by orchestrating and coordinating the activity of the banks and firms it directly controls. The investment share of the public sector continually declined from 2004 to mid-2015, when for the first time it matched that of the private sector. Over the last eighteen months, however, the public sector share has increased again to 39 percent, which is greater than the private sector share. This is a clear setback for an economy that is trying to move toward a more market-based system.
Almost two years of macroeconomic engineering is showing effects. As in standard textbook economics, the combination of curbed supply and expanded demand has led to a spike in factory prices, which at the beginning of 2017 jumped out of the red and are now growing at above ten percent on a year-on-year basis. And in upstream industries, higher factory prices are boosting SOEs’ profits. They are almost doubling on a monthly basis after having declined for two years. These inflationary pressures have made it easier to pay back debt but also reduced its value in real terms by about three percent.
So here is the dilemma for Chinese authorities: If they continue with this policy mix, they might keep temporarily increasing profits. But higher factory prices will at some point translate into higher inflation for consumers that could rapidly spiral out of control. At the same time, the rescue of crumbling SOEs will delay a much-needed clean-up of the industrial system, keeping out of the market many firms with high potential. And eventually, the debt problem will materialize again in a more virulent way, infecting the rest of the world.
However, without the government’s intervention, many firms would struggle to create enough profit to stay afloat. Their bankruptcy would be financially, socially, and politically destabilizing too. Workers would take to the streets, banks would go bankrupt, and the Communist Party would struggle to maintain its grip on the country. And a global equity rout, far more devastating than the one experienced at the beginning of 2016, would be inevitable.
Beijing must thus perform a complicated balancing act: reining in credit growth while supporting only the most efficient firms. The recent tightening in regulation for China’s shadow banking is just a small step in the right direction. The People’s Bank of China has recently introduced rules that limit off-balance sheet operations that are usually outside the control of the central bank and directed to risky investments, as was the case with the shadow banking in the United States right before the subprime crisis. As argued by the International Monetary Fund, only debt write-offs, combined with the recapitalization of the banks that have been weakened by non-performing loans of failed SOEs, will allow the financial system to redirect lending to more profitable sectors.
Moreover, rather than curtailing production, Beijing should adopt proper supply-side reforms to unleash the unexpressed entrepreneurial potential of many aspiring producers, while selectively and gradually letting the least efficient SOEs go out of business. The short-term losses in output and employment cuts—which could be tamed with some form of unemployment insurance—would eventually lead to higher and more sustainable growth.
Unfortunately, little of this will happen before the Communist Party gathers in November. Meanwhile, Beijing will keep inflating away its debt—at its own and the world’s peril.