But this time it’s different

We would caution that the starting point in 2019 is very different from that of 2009. A decade of rapid debt accumulation means that China’s debt to GDP ratio now stands at about 300% of GDP, almost double the level of 2008. While official Government debt to GDP is relatively low at 50% of GDP, the non-financial corporate sector has a debt mountain totaling more than 150% of GDP and given the dominance of state-owned enterprises in China’s economy much of this is ultimately Government debt. The consumer sector has experienced the most rapid growth of late and now has a debt pile of more than 50% of GDP. Excluding the financial sector, the Chinese economy has taken on an additional USD27 trillion of debt since 2009 according to the IIF. This represents 3 dollars of debt for each additional dollar of GDP growth and reflects the falling return on investment as capital-output ratios have deteriorated.

The efficiency of Chinese investment has declined

It should perhaps not be a surprise that the efficiency of Chinese investment has declined, given how much of it there has been, and the way resources are allocated. In the ten years up to 2009, Chinese Gross fixed capital formation (GFCF) totaled USD10 trillion, accounting for about 9% of the global total and contrasted with about USD27 trillion of GFCF in the United States. In the ten years through to 2018, Chinese gross fixed capital formation totaled USD42 trillion, accounting for 23% of the global total and contrasting with USD34 trillion in the United States. The USD42 trillion of investment in China in the past decade was associated with a USD9 trillion rise in GDP – a ratio of 4.7:1.

This sharp deterioration in the efficiency of investment in China strongly suggests a repeat of the 2009 policy of investment-led stimulus is not an option. Let us assume, for example, that Chinese GDP growth averages 6% in nominal dollars over the next decade and investment as a percentage of GDP were to remain at the 2018 level of 42%. China’s economy would grow by about USD10 trillion over the next ten years with an additional investment – cumulative – of USD86 trillion, a ratio of 8.6:1. What appears clear is that the efficiency of Chinese investment has to improve and that probably requires two things to happen: investment needs to be more market driven and the quantum needs to decline.

A decline in Chinese domestic investment would result in an unacceptable increase in the current account surplus

For any given level of saving, if investment declines, the current account surplus must increase. This is a GDP accounting identity. Given the current international trade environment, it appears unlikely that the world will tolerate a sustained, large rise in China’s current account surplus: it is not just the United States whose patience has been tested by China’s perennial surpluses. Thus, the export-oriented route to growth and the state-driven investment route both seem to be exhausted.

China needs a consumption-led recovery

In consequence, this means that a fall in investment relative to GDP needs to be accompanied by a rise in domestic consumption (and hence a fall in national savings). This in turn means that the right policy response to the COVID-19 recession in China is a more Western style effort to stimulate domestic household demand through income tax cuts and wage increases to put money in the hands of consumers. From the Chinese authorities’ perspective, however, there are a number of issues with such a response.

Stimulating consumption would divert resources from China’s nationalist agenda

The problem for the Communist Party is that a more market oriented method of allocating investment resources would divert resources from its current neo-mercantilist and nationalist economic agenda. In addition, if a consumption boom were to result from China’s reflationary policies, there may well be a rise in the propensity to import, off-setting the terms of trade boost from lower oil prices and, through mercantilist eyes, such stimulus (money spent on “unnecessary” consumer imports) is wasted. Is China prepared to run a meaningful current account deficit, with the implications for reserve assets or the exchange rate? Furthermore, if a transfer of resources to the household sector were to come at the expense of the heavily indebted corporate sector – as labor takes a larger share of the economic pie – China runs the risk of inducing a financial crisis as corporates’ ability to service their debt is impeded. Corporate failures, with the resulting loss of jobs would challenge the Communist Party’s credibility with the people.

China can no longer rely on an export-led recovery

China’s previous export-driven strategy relied on overseas demand to reflate economic activity through exports in order to enhance employment and incomes in the domestic economy. The new-found reticence of parts of Europe and America to play along with this arrangement will force China to make some tough decisions.

Internally generated growth comes from the efficient use of scare resources and efficiency, which is not necessarily consistent with policies of national aggrandizement. A large part of China’s capital stock does not cover its cost of capital. The mercantilist model has mis-allocated resources on a huge scale to which the decline in investment efficiency, particularly at such a low level of per capita GDP, is testimony. The Belt and Road initiative, for example, is expensive and if it were economically viable, one wonders why, in a world awash with savings, these investments have not been made already. The militarization of the South China Sea and the East China Sea does not come cheap and is a direct provocation to China’s neighbors, on whom China will become increasingly dependent for trade as unfettered access to the markets of the West disappears.

RMB devaluation would damage credibility at home and abroad

Of course, China can resort to the out-right monetization of its debts through money printing as Western economies have done. The constraint here, as it is elsewhere, is the loss of trust and the impact that would have on the exchange rate and domestic inflation. The CCP has spent much of the last twenty years building trust among China’s own citizens in “the peoples’ money”. It has recently, and so far, unsuccessfully, tried to extend that trust beyond its borders. The experiences of 2015, when China spent a quarter of its exchange reserves defending the value of its currency when a part of its elite lost faith in it, should serve as a reminder that trust in the RMB is fragile. COVID-19 does to appear to have solidified trust in the CCP within China’s borders and therefore its scope for money printing without ramifications is perhaps limited. However, as the crack-down of 2015 demonstrated, when market forces rear their head, coercion in the form of tighter and more draconian capital controls, can be stepped up to suppress them.

Real reforms are the only option for China

For 20 years Western economic engagement with China, aimed at liberalizing the regime by promoting prosperity through trade and investment, often to the detriment of employment and income in the West, has failed to produce meaningful reform of China’s economy towards market norms. It may well be that a dose of economic hardship, brought about by a devastating home-grown virus, coupled with an unwillingness on the part of the United States to absorb the output from mis-allocated Chinese capital, could finally achieve those goals.

But Western fiscal policy is more likely to resolve the global economic crisis

Unfortunately, these much need reforms may not happen until all other avenues have been exhausted. It is more likely that the statistical rebound in economic data will be led by Asia but a sustained global economic recovery will be driven by the fiscal response of the West.