The Chinese economy is drowning in a sea of bad debt that being rolled over indefinitely, rather than being cleared up through defaults or other forms of write-downs. That practice overstates GDP by a big margin, Michael Pettis argues in his excellent article, Global Imbalances and the Chinese Economy. And it has negative consequences on future economic growth….
Because bad debt doesn’t just disappear.
Rapid economic development in China has created numerous distortions, including the creation of a mountain of debt, “which further impacts the evolution of these distortions.”
But as the economy changes, the nature and extent of the imbalances change too, and it is inevitable that eventually the system forces a reversal of the imbalances. This is especially true in countries, like China, with highly centralized decision-making. In these countries the imbalances can be taken to extremes impossible in other countries, thus creating all the more pressure for a reversal of the imbalances.
This ballooning debt was central to China’s growth model. Now, “we have arrived at the stage, probably described most imaginatively by Hyman Minsky in his work on balance sheets, in which the system requires an acceleration in credit growth simply to maintain existing levels of economic activity.
[T]ransferring bad debt from local governments to the central government, while undoubtedly reducing the probability of a legal default, does not in the slightest way address the cost of resolving the bad debt.
China’s mountain of mal-investments – when the productivity from an investment is “less than the correctly calculated debt-servicing cost” – hasn’t been cleared up by “defaults or other forms of debt write-down.” Instead, the “the implicit losses have simply been rolled over, most likely in the balance sheets of the Chinese banks.”
With big implications. Here are some highlights:
GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today … may be overstated by as much as 20-30%.
Losses that are rolled over do not disappear. They are implicitly amortized over the period of the loan, which, assuming that loans are rolled over indefinitely, means that every year a declining portion of that loan is effectively written down. Over long periods of time every economy recognizes investment losses, but depending on how these losses are treated, the recognition can take place either in the period in which the losses occur or over the loan amortization period.
Implicit amortization of unrecognized losses.
An investor who borrows $100 for a project that end up creating only $80 in value actually creates a loss of $20. If the loan isn’t written down by the amount of the loss, the gap “between the true economic value of the debt servicing cost” and the actual value it created are “covered by implicit transfers from some other part of the economy.” These transfers aren’t free; they “reduce economic activity that would have otherwise been created.”
If the gap is covered by financial repression … the cost of amortizing the loss is passed onto the net lenders (usually, but not always, the household sector, who are net lenders to the banking system) in the form of a lower return on their savings. This lower return reduces their total income and, in so doing, reduces their consumption, which effectively reduces future GDP growth by reducing demand.
Remember that the only way debt can be resolved is by assigning the losses, either during the period in which the losses occurred or during the subsequent amortization period. There is no other way to “resolve” bad debt – the loss must be assigned, today or tomorrow, to some sector of the economy. “Socializing” the debt, or transferring the debt from one entity to another, does not change this.
These losses can be assigned to three sectors: households, businesses, or the government.
In China we might usefully think of these as households, small and medium enterprises (SMEs), and the state sector (in principle there is a fourth sector, foreigners, to whom the losses can be assigned, but it is very unlikely that they will bear much of the losses).
And who will be assigned to eat the losses that are “still unrecognized and hidden” on balance sheets around the country? Pettis makes no predictions, other than reminding us that after China’s banking crisis of the late 1990s, households were assigned to eat the losses via financial repression.
Same as in the US after the financial crisis. And one of the handicaps facing the US “recovery.” The Fed has practiced financial repression for years to transfer the losses of bank gambles gone bad to another sector of the economy: households.
And they are “straining against rising prices on daily essentials,” and they are cutting back on things they want to buy, according to a new deep dive into the spending habits of American consumers. Read…. Gallup Slams Lid On Hopes For US Economy