Can Consumption Growth Be Maintained If Investment Growth Is Reduced?

I have been arguing for several years that once China begins the adjustment process, which I expect to characterize the ten-year period of the current administration, growth rates must slow significantly. My expectation for long-term growth is that it shouldn’t average much above 3-4% annually. This is what it will take for household consumption to rise to roughly 50% of GDP in a decade if consumption growth can be maintained at its historic rates of around 8%.

But I always warn that this is likely to be an upper limit, not a lower limit, to growth The key is whether or not it is possible to maintain current levels of consumption growth once investment growth is sharply reduced. A recent paper by the IMF on the topic is very interesting and not encouraging.

In the article in the WSJ about Chinese debt, in which he cites analysts who argue that because the government has assets that exceed the liabilities, we should be less concerned about the size of the debt. It’s a short article worth citing in full because, I think, it demonstrates a number of popular misconceptions:

China’s debt is scary, but its assets are reassuring. Taken together with local government borrowing and other obligations, China’s gross government debt could be as much as 60% of gross domestic product, says UBS China economist Wang Tao. Corporate and household debt has also been on a tear, up to 201% of GDP at the end of the first quarter from 138% at the end of 2008 according to Bernstein Research.

Those are alarming trends. But debt is only half of the story. On the other side of China’s balance sheet, there are some significant assets. The net assets of state-owned enterprises reached 27.3 trillion yuan ($4.4 trillion) in 2011 equal to 58% of GDP in that year, says Dragonomics China analyst Andrew Batson. The state is also a major owner of land. China’s public sector is out of the red, even without taking account of massive foreign exchange reserves, which couldn’t easily be used to bail out domestic problems.

For the corporate sector, assets have grown in line with liabilities. Take the firms listed in Shanghai–China’s flagship equity market. The asset to liability ratio for this group has risen to 118% in 2012, up from 113% in 2007, according to Factset. Industrial overcapacity and reckless building by local governments mean some of China’s investment has not been valuable. A bridge to nowhere is not easy to bank. In a crisis, political paralysis and illiquid markets mean selling assets would be tough–Latin American countries discovered as much during debt crises in the 1980s and 1990s.

Still, China’s strong asset base points to a fundamental difference with the build-up of debt in the U.S. Borrowing to fund consumption–the U.S. model–does not create a stream of future income or an asset that can be used for repayment. Borrowing to fund investment–the China model –does.

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One of the big problems with analysis of China is that most analysts seem to have little experience with other developing countries, and especially with debt problems in other developing countries. As a result they tend to repeat mistakes in a fairy predictable way. For one thing, they look at current debt levels without factoring in what I call balance sheet inversion in my 2001 book, The Volatility Machine.

Basically what this means is that under certain kinds of conditions or balance sheet structures, an adverse shock, or slowing growth, causes an explosion in contingent liabilities, most often through the banking system, and it is this explosion in contingent liabilities that creates the debt problem for the country. If growth slows in China, in other words, this should cause a sharp rise in NPLs, especially if borrowers are counting on rising prices to service the debt, which will itself cause slower GDP growth, and so on in a self-reinforcing way. If we want to understand the debt problems facing China we have to consider not just the current debt on the balance sheet but also what the balance sheet is likely to look like after an adverse shock.

In fact there is a regular pattern that we see when debt levels rise in a country to the point at which either we suffer from a debt crisis or from a lost decade of difficult adjustment. First, as sovereign debt levels and contingencies rise, we deny that they are rising. Then we acknowledge that they are rising but we argue that debt levels are very low. Then we acknowledge that they are high, but we point out that the sovereign has more assets than debt. Next we acknowledge that the excess of assets is irrelevant but the country is only suffering from a liquidity crisis. Finally we acknowledge that there is indeed a debt problem.

This seems to be what the WSJ article is describing. It is good that even analysts who used to be much more optimistic are finally recognizing that there is too much debt, but is it true that the Chinese government has more assets than debt? Of course it is. But this was also true in every single country in history that has ever had a debt crisis. Governments always have enough assets, or taxable authority, but since they enjoy sovereign immunity the question is not whether they have enough assets to cover the debt but rather whether they are willing to liquidate assets (and the power that comes with control) to cover debt. They almost never are.

In fact this whole issue is irrelevant. China is not going to default on its debt, and so whether or not lenders can seize government assets doesn’t matter. What matters is whether the returns on the assets are sufficient to pay the true unsubsidized cost of the debt. If they are not, then there must be a transfer from somewhere else to cover the difference, and this somewhere else is usually, and has been in the case of China, the household sector. It is the size of this transfer that causes growth to slow.

Written By: Michael Pettis