Event Recap – China: A Bullish Case

April 16, 2017
Chen Zhao

Against the prevailing diagnosis of the Chinese economy–over-capacity, over-investment and over-leverage in the backdrop of slower growth, Chen Zhao, former Co-Director of Global Macro Research, Brandywine Global, offered a forceful counter argument. He spoke recently at the Critical Issues Confronting China Seminar, titled “China: A Bullish Case.” His analysis demonstrated that China’s dramatic slowdown in economic growth rate since 2008 is not necessarily a reflection of serious economic illnesses, as many Wall Street analysts have argued. He remained optimistic about China’s long-term growth prospect.

First, he noted, at per capita GDP of around $9,000, steady state growth rate usually begins to slow as the impact of diminishing returns is felt. Compared with the average growth profile of Japan, South Korea and Taiwan during their similar stages of developments, China’s current slowdown is just in line with the pattern of these “Asian tigers” before it.

Second, a profound change in the world economy since the 2008 financial crisis has brought down the growth rate of the entire world economy, including China’s. Prior to the 2008 crisis, the world economy was characterized by a massive borrowing and consumption boom in the U.S. living side by side with a huge saving/investment boom in China. Since 2008 however, American households have stopped their spending binge, and a deleveraging cycle has started. This has led to a dramatic drop in private consumption and global aggregate demand. As a result, all major suppliers, including China, have begun to suffer an over-capacity problem. Thus, China's over-capacity problem is more of a reflection of this lower underlying global demand than over-investment from earlier periods.    

Third, the depth of the Chinese economic slowdown has been exacerbated by a series of policy mistakes. The RMB’s de facto peg to the U.S. dollar, which has appreciated dramatically in the last couple of years, has greatly compounded the export contraction. The Chinese government was reluctant to stimulate aggregate demand in 2014-15 when deflation was a clear threat. The central bank kept a very tight policy even though rates in the developed world fell to zero. All of these inappropriate policies further weakened China’s economic conditions.  

Zhao then rebutted the widespread view that China is over-leveraged. While most people often cite a high debt/GDP ratio as a key indicator for economic risks and systemic vulnerability, few have noticed that there is a counter-intuitive correlation between interest rates and indebtedness of a nation: the higher the debt ratio, the lower the interest rates. This runs against the prevailing belief that the higher the leverage of an economy, the higher the financial risk.

Why? The trick lies in the fact that savings and investment are the two sides of the same coin. Savings are intermediated into investments through three channels of any economy: the debt market or banks, the capital markets, or lending out the savings surplus to foreign countries if savings exceed domestic investment. Therefore, it is entirely possible that nations with higher saving rates end up with higher domestic debt levels. This is simply because they have larger pools of savings that need to be intermediated. Hence, the debt/GDP ratio is a poor measure of systemic risk for a nation’s economy.

The difference between the U.S. and the rest of the world is that the U.S. intermediate about 70 percent of financial resources through capital markets, while Europe and Asia must rely on banks for intermediation. As China and other Asian nations have very high saving rates, naturally, their debt ratios are very high. This implies that it is a very bad idea to engineer the so-called deleveraging process in a high saving economy such as China’s as it is a recipe for financial disintermediation leading to saving excess and nominal contraction.

During the 2008-09 financial crisis, the U.S. government deficit shot up to about 10 percent of GDP due to bail-out programs like the TARP. In contrast, the Chinese government deficit during that period didn't change much. However, Chinese bank loan growth shot up to 40 percent while loan growth in the U.S. collapsed. These contrasting pictures suggest that most of China’s four trillion RMB stimulus package was carried out by its state-owned banks. Thus, these banks de facto carry fiscal responsibilities. The so-called “bad debt problem” is effectively a consequence of Beijing’s fiscal projects and thus should be treated as such.

Why is Zhao optimistic about China’s long-term growth prospects? First, Zhao estimated that China's industrialization process is about half-way through; there is still substantial room to go, including a continuation of moving millions of people per year from rural land to urban areas where productivity and wages are much higher than those in rural areas.

Second, the structure of Chinese manufacturing has been shifting at lightning speed from low value-added production, such as textiles and garments for exports to much higher value-added manufactures like electronics and equipment. Robots are widely used to lift productivity by exporters. Chinese private businesses are efficient, nimble and highly productive, surviving in a very tough business environment.

Finally, the driving force behind China’s growth has also begun to shift towards the one that is more suitable for a middle income economy. Chinese consumption has picked up in recent years, leaving investment less important in sustaining aggregate demand than before. The service sector has also exceeded the manufacturing sector. Zhao was optimistic that China would keep delivering a six to seven percent growth rate in the coming decade, with six to 6.5 percent as a steady state.           

Zhao was not oblivious to Chinese problems, however. He was worried that China could regress to the old model where state owned enterprises (SOEs) played a more dominant role in the economy. This regress could lead to slow erosion of productivity growth. Zhao was also concerned that populist policies, such as escalating the minimum wage, social welfare and insurance, would sharply increase the operating costs of small businesses.