Distortions in the Balance Sheet Matter to China's Growth
Michael Pettis is a Finance Professor in the Guanghua School of Management at Peking University and a Senior Associate at the Carnegie Endowment for International Peace.
In his most recent book, Markets over Mao: The Rise of Private Business in China, Nicholas Lardy carefully compiles and analyzes an enormous amount of data to support his claim that China's private sector, and not the state, has become by far the most important source of recent growth in Chinese productivity and employment. Between 2010 and 2012, Lardy argues, private sector firms produced between two-thirds and three-quarters of China's GDP, far more than the state sector, even as they received a disproportionately low share of resources (pp. 139–41).
While reviewers have praised this important book mainly for refuting conventional wisdom on the central role of China's state capitalism, I think they overstate the novelty of Lardy's argument, and in doing so perhaps understate the real value of the book. It is widely known that in spite of limited access to capital, China's small and medium-sized enterprises are highly productive, often extraordinarily so. What is more, worries about the sustainability of the growth in Chinese debt are driven precisely by concerns that the systematic tendency of the public sector to misuse resources—capital, most importantly—has driven down profitability even as debt has risen steeply. That China's private sector produces more with less is not a secret.
Rather than reshape our understanding of the relative contribution of China's market and nonmarket sectors, Lardy's real contribution is to document carefully the ways in which the main sources of growth in Chinese productivity and employment have evolved from the centralized decision-making process that was set up more than twenty years ago to provide much-needed infrastructure and manufacturing capacity to one today that includes a highly productive, market-oriented private sector. By describing and explaining this extraordinarily complex and poorly understood story, Lardy also suggests the key reforms on which President Xi Jinping and his administration must focus.
Economists who are confident that China will maintain rapid growth while successfully rebalancing its economy—including Lardy himself, who argued in an April 30 presentation that “China could grow at roughly 8% a year for another 5 or 10 years,” against consensus forecasts of 6%–7% —will agree with Lardy that if China's market sector managed to grow as rapidly as it did in spite of limited access to capital and other resources, simply by reversing these constraints Beijing can ensure rapid growth as China's economy rebalances.
But here is the paradox. Those who expect growth to slow significantly, as I do, find Lardy's work no less useful than do his peers in optimism. It is a testament to the objectivity of Lardy's research that we too will praise the quality of his data and agree with much of his interpretation. We will argue, however, that it is precisely because Lardy correctly identifies the reforms required to maintain high growth that we expect growth rates to drop sharply.
Economists notoriously ignore history, but history nonetheless suggests that the many attempts among developing countries to impose similar reforms have always proved far more difficult than anyone expected. Because redirecting the flow of resources necessarily undermines institutions that have long controlled access to these resources, in China as elsewhere, these institutions prevent reforms from being implemented quickly enough to avoid either much slower growth or a risky increase in the debt burden. Premier Wen Jiabao promised in 2007, after all, to rebalance the economy with similar reforms, and yet China's imbalances deteriorated rapidly during the next five years just as Beijing began denouncing the nefarious role of “vested interests.”
There is a second set of constraints, however, that limit the positive impact of reform in ways I believe Lardy, and most economists, tend systematically to underestimate. While Markets over Mao carefully describes the operations of the Chinese economy—or, put differently, how China's “assets” are managed—it largely ignores how China's liability structure will affect growth.
This point is often contested, mainly because it is so poorly understood. Most economists assume that growth is primarily a function of how productively a country's assets and operations are managed. While they readily acknowledge that “too much” debt is bad for an economy, they still assume implicitly that debt is functionally irrelevant in determining the pace of growth. Ask how much debt is too much, and these economists usually respond with debt ratios. Ask how and why too much debt can reduce growth, and their responses either are mostly unintelligible or consist of circular references to “confidence” or the risk of debt crises.
But debt matters enormously in two important ways that are largely missing in the debate about China. First, the structure of the balance sheet can exacerbate volatility. Second, it can create financial distress costs. In either case, economic performance can no longer be evaluated mainly as a function of how a country's assets are managed.
To take the former, my book The Volatility Machine (2001) showed how rapidly growing developing countries like China create “inverted” balance sheets in which economic performance is systematically exacerbated by highly pro-cyclical financial system mechanisms. As the economy expands, these mechanisms reinforce growth, often to the point of generating growth “miracles.” Because few analysts understand these pro-cyclical mechanisms, their initial surprise at the vigor of economic expansion eventually turns into rising estimates of the economy's potential growth rate.
Distortions in the credit market, and especially in interest rates, usually create imbalances in the way growth is distributed, and the more growth depends on pro-cyclical credit expansion, the more it is unbalanced. Albert Hirschman often reminded us that all growth is unbalanced, and that these imbalances eventually reverse. But as the optimism of the 1950s and 1960s among development economists was eroded by events, so too was his casual attitude toward rebalancing. By the 1980s Hirschman began to worry that a successful rebalancing was the most difficult constraint to long-term growth.
Rebalancing is often harder than expected, in other words, not just because of opposition by vested interests, but more importantly because highly inverted balance sheets cause policymakers to overestimate potential growth during the miracle years. But when growth during the rebalancing phase contracts more than expected, the same balance sheet inversion that exacerbated the expansion phase will also exacerbate the slowdown, especially as declining credit quality reinforces, and is reinforced by, slower growth.
It is easy to find typical pro-cyclical balance sheet mechanisms in the Chinese financial sector. While this review is not the place to delve more deeply into a detailed explanation, it is worth noting that nearly every period of unexpectedly high growth in modern history has been followed by a surprisingly severe adjustment. This cannot be just coincidence.
The second way liability structures can constrain growth, while often poorly understood by economists, is actually well understood in finance theory. An economic entity will suffer from “financial distress” if debt has risen so much faster than expected, or growth is so much lower than expected, that economic agents become uncertain about how higher debt-servicing costs will be assigned to different sectors of the economy. This uncertainty forces these agents to react in ways that unintentionally but automatically intensify balance sheet fragility and reduce growth. This uncertainty is intensified if the debt burden rises and falls inversely with debt-servicing capacity, which almost always happens when economic growth is highly credit-intensive, and which seems to be happening in China.
While once again this review is not the place to explain why too much debt can limit the extent and effectiveness of policymaking and can lead to unexpected financial distress costs, it is worth noting that history provides many examples of countries in which unexpected surges in debt coincided with unexpectedly slower growth. It provides surprisingly few cases, however, in which policymakers were subsequently able to implement the “right” reforms and grow the economy at anywhere near the rates that were the expected outcome of these reforms.
While Markets over Mao is heavily skewed toward what I would call asset-side analysis, I disagree with Lardy's optimism mainly because of our different assumptions about liability constraints. This, I think, is why I value Lardy's analysis so highly, even though he expects more than twice as much GDP growth as I do during Xi's administration. It is also why I believe, and Lardy probably does not, that Beijing must prioritize debt management during the reform process if it wants to avoid a disruptive adjustment. And finally, while Lardy would probably interpret average GDP growth rates of 3%–4% as a sign of failure, I would argue that as China rebalances, these growth rates imply average growth in household income of 5%–7% and would represent an enormously successful adjustment by historical standards.
We tend to believe that sharp differences in growth forecasts reflect sharp disagreement about the evolution and structure of a country's underlying economy. When it comes to China, however, I think the main difference between optimists like Lardy and pessimists like me is probably in the very different assumptions we make about how balance sheets determine growth rates. While I think that Lardy, like most economists, has underestimated the important role of the liability side of China's balance sheet in the country's past and future performance, I have little doubt that when it comes to assessing the asset side, Lardy's book is invaluable and among the most useful in helping unravel the complexity of China's economic evolution. Markets over Mao will be read avidly by all sides in the contentious debate over China's future.
 Nicholas Lardy, "Market versus State" (presentation at Chatham House, April 30, 2015, London).