e Denouement: China Enters Lost Decade

Anusar Farooqui*

September ,

*Department of Mathematics, McGill University, Montreal QC H A B . Email:farooqui@math.mcgill.ca

Abstract

China’s asset price bubble is rapidly unraveling despite Beijing’s frantic efforts tostem the tide. Before long, China is likely to enter a full-scale financial panic;followed by secular stagnation that may last as long as Japan’s lost decade. eChinese panic marks the third round of crises since ; the first being the panicof - centered at the US; the second, the eurozone crisis of - .All three have been driven by the systematic unraveling of global imbalances.

We have previously argued that global imbalances are the result of the high-savings strategies pursued by Germany, Japan, and China. What is unfolding inChina and global markets in the summer of , is nothing short of the denoue-ment of China’s high-savings strategy. In what follows, I will show why this is to beexpected and argue that China is entering into its lost decade; with vast implicationsfor global markets and the balance of power in Asia.

eory of large open economies

In an isolated economy without a financial sector, equilibrium national income, y∗,is implicitly determined by equating desired saving and investment,

I(y) = S(y). ( )

Introducing a money market, we obtain the familiar IS-LM equations with twoendogenous variables: national income and the interest rate.

I(r, y) = S(r, y), ( )L(r, y) = M(r, y), ( )

where L and M are the demand and supply of loanable funds. In other words, theLMcurve, equation ( ), shows the combinations of national income and the interestrate for which the money market clears. e simultaneous solution of equation ( )and equation ( ) determines the equilibrium interest rate r∗ and national incomey∗.

e Mundell-Fleming model is an extension of the IS-LM model for a smallopen economy in an international order with perfect capital mobility; and hence, asingle global interest rate. e economy is small in the sense that developments inthe economy have no perceptible effect on the global interest rate. is assumptioneffectively means that the interest rate rw is given exogenously. Assuming thatthere is a single currency in the national and international economy, one obtainsthe governing equation for national income y,

S(y) = I(y) + X(y), ( )

where X(y) is the net capital outflow (“net exports” or “excess savings”).Now consider an isolated bipolar system consisting of two open economies trad-

ing with each other. Assume again for the sake of brevity that both use the samecurrency. We then have a set of three equations that determine the national incomesof the two poles as well as the global interest rate.

S1(r, y1, y2) = I1(r, y1, y2) + X1(r, y1, y2), ( )S2(r, y1, y2) = I2(r, y1, y2) + X2(r, y1, y2), ( )

0 = X1(r, y1, y2) + X2(r, y1, y2), ( )

where yi is national income of country i = 1, 2 and r is the global interest rate.Equations ( ) and ( ) require the difference between domestic desired savings andinvestment to be equal to net exports of the country. Equation ( ) follows from thebalance of payments identity under the bipolar assumption.

Figure : Saving, investment, and trade balance in a bipolar system

..

r∗

.X∗

.

r∗∗

.X∗∗

.b

.d

.a

.c

.a′

.c′

.b′

.d′

. S, I.

r

.

SChina

.

SChina

.

IChina

. S, I.

r

.

SUS

.

IUS

. X.

r

.

XChina

.

XChina

. −XUS

It is possible to introduce exchange rates, along with money market (LM) equa-tions for the two countries. We will keep the model straightforward and investigatethe interaction in the absence of monetary intervention and exchange rate move-ments.

Figure ( ) displays the comparative statics of an exogenous upward shift of thesavings in one country (“China”) on the equilibrium interest rate and the balanceof payments in the bipolar system described by equations ( - ). e left panelshows China’s saving and investment at given levels of the global interest rate; themiddle one shows the saving and investment in the United States; and the rightpanel displays the excess savings of China (XChina) and the United States tradedeficit (−XUS). As a result of the bipolar assumption, the gaps between savingand investment must match up between the two countries. us, China’s initialexcess savings (b − a ) and the US’ initial excess savings (b′ − a′ ) are both equal inmagnitude to the trade balance (X∗). Similarly, |d − c | = |d ′ − c′ | = |X∗∗|.

An outward shift of China’s savings curve (from SChina to SChina) is reflectedin the balance of payments, the figure on the right. e savings shock pushes outChina’s excess savings curve to the right (from XChina to XChina). e new equilib-rium features a larger current account surplus in China (equivalently, a larger currentaccount deficit in the United States). e larger the shift, the large the trade imbal-ance. China has effectively pushed its unwanted savings out to the United Statesand imported demand. is is the essence of China’s high-savings strategy.

e new equilibrium interest rate is lower than before the exogeneous savingsshock. is was the source of Greenspan’s conundrum—the failure of long-termrates to rise despite monetary tightening—that Ben Bernanke called the “globalsavings glut.” e lowering of the global interest rate causes an expansion of invest-ment in both the United States and China, both of which are higher than beforethe exogenous savings shock (c > a , d

′> b

′ ).

China’s high-savings strategy

ere is nothing particularly novel about China’s high-savings strategy. Otherstates, most notably Japan, have followed essentially the same strategy. Namely,push down consumption and channel the high savings into growth enhancing in-vestments. e basic weapons in the underconsumptionist arsenal are financial re-pression, wage suppression, and underpricing of the national currency. Since ,Beijing has deployed all three with gusto.

China practices a strong form of financial repression. e People’s Bank ofChina (PBoC) administers ceilings for interest rates on deposits and floors for lend-ing rates. is ensures comfortable interest rate spreads for banks and keeps the costof capital low for firms. In - , the average loan in China was taken out at. per cent, compared to . per cent in the nineties. e repression of interestrates is effectively a tax on households and a subsidy for borrowers—the state andstate-backed firms, exporters, and real estate developers. e low rates have allowedan investment boom of unprecedented proportions.

China has a vast reserve army of workers, around million strong, who areunderemployed in the traditional sector. is has naturally kept wages from grow-ing rapidly; in accordance with the familiar Lewis model. However, China’s wagesuppression is also the result of conscious draconian policies. For example, migrantChinese workers from the interior, who work illegally in the coastal areas, have nolegal recourse against their employers. And Beijing is always quick to respond withpolice power at the first sign of labor unrest. e result is that real wages have grownslower than productivity.

When a central bank intervenes to keep the currency undervalued, it accumu-lates the reserve currency. China’s stupendous pile of trillion dollars in officialreserves attests to the scale of the PBoC’s efforts to keep the renminbi down. eappreciation of the renminbi is no more than what would be natural of a devel-oping country—the so called Balassa-Samuelson effect. Because the PBoC hasnot allowed the renminbi to appreciate at anywhere near the market-clearing pace,China has continued to accumulate foreign exchange reserves at a rapid clip.

China’s high savings strategy has driven its consumption rate down to a mind-boggling per cent of GDP, if the World Bank numbers for are to be be-lieved. By comparison, the United States consumes per cent of GDP; whileGermany and Japan, both high-savings countries, consume per cent and percent of GDP respectively. Meanwhile, China’s gross investment rate is per centof GDP; another record. e gross investment rate in the United States is percent, while the German investment rate is per cent and the Japanese is percent. However, unlike the other poles in the center of the world economy, Chinais a developing country. Its rate of investment ought to be higher. Still, a country

investing nearly half its national income is likely to be misallocating capital on amassive scale. is is indeed the case, as we shall see presently.

e bottomline is that China’s savings rate far exceeds its investment rate. ismeans that China has been pushing its unwanted savings onto its trade partners—the United States above all—and importing demand; in accordance with the the-oretical analysis of the previous section. is crucial observation means that whileChina’s growth model may be called export-led or investment-led, in terms of itsimpact on the global economy, it is more properly called a high-savings strategy.

e denouement

e collapse of global demand in the aftermath of theWestern financial crisesmeantthat China could no longer rely on importing demand from its major trade part-ners; especially Europe. Beijing’s immediate response was to cut interest rates andlaunch a six-hundred billion dollar stimulus channeled through state-owned enter-prises (SOEs). Money poured into infrastructure and housing; exacerbating theoverinvestment in these sectors. While the fiscal stimulus may have been enoughto buoy up investment demand in the short run, a one-off injection was alwaysunlikely to solve China’s demand deficit problem even in the medium term.

e real solution hit upon by China—and here again it was following in Japan’sfootsteps—was to expand debt. Between and , China’s overall debt grewfrom per cent to per cent of GDP, or about trillion dollars. An estimated

per cent of it is held by shadow banks. Lending by shadow banks has grown atper cent since ; compared to per cent for bank lending. Meanwhile privatedebt-to-GDP ratio rose from per cent to per cent. By comparison, USprivate debt-to-GDP peaked at per cent in the depths of the Great Recession.

e unprecedented expansion of debt yielded a supermassive asset price bubble;most especially in real estate. More than half of China’s ballooning debt, aboutper cent, is tied to property.

Before the Chinese financial panic began this summer, China’s stock markethad more than doubled in value in the preceding twelve months. e ShanghaiComposite Index rose from around , in July , to above , in June .But the real bubble was not in the stock market—it was centered on real estate.Since , land prices have increased fivefold. In alone, real estate prices rose

per cent. e scale of overinvestment in China’s real estate is truly stupendous.In just two calendar years, and , China produced more cement than theUnited States did in the entire twentieth century. China has billion square feet—five years’ worth of annual demand—of new property coming online. With demandfalling instead of rising, the real estate bubble began to pop at the beginning of .

Proceeds from land sales plunged per cent compared to the year before. Newhome prices fell for four straight months and are down per cent year on year.

In China, unlike in all other polar economies, the government owns almostall the land and two-thirds of its productive assets. Local governments enjoy amonopoly over the supply of land by controlling the opening of agricultural landto urban development. Proceeds from land sales account for the bulk of the rev-enues of local governments. For instance, land sales accounted for per cent oflocal government revenues in . But most of the cash in the coffers of localgovernments comes from loans secured through shell companies using public landas collateral. ere is an obvious limit to debt expansion on the backs of overvaluedmarginal land: It can only go on so long as the real estate bubble keeps inflating.

Once land prices started falling, local government borrowing and debt settle-ment became difficult; to put it mildly. Beijing’s response was to push a massivedebt swap. Local governments would issue nearly half-a-trillion-dollars worth oflong-term bonds and retire an equivalent amount of risky short-term debt. Whilethis is a step in the right direction, the scale of the toxic debt hidden in opaqueoff-balance sheet vehicles is unknown.

In , China announced that private investors may take minority positionsin the roughly one hundred and fifty thousand state-backed firms. is has exac-erbated the distortion of the economy in favour of the inefficient state sector. eborrowing costs of state-backed firms is significantly lower than private firms sothat they have cornered the capital that would otherwise flow to the more produc-tive counterparts in the private sector.

Beijing’s trilemma

Beijing wants to avoid a full-blown financial crisis, rebalance the economy awayfrom dependence on exports, and keep up growth rates. e hard truth is thatthere is no way to achieve all three objectives. Indeed, Beijing will be hard-pressedto accomplish even one of the above.

e immediate problem facing policymakers in Beijing is the slow-motion burst-ing of the asset price bubble. Beijing has already tried direct intervention in thestockmarket. Less well-known is themanipulation of land prices by local governments—by getting pairs of state-backed firms to buy and sell at inflated prices. Both effortshave largely failed so far. Even if these and other measures do succeed in proppingup asset prices, they will exacerbate the deeper problems facing the economy—thebuild-up of toxic debt in the shadow banking system, the massive overinvestmentin property, and the misallocation of resources with the attendant slowdown inproductivity—which will further lower growth rates.

Many observers suggest that China has enough firepower— trillion dollars’worth—to hold the tide in a financial panic. However, China cannot deploy itsreserves at any appreciable scale without considerably strengthening the renminbiand absorbing a large negative demand shock through the external account. Asthe panic continues to built this autumn, Beijing might very well be forced to takethis route. A massive appreciation of the renminbi would indeed accomplish arebalancing and perhaps even avoid a full-blown financial crisis. But it would be doso at a considerable cost: Growth rates under this scenario will be sharply lower;perhaps even negative.

Some have argued that Beijing has demonstrated considerable skill in manag-ing economic shocks. e central government has indeed moved deftly to deal withdemand shocks. As a rule, this has been accomplished by directing state banks toexpand lending and pushing state-backed firms and local governments to expandinvestment. But expanding investment is not a solution to a crisis of overinvest-ment. All that can hope to accomplish is to perhaps postpone the day of reckoning.And when the crash finally comes, it would be even bigger than otherwise.

Maintaining high growth rates in the medium term will be especially hard. echief obstacle to maintaining high growth rates is the considerable misallocation ofresources. e overinvestment in property is likely to take years to work itself out.State-backed firms have cornered the lion’s share of resources at the expense ofmore efficient private firms. is distortion is unlikely to unwind by itself due tothe backing of the state. Indeed, it is getting worse as of writing. Both of these dis-tortions will have to reverse for growth prospects in the medium term to brighten.Growth will also be harder to maintain unless the build-up of toxic debt is takencare of. is is best done in one fell swoop. It would require Beijing to transferthese debts onto its own balance sheet. e central government debt is thereoforelikely to balloon—yet again, following in Japan’s footsteps.

e -pound gorilla in the room is of course rebalancing the economy awayfrom its dependence on external demand. is would require an unwinding ofChina’s high savings strategy. As argued above, China’s high savings are the resultof financial repression, wage suppression, and an undervalued exchange rate. Inorder to rebalance the economy, China must liberalize interest rates, raise wages,and let the renminbi appreciate. Rebalancing would significantly reduce growthrates down to perhaps per cent per annum. But on the bright side, real householdincome would rise at a faster clip; leaving people actually better off despite theslowdown in the economy. It would also contribute to the global recovery.

e ideal strategy for Beijing is to therefore to avoid a full-blown financial panicand rebalance the economy at the expense of growth rates. However, it is hard tosee policymakers in Beijing pursuing this strategy for the simple reason that all theheavy-weights in the Party have very close ties to the beneficiaries of China’s high

savings strategy. e rank and file of the Party is also unlikely to be anywhere closeto being enthusiastic about a strategy that promises a growth rate of per cent perannum. Beijing’s policy response is therefore likely to be muddled and rudderless.

China is unlikely to sustain high growth rates for the foreseeable future. Giventhe weight of China in the world economy, the implications for global markets aredire. e ride ahead will be bumpy. Despite the recovery in the United States, theFed will find it impossible to exit the zero lower bound in September and perhapseven December. e party is officially over.

NotesIncluding the exchange rate means that we need two equations to determine the equilibrium

exchange rate and national income. e second equation is then the balance of payments.One can think of country as “rest of the world” and think of this model as one of a large open

economy; large in the sense that large domestic shocks have a perceptible effect on the global interestrate.

e recent slowdown in productivity growth even as wages have continued growing temper thisconclusion.

US private debt-to-GDP has declined to per cent since the financial crisis as firms andhouseholds have rebuilt their balance sheets.