Don’t Breathe Easy About China Yet

(Bloomberg Opinion) -- While new factory data, and signs of a trade truce with the U.S., have investors feeling more bullish about China, most analysts now accept that GDP growth will inevitably have to slow if Beijing is serious about reining in credit expansion. Till now, China has met its GDP growth targets only because soaring debt allowed it to capitalize non-productive activity, i.e. value it at cost rather than its real economic value. The target could be 6 percent just as easily it could be 7 or even 8 percent: As long as local governments and state-owned enterprises had debt capacity, they could generate enough activity to meet almost any target.

What’s less-understood even now is that if China begins a serious deleveraging, reported GDP growth rates will fall by a lot more than expected -- by more than the amount of non-productive activity that had formerly been capitalized. This is clear from the historical precedents. In every modern case where countries enjoyed similar investment-driven growth “miracles” and then suffered painful adjustments, medium- and long-term GDP growth rates slowed much more than even the most pessimistic projections.

The reason is that a reversal of the balance-sheet dynamics that had boosted growth during the expansionary phase forced GDP growth down during the contractionary phase. There are at least two ways in which this works. First, many years of excessively high GDP growth targets create an overstatement of total assets and total wealth.

If a loan funds a $100 dollar investment in a project that creates only $60 of value, for example, there is a $40 loss that should normally reduce the value-added component of the GDP calculation. But, if this loss is capitalized and the investment carried at cost, the full $100 expenditure is added to GDP and the total amount of real wealth in the economy is overstated by $40.

This overstatement doesn’t last forever. Once debt stops growing, this $40 will effectively be written down in the form of lower future GDP growth, in part because real growth is being measured relative to an artificially high base.

After many years of overstatement, then, reported GDP growth rates will begin to understate real growth in the underlying economy. This can happen quickly in the form of a crisis or, as is more likely in China’s case, it can take place over many years as seems to have happened in Japan.

The second way in which balance-sheet dynamics will push down growth is by forcing a heavily indebted economy to absorb what finance specialists refer to as “indirect” financial distress costs. Surprisingly, considering how powerful the impact has been in the past and how well understood it is in finance theory, this concept is almost wholly ignored or misunderstood by mainstream economists.

In finance theory, these costs mount when rising fears of bankruptcy encourage stakeholders to protect themselves in ways that reduce or destroy economic value. Of course, countries don’t go through the same kind of bankruptcy process as businesses do. Still, those with high debt levels can suffer from similar behavior.

This can happen because of substantial uncertainty about how future debt-servicing will be allocated. Once debt is no longer rolled over, debt-servicing costs must be absorbed directly or indirectly by one sector of the economy or another, causing each to try to minimize its losses.

We can already see this process at work in China in the form of capital flight, private-sector disinvestment, regulatory maneuvering and elevated levels of financial fraud. Costs will truly spike, however, once rising debt is no longer simply rolled over. These two phenomena -- financial distress costs and the amortizing of overstated wealth -- could drive down GDP growth to below half current levels.

What’s more, their impact is a function of the amount of bad debt that’s previously been accumulated. The more debt China builds up and the longer it takes to shrink the pile, the lower we should set our long-term growth projections. Just as high reported GDP growth rates today make the economy's performance look better than it is, low reported growth rates tomorrow will paint a much bleaker picture. 

To contact the editor responsible for this story: Nisid Hajari at nhajari@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Michael Pettis is a professor of finance at the Guanghua School of Management at Peking University in Beijing.

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