You mentioned that Xi had consolidated his power and was able to start reforms. Is he really a reformer?
China really does not have a choice. You can’t allow your debt to grow at two to three times your debt servicing capacity year after year, when already your debt is probably well over 300% of GDP and you’re a developing country. Most people realize that this is a ticking time bomb. Beijing has got to address the debt issue. I think there is this recognition that they’ve got to stop the debt from growing and they understood that it’s impossible to do that without seeing a significant drop in GDP growth.
How should the debt problem be addressed?
The typical economist would tell you that you have to implement productivity enhancing reforms and grow your way out of the debt. But let’s face it: No country in history with too much debt has ever been able to just grow out of it. They reduce their debt either by defaulting, by inflating it away, by squeezing the workers or expropriating the rich. In the case of China, the source of the huge growth in debt has been massive amounts of misallocated investment in non-productive infrastructure and unnecessary manufacturing capacity. So as a first step, you have to stop the non-productive investment. But if you do that, you reduce growth. And if you don’t want growth to drop too much, you need another source of demand.
Such as?
For an economy the size of China, the obvious choice is household consumption. Household income and consumption in China today are at below 50% of GDP. That is the lowest level ever recorded in history. So to me it’s clear that China’s economic growth now must come from the consumption sector. They need to replace non-productive investment with consumption.
How can that be achieved?
There are only two ways to grow consumption: One is to boost household debt, which is what they did in the last four years. Household debt in China has exploded. But of course that doesn’t solve the debt problem, it just moves it to the household side. The other way to boost household consumption is to boost household income. After 30 years in which the household share contracted, we now need the household share to expand. That means the group that benefited most in the last 30 years, the group that enjoyed an expanding share of a rapidly growing economy, must now retain a contracting share of a much more slowly growing economy.
Who is that group?
The local elites and the local governments, which are controlled by the local elites. So the solution is very simple: You have to transfer wealth from local governments and elites to ordinary households. They’ve known that solution since 2007, and if you look at the 2013 Third Plenum reforms, they were all about that transfer of wealth. It’s just politically incredibly difficult to do that.
To put it simply, you’re saying the central government is battling against the vested interests in the provinces?
Yes. It’s interesting to know that the term «vested interest» only emerged in China in early 2008, after premier Wen Jiabao promised to begin rebalancing the economy. That’s not a coincidence. If you’re going to impose those reforms, you have to significantly weaken the vested interests and strengthen the central government. Which is what Xi Jinping has spent the first five years of his presidency doing.
So let’s say the domestic debt level in China today amounts to 300% of GDP. How can that be wound down?
First, we need to understand that there are two types of debt: Good debt is when you borrow money to build something that creates enough economic value to repay the debt. And then there is the other debt, the bad one, that is used to build something that does not create economic value. The way to deal with that is you have to get rid of the debt and assign the cost to somebody. How can you do that? Well, you can default and restructure, which means the creditors bear the cost. That’s difficult in China, because the creditors are the banks and the banks are guaranteed by the government. Another way is you can assign the costs to the household sector, which tends to be politically weak.
How is that done?
By imposing negative real interest rates on household savings. That’s what happened in China in the last decades. The problem today is the issue we just talked about: If the government wants the households to boost their spending, they can’t squeeze them to bear the costs of all the unproductive debt in the economy. So who else? Ideally, you would like to get the foreigners to bear the cost of bad debt, but in China the foreigners are not the lenders. So there is only the government left. And by that, I don’t mean the central government, but local governments. The most effective way for China to reduce the debt level is to force local governments to pay for the debt in their region.
How can they do that?
Local governments own a lot of assets, such as real estate and state-owned enterprises. They should sell those assets and use the proceeds to pay down the debt. There have been many proposals, but it's just not happening. The power of the local elites depends to a large extent on the local government’s control of these assets. It’s incredibly difficult for the central government to take on the local elites.
