The first quarter GDP numbers that China’s National Bureau of Statistics released last week have renewed what was already an aggressive debate about whether or not China would be able to meet the 5.5 percent GDP growth target it set for itself this year. Two weeks ago, for example, for the second time in three months, the International Monetary Fund lowered its GDP growth forecast for the country to 4.4 percent from 4.8 percent in January 2022 and 5.6 percent last October. Given the serious headwinds the economy is facing, many analysts question whether China can achieve even this rate of growth.
But it’s a mistake to view China’s growth in terms of whether it can or cannot achieve a particular GDP target. China’s GDP growth is not a measure of the country’s economic output and performance in the same way the statistic is for other major economies. China’s GDP growth target is an input decided by Beijing at the beginning of the year. Its fulfillment depends on the extent to which the economic authorities are able and willing to use the country’s resources and debt capacity to achieve the required amount of economic activity.
Higher GDP growth for China, in other words, doesn’t mean a better economic outcome than lower GDP growth, as it does for most other economies. It just means that the authorities were more willing to employ resources for creating economic activity, whether or not that activity is productive or sustainable. System inputs cannot indicate anything about the performance of that system. Because GDP growth in China is such an input, it cannot be a measure of how well the economic system performs. Only an output measure can gauge its performance.
That being the case, what matters is not the level of GDP growth China manages to reach in 2022 but rather the way in which that growth, whatever its level, is achieved. Beijing has already long distinguished between “high quality” growth and “other” growth, a distinction that seems to be reflected in an important essay last year by President Xi Jinping in which he calls for more “genuine,” not “inflated,” growth:
I said that we needed to shift the focus to improving the quality and returns of economic growth, to promoting sustained and healthy economic development, and to pursuing genuine rather than inflated GDP growth and achieving high-quality, efficient, and sustainable development.
Broadly speaking, genuine growth can be thought of as sustainable growth generated largely by consumption, exports, and business investment (with the last of these elements aimed mostly at serving the first two), whereas “inflated” growth consists mainly of nonproductive, or insufficiently productive, investment in infrastructure and real estate. The purpose of inflated growth is to bridge the gap between genuine growth and the GDP growth target deemed necessary to achieve the Chinese leadership’s political objectives.
To simplify matters, a better economic outcome for China is not more GDP growth but rather more genuine growth and less inflated growth, whereas a worse outcome is the opposite. In that sense, whether or not China achieves a GDP growth target that exceeds the economy’s underlying genuine growth only reveals how determined Beijing is to achieve that level of economic activity, and how much debt it is willing to allow and how many resources it opts to sacrifice, to achieve a politically acceptable level of economic activity as measured by GDP. This GDP target says little about how healthy the economy is.
The rise in debt itself is not necessarily a problem, but while an accurate measure of the problem of wasted resources in the Chinese economy would be fairly complex, a disproportionate share of Chinese debt goes to fund investment. This means that, in principle, the country’s debt-to-GDP ratio is a reasonable proxy for the amount of inflated growth in China’s GDP numbers. For example, in 2020, when the onset of the coronavirus pandemic caused consumption to collapse, which in turn drove a contraction in genuine growth, more than 100 percent of China’s GDP growth was explained by the consequent surge in investment in infrastructure and property. It is therefore perhaps no surprise that China’s official debt-to-GDP ratio rose that year from about 247 percent to 270 percent.
In 2021, however, there was a major reversal of the previous year’s collapse in consumption, along with a surge in exports, a combination that also caused business investment to rise. At the same time, Beijing came down hard on the property sector and restrained growth in infrastructure investment. The result was that most, if not all, of the growth that year represented genuine growth and, not surprisingly, China’s debt-to-GDP ratio did not rise.1 This reinforces the idea that the surge in China’s debt burden in the past decade, among the fastest in history, is a result of the economy’s overdependence on nonproductive investment in property and infrastructure to balance out its structurally high savings rate and to bridge the gap between genuine growth and the GDP growth target.
From Productive to Nonproductive Investment
Investment in property and infrastructure doesn’t inherently cause an economy’s debt burden to rise. If the investment is broadly productive—that is to say, if the direct and indirect economic value it creates exceeds the cost of the investment—then any increase in debt will be more than matched in the short term to medium term by an increase in GDP, which is usually a proxy for the value of goods and services produced by the economy. If the created value outweighs the cost of the investment, the country’s debt-to-GDP ratio will not rise.
This was the case in China from roughly the late 1970s until the mid-2000s, when Chinese debt rose sharply, but GDP rose at least as rapidly. The relationship changed between 2006 and 2008, after which there was an observable acceleration in debt and a deceleration, gradual at first, of GDP growth.
While it is possible for productive debt to rise faster than GDP for short periods of time, when the growth benefits associated with the investment are postponed, this is unlikely to be the case when debt surges relative to GDP year after year for many years—as happened for the past fifteen years in China’s case. When that happens, it becomes obvious that the value of resources employed in the investment, for which debt is a proxy, is less than the value of productive capacity generated by the investment, for which GDP is a proxy. This creates a strong case for a claim of systematic malinvestment.
Investment in China can broadly be divided into two categories that mirror the distinction between genuine and inflated growth.
- private business investment: investment by entities that operate under hard budget constraints, activity that tends to be productive because nonproductive investment eventually lead to insolvency
- investment by entities without hard budget constraints: investment by local governments, state-owned enterprises, and, until recently, the property sector—whereby loss-causing activities can be subsidized or ignored for long periods
It is mainly this latter category that accounts for the surge in China’s debt-to-GDP ratio. To the extent that much of China’s investment in property and infrastructure in recent years cannot be justified economically, in other words, it explains the sharp rise in the country’s debt burden.
It is worth repeating that China’s overdependence on investment by entities that operate under soft budget constraints hasn’t always resulted in a rising debt burden. China began its reform period in the late 1970s after five decades punctuated by the Second Sino-Japanese War, civil war, and Maoism, all of which left the country hugely underinvested in infrastructure, logistics, and manufacturing capacity for its level of social development. Until the mid-2000s, while the Chinese economy remained underinvested relative to the capacity of Chinese businesses and workers to absorb investment productively, most investment tended to be productive.
Even with a substantial and rising amount of wasted investment, which showed up in the staggering amount of nonperforming loans in China’s banks that were cleaned up between 2000 and 2010, China’s high investment levels were nonetheless productive in the aggregate and resulted in rapid, sustainable growth. By 2006 to 2008, however, like every other country that has followed a similar high savings, high investment growth model—most notoriously the Soviet Union in the 1950s and 1960s, Brazil during those same decades, Japan in the 1970s and 1980s, and perhaps a dozen other countries—China seemed to have closed the gap between its level of capital stock and the level that its workers and businesses could productively absorb, after which China’s debt burden began to rise rapidly.2
China’s Five Paths
The problem with this stage of the development model—and it is worth repeating that this also happened to every other country that followed a similar approach—is that the continued high levels of growth generated by systemic investment misallocation are not sustainable. Once it reaches that stage, such a country must shift to a new growth model, perhaps a much more bottom-up one in which the authorities abandon their previous supply-side orientation in favor of income redistribution and demand-side support.
Until the country begins its difficult adjustment, it can continue to grow rapidly only with the piling on of more nonproductive investment, creating more inflated growth. Because this fictitious growth isn’t sustainable, it must eventually be amortized, and in every previous case the period of adjustment reversed much of the previous growth. Unfortunately, the more fictitious growth that is created, the more politically difficult and economically costly the amortization of this growth tends to be.
Once it is recognized that China’s surging debt burden is a function of nonproductive investment, and that this investment must eventually be curtailed, it turns out that there are a limited number of ways the economy can continue growing. Any economy broadly speaking has only three sources of demand that can drive growth: consumption, investment, and trade surpluses. For that reason, there are basically five paths that China’s economy could take going forward.
- China can stay on its current path and keep letting large amounts of nonproductive investment continue driving the country’s debt burden up indefinitely
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with productive investment in forms like new technology
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with rising consumption
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with a growing trade surplus
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with nothing, in which case growth would necessarily slow sharply
These are the same five paths, by the way, faced by every other country that has followed the high savings, high investment model. Each of these paths creates its own systemic difficulties and each, except for the first, implies substantial changes in economic institutions that, inevitably, must be associated with substantial changes in political institutions. This may be why in the end every previous country followed the last of the five paths.
It is nonetheless worthwhile to examine each of the five paths in turn. Doing so will underscore the constraints that Beijing must accept or overcome in pursuing each path.
Path 1: Can China Keep Doing What It Has Been Doing?
For China to stay on its current path of high-level growth fueled by nonproductive investment, the country would need to allow a persistent, indefinite increase in its debt burden.
There have been many attempts to argue that rising debt isn’t a problem for China. Some commentators argue, rather foolishly, that debt is only a problem if it involves external debt and is not funded by domestic savings. But surging debt funded by domestic savings rather than foreign savings just means that the country accumulating the debt is running a current account surplus. It should be enough to point out that the surge in U.S. debt in the 1920s and the surge in Japanese debt in the 1970s and 1980s—both countries with persistent current account surpluses, high domestic savings, and no external debt—turned out to be among the two greatest debt-related calamities of the past century.
Others argue that as long as China is monetarily sovereign, there is no limit to the amount of debt it can create and absorb. This is basically the same argument as the one above, couched in slightly different terms, but (as I’ve discussed elsewhere) it is based on a naïve misunderstanding of modern monetary theory. An expansion in debt that results in an expansion in demand relative to supply must be resolved by implicit or explicit transfers that, in turn, always undermine economic growth, whether the debt is funded domestically or externally.
More importantly, however, it has become clear that the majority of economic policymakers and economic advisers in Beijing do not believe that a persistent increase in the country’s debt burden is sustainable. They have stated many times that they are determined to get off this particular path and have tried to implement policies seeking to restrict nonproductive investment and the growth in the country’s debt burden, even if none of these attempts have been successful. That is because of how difficult it is, or how unwilling they are, to accept the consequences of any of the four remaining paths.
Path 2: Can China Replace Nonproductive Investment With Productive Investment?
Beijing could bring debt under control while maintaining high growth rates by replacing nonproductive investment with investment in more productive economic sectors. Chinese authorities have been proposing this for many years as the most likely path to follow, but they have been unable to fulfill these promises.
This shouldn’t be a surprise. Every country that has followed this growth model has, in the model’s later stages, proposed the same solution, but there are at least three important reasons this solution is difficult to implement.
The first hurdle is the sheer size of the required transfers relative to the potential size of the would-be recipient sectors of the economy. China currently invests 40 to 45 percent of GDP every year, the highest figure ever recorded by any country, even if this number is down from earlier levels; a little more than roughly 30 percent of this amount has been channeled into infrastructure investment and a little less than 30 percent has been allocated for property investment.3 In contrast, the Chinese economy’s high-tech sectors, in which so many place their faith, represent less than 10 percent of GDP according to the most generous of definitions.4 The idea that there are highly productive sectors in the Chinese economy that can easily absorb even a fraction of the investment in nonproductive or low-productivity sectors is pretty far-fetched.
That leads to the second problem. It is not at all obvious that these presumably more-productive sectors are starved for capital. China’s private-equity and venture-capital sectors have grown explosively in the past two decades, and it is widely mentioned by practitioners that raising capital to fund new ideas is far easier than finding profitable new ventures to fund. This is not just an issue in China—Apollo CEO Marc Jeffrey Rowan recently noted, for example, “Our market sometimes loses sight of what’s in short supply; capital as a general matter is plentiful, and it is assets that offer appropriate risk rewards that are in short supply”—but it has been a bigger concern in China than elsewhere. That being the case, diverting large amounts of additional investment into these sectors is likely to replace one kind of nonproductive investment with another.
The third problem, one that crops up in any discussion of how the Chinese economy is to adjust, is probably the most difficult to resolve. An economy that has invested between one- quarter and one-third of its GDP in property and infrastructure for three decades or more, and one that has seen the amount of wealth accounted for by property and infrastructure investment soar, will have developed social, economic, financial, and—most importantly— political institutions that were constructed around this method of investment. Such a tradition of investment misallocation is also likely to result in a household sector for whom home ownership is a disproportionately large share of total household savings—up to 70 percent by some measures.
Such a radical transformation of a country’s investment process cannot help but disrupt these social, economic, financial, and household institutions. It is hard to imagine that such shifts would not also require or result in fairly radical transformations of political institutions in ways that have historically been extremely difficult to absorb and predict. While economists rarely—with few exceptions, like Albert Hirschman or the dependencia theorists of the 1960s and 1970s—discuss these institutional constraints, historically they have always been the most important constraints that have prevented successful adjustments.
None of this means, of course, that it is impossible for China to follow this path, but it does indicate that doing so would be extremely difficult and would inevitably require institutional changes that are hard to predict. At the very least, such a path would require that the authorities in Beijing have a clear understanding of why other countries that followed this growth model found this form of adjustment so difficult to implement.
Path 3: Can China Replace Nonproductive Investment With Rising Consumption?
Beijing could bring debt under control while maintaining high growth rates by replacing nonproductive investment with a rising consumption share of GDP. This is what Beijing has been proposing since at least March 2007, when (during his closing press conference at the Two Sessions parliamentary meetings) then premier Wen Jiabao announced that the rebalancing of domestic demand toward consumption would be a top priority of Beijing’s economic policymakers.
Household consumption composed less than 40 percent of China’s GDP as of 2020, versus a global average in other countries of roughly 60 percent. With other consumption (such as government consumption) adding 10 to 15 percentage points, an amount in line with the figures for other countries, China has by far the lowest consumption share of GDP of any economy in the world.
There’s no mystery as to why the Chinese consumption share of GDP is so low. Chinese households retain a very low share—in the form of salaries and wages, other income, and transfers—of what they produce, so they are unable to consume more than a low share of what they produce. Beijing’s new common prosperity policies focus on redistributing income from the wealthy to the poor and the middle class, but even if the program is successful, this will only help at the margins.
That is why there is also no mystery about how to sustainably raise the consumption share of GDP: Chinese households must retain a larger share of what they produce, which of course also means that some other sector of the economy—either businesses, the government, or foreigners (although this last category is too small to matter)—must retain a reduced share.
With businesses in China retaining roughly the same share of GDP as in other countries, it would be costly for Beijing to force businesses to absorb the extent of the necessary transfer, which leaves only the government sector (mainly meaning local governments). The only way to rebalance consumption in China meaningfully and sustainably, in other words, requires substantial transfers from local government to households.
But this is also why it has been so difficult for Beijing to manage the rebalancing process and why, the consumption share of GDP has only risen a few percentage points, even fifteen years after Wen first promised to rebalance demand. It is inconceivable that a transfer of 10 to 20 percentage points of GDP from local governments to households wouldn’t also imply a huge shift in the relative political power of different sectors of the economy and a major transformation in the country’s relevant social, political, and economic institutions.
Again, none of this means that it is impossible for China to follow this particular path, but recall Hirschman’s insight that the constituencies that have benefited disproportionately from the older model—and have amassed a disproportionate share of political power in the process—are likely to block an adjustment to this model that requires them to absorb a disproportionate share of the adjustment costs. Put differently, it is easy to figure out the arithmetic of the rebalancing adjustment, but it is difficult to absorb the political consequences.
Path 4: Can China Replace Nonproductive Investment With a Rising Trade Surplus?
Another way that Beijing could bring debt under control while maintaining high growth rates would be by replacing nonproductive investment with a rising trade surplus. While this option is possible in theory, in practice it isn’t.
China’s trade surplus, at roughly 4 to 5 percent of China’s GDP at the end of last year, was already equal to nearly 1 percent of the GDP of the rest of the world, and by my calculations it would need to increase the surplus every year by at least 3 percentage points of Chinese GDP to replace domestic nonproductive investment. This is a possible strategy for a small economy, but China’s trade surplus is already unacceptably high for such a large economy. The rest of the world would not (and probably could not) accept a system in which China depends for growth mainly on its ability to absorb a larger and larger share of scarce global demand.
Path 5: What Happens If China Does Nothing to Replace Nonproductive Investment?
Given that investment accounts for 40 to 45 percent of GDP in China, with investment in infrastructure and property accounting for nearly two-thirds of that amount, it is clear that a significant reduction in nonproductive investment—if it is not replaced with another equivalent source of growth—must result in a sharp contraction in China’s GDP growth. My back-of-the-envelope calculation suggests that the upper limit of GDP growth for many years, should that prove to be the case, would likely be 2 to 3 percent.
Unfortunately, historical precedents suggest that such adjustment costs tend to be underestimated. This growth model is highly pro-cyclical, with massive infrastructure spending causing rapid growth, and rapid growth in turn justifying more infrastructure spending. If the adjustment is not carefully managed, an initial slowdown can become—and has become in every previous case—self-reinforcing. That may be because the more the economy slows, the more it undermines the value of previous investment in infrastructure and manufacturing capacity, which only increases the amount of fictitious wealth (bezzle) that must ultimately be written down, a process that in turn depresses growth further.
Historically, there have been two ways (or some combination of ways) in which the adjustment to much slower growth occurs. One way is for this shift to happen rapidly, usually in the form of a financial crisis along with a sharp contraction in GDP. The other way is through lost decades of very low growth. The first way may be more costly in the short run but less costly over the long run, unless it leads to political and social disruption.
Whether the Chinese economy is likely to adjust in the form of a financial crisis or in the form of lost decades of sluggish growth is probably mainly a factor of the stability of the country’s domestic balance sheets and the financial system and the ability of financial authorities to control and restructure systemic liabilities. In my opinion, domestic financial conditions are such that China is still unlikely to have a financial crisis or a sharp economic contraction. It is much more likely, in my opinion, that the country will face a very long, Japan-style period of low growth.
The Outlook for the Rest of 2022
Beijing is trying to reduce nonproductive investment as rapidly as it can while trying to make progress toward the second, third, and fourth paths outlined above. But for political reasons, Chinese policymakers have never been able to accept the extent of the necessary slowdown, which is why debt continues to surge. As long as increases in fixed asset investment continue to be Beijing’s main lever for maintaining politically acceptable growth rates much above 2 to 3 percent, there is no way to prevent the country’s debt burden from ballooning.
While Chinese economic policymakers and advisers increasingly recognize that China’s existing growth model is reaching its limits, the political importance of the year 2022 for the country’s leadership is likely to mean at least one last year of rapid growth driven by investment excesses, even though the economy has been badly hurt by the March and April 2022 pandemic-related lockdowns of significant parts of the economy.
Once the decision has finally been made, however, to regain control of the country’s balance sheet, eliminate or sharply reduce nonproductive investment, and accept the consequences in terms of slower growth, the question then becomes how much slower growth can Beijing accept? My best guess is that growth must slow to below 2 to 3 percent, but I suspect that even the Chinese policymakers and advisers that most agree with my analysis don’t expect the sustainable growth rate to drop much below 4 percent, in which case they will have trouble accepting the required adjustment and debt will continue to rise for many years even as growth slows sharply.
Whatever Beijing decides, one way or another China will be forced to shift from the first path to one or more of the other four paths listed above, although because of the size of the Chinese economy the fourth path (replacing bad investment with surging current account surpluses) is extremely implausible. But at the same time because the first path isn’t sustainable, this also means that either Chinese policymakers will find some way to overcome the historical difficulties associated with the second and third paths, or they will be forced eventually onto the fifth path. Historical precedents suggest that the longer it takes for Beijing to make this decision, the more economically difficult and politically disruptive the ultimate adjustment is likely to be.
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1 In fact, while the outstanding amount of debt roughly stabilized, it fell as a share of GDP by six percentage points, to 264 percent, mainly because part of that year’s economic activity had been funded by the previous year’s surge in debt.
2 It is probably not just a coincidence that China’s debt-to-GDP figure rose especially rapidly in periods during which Beijing had to rely more heavily than usual on property investment and public-sector investment in infrastructure—such as from 2009 to 2010 and in 2020—to achieve GDP growth targets that otherwise exceeded the capacity of the private sector.
3 These are my own calculations based on data from the National Bureau of Statistics. Given last year’s crackdown on the property sector, the property share has almost certainly declined in recent months while the infrastructure share is rising. See Chinese National Bureau of Statistics, “Statistics Database,” Chinese National Bureau of Statistics, http://www.stats.gov.cn/english/.
4 The technology input subindex represents 25 percent of the Caixin New Economy Index, which itself represents less than 30 percent of China’s overall economic input activities. Even then, I suspect that this index overstates the useful new technology sector by including security operations (which comprise the bulk of AI activities) and retail operations that have moved online. In such cases, it will be hard to squeeze extra productivity from increased investment. See Guo Yingzhe, “Shrinking Capital Investment Drives Down Caixin New Economy Index,” Caixing Global, September 9, 2021, https://www.caixinglobal.com/2021-09-02/shrinking-capital-investment-drives-down-caixin-new-economy-index-101767858.html.