China’s rapid debt growth in recent years has received worldwide attention (see Figure 1), not least because when choosing between bolstering growth or pursuing reforms and deleveraging, the Chinese government has chosen growth. By doing so, legacy problems, especially rising debt levels but also overcapacity, have been further exacerbated. Ultimately, an investment and stimulus-backed growth model will deliver diminishing returns by struggling even to deliver a higher growth rate. The basic problem is that each yuan invested by the state is becoming less efficient, which, in turn, requires more easy money to achieve the same amount of marginal growth. In short, China is certain to get less bang for its buck over time.
Figure 1. Chinese Non-Financial Sector’s Total Debt (% of GDP)
Source: Bank of International Settlements.
This is not really news. After all, Beijing’s preference for short growth over reform is already widely known. But I would argue that this preference for juicing growth will lead to additional perverse outcomes, which are receiving less attention. Specifically, more financial vulnerabilities are sure to emerge that will make future reforms even more difficult over the medium term. In other words, there is a vicious cycle now between the buildup of debt and Beijing’s unwillingness to reform. And as the Chinese economy becomes increasingly complex, connected, and potentially volatile, any future policy change will likely lead to unintended consequences. For a policymaker in Beijing, the choices often can be harrowing but there are likely to be more payoffs in exchange for some leap of faith into the unknown and greater stomach for tolerating higher levels of risk.
Chinese leaders are usually very clear-headed about the risks associated with reforms—and have repeatedly acknowledged the difficulties of reform over the past four years. But in retrospect, Chinese policymakers have actually had a tendency to overestimate their ability to tolerate serious volatility and risk. When volatility has hit, some policymakers seem to want to reverse all reforms indiscriminately, even at the cost of possibly abandoning worthwhile and well-designed reform policies.
Recent cases such as stock market volatility and capital account liberalization demonstrate that reform measures have been withdrawn or shelved because they risked undermining Beijing’s other objectives of growth and stability. High-profile reforms, such as to the stock market, eventually stalled. Another example is the trigger of the Chinese central bank’s (PBOC) August 2015 currency depreciation. A decision was taken to relieve considerable capital outflow pressures that had emerged from the creation of new money to bail out the stock market. Yet despite the central bank’s earnest intention to create a more market-driven exchange rate, depreciation pressure continued to build as high credit growth persisted. As a result, the PBOC saw little choice but to intervene more in the currency market, even as it tried to move to a market-based exchange rate. In other words, short-term pressures defeated a longer-term interest in structural reform.
To be fair, the current pattern of timidity has much to do with the rapid accumulation of credit and systemic vulnerabilities rather than the relative competence of economic policymakers. No policy design will ever be perfect, and policy change always leads to volatility. But the elevated level of credit in China’s economy today is tending to amplify policy mistakes as “reform” is increasingly conflated with “volatility.”
But this kind of timidity will make state-owned enterprise problems, systemic over-capacity and other legacy problems much more severe, just as they have grown more severe today when compared, say, to 2012. Even if reform accelerates again after this fall’s 19th Communist Party Congress, arresting the current deterioration of reform trends will mean that Beijing likely needs even longer to undo the damage from nearly a decade of stimulus–induced capital misallocation. So Beijing is now running a race against vulnerabilities of its own creation.