Out of the Red and into the Black

Out of the Red and into the Black

Now that China has wrapped up the annual session of its pro-forma parliament, the National People’s Congress (NPC), it is clear that a gulf has opened up between economic policymakers in Beijing and outside analysts. Many outsiders say China must quickly cut back on debtor face a financial crisis. Beijing, by contrast, seems happy to let debt keep piling up while it tackles some tough structural reforms. This strategy is less risky than it sounds.

According to a common outside view, China’s biggest problem is a huge debt increase. The combined debt of households, corporations and government soared from 138 percent of gross domestic product (GDP) in 2008 to 205 percent in 2013. Unless this spiraling leverage is brought under control, the argument goes, China risks a financial crisis similar to the one the United States suffered after its debt-fuelled housing bubble. Ideally, according to this analysis, China should act swiftly to first stabilize, and then reduce, the ratio of debt to GDP, commonly known as the leverage ratio. To do so, Beijing must sharply reduce the growth in credit, from its current rate of around 17 percent annually to roughly 10 percent. But inevitably, a credit squeeze of that magnitude will cut into economic growth. So the conclusion is that if Beijing is serious about controlling leverage, it must accept significantly lower economic growth for at least a few years. If, on the other hand, the leaders insist on keeping economic growth at its current pace, this means they cannot be serious about controlling leverage — increasing the likelihood of a financial train wreck.

It is evident from the work reports at the NPC — and from the earlier reform program announced at the Third Plenum, a major Communist Party meeting last November — that China’s leaders disagree with this outside opinion. They aim to stabilize real GDP growth at around its current rate of 7.5 percent a year, and will let credit keep flowing to support that growth. Meanwhile, they will focus on structural reforms: making the bloated state-owned enterprise sector more efficient, and fixing the dysfunctional finances of local governments. It is almost certain that under this policy mix, leverage will continue to rise.

But China’s leaders are not driving the nation off a financial cliff. Their strategy is sensible, though not risk-free, and demonstrates that China’s President Xi Jinping and his colleagues have a good grasp of the real challenges in China’s economy. It also shows they have absorbed valuable lessons from the way the United States, Europe, and Japan have handled — or mishandled — financial crises over the past two decades.

The essence of Beijing’s approach is the recognition that a credit tightening would punish good and bad borrowers alike. It will also be self-defeating if it does not address the underlying causes of the debt buildup. In short, China’s leaders see the leverage ratio as merely a symptom. They are betting that if they attack the disease, the symptoms will eventually take care of themselves.

This explains the choice of reform targets. The two biggest sources of excessive borrowing in the past five years are state-owned enterprises (SOEs) and local governments, which together account for more than half of all the country’s debt. By reducing the incentives for SOEs and local governments to borrow, and ensuring that the money they do borrow is used productively, Beijing should be able to control the debt problem.

Both SOEs and local governments started piling up debt at a hectic pace in 2009, essentially because they were ordered to do so. In response to the global financial crisis, Beijing launched a massive economic stimulus that consisted mainly of heavily-leveraged investments in infrastructure. The main agents for this investment were the SOEs and special-purpose infrastructure companies controlled by local governments.

But SOE and local government borrowing have deeper causes as well. From 1998 until 2008, the SOEs were subject to a reform drive that forced them to shed non-core and non-productive assets, exit competitive sectors in favor of nimbler private firms, and focus on "strategic" activities such as aviation, telecoms, power and petrochemicals. During that decade, the number of state firms fell from 260,000 to 110,000, the private sector’s share of national fixed investment rose from less than a quarter to 58 percent, the profitability of state firms rose dramatically (nearly matching the returns in the private sector), and the proportion of SOE assets in "strategic" sectors rose to an all-time high of 62 percent.

Since the 2009 stimulus program, which relied heavily on investment by state firms, most of these gains have stalled or been reversed. Crucially, the return on assets in SOEs plummeted to less than half the private-sector average, and state firms began to re-colonize sectors from which they had previously retreated: by 2011, 50 percent of SOE assets were in these non-strategic sectors.

For local governments, the deep-seated problems are chronic deficits and unfunded mandates. Localities collect only about 45 percent of all government revenue, but their share of total expenditures has risen from 65 percent to 85 percent of the national total in the past decade. Most of this increased burden resulted from demands from Beijing to provide ever more social goods and services: low-cost housing, healthcare, education and environmental protection. These new mandates did not come with any new funding sources.

In theory, transfers from the central government bridge this budget gap, but in practice the transfers often do not match up well with localities’ actual needs — either because the money arrives late, is insufficient, or is earmarked for the wrong purposes. Not surprisingly, localities respond to this structural deficit by resorting to a variety of off-budget funding schemes, the most popular of which is to grab land from farmers at below-market prices and then use the land as collateral for bank loans.

The reforms sketched at last November’s Party Plenum and fleshed out at the just-concluded NPC are comprehensive. State firms will be compelled to improve their abysmal return on capital, rather than simply expanding their assets as they have done for the past several years. Direct private investment in SOEs and in state-led investment projects will be encouraged, and previously restricted sectors like banking, aviation, and telecoms services will be opened to private firms. And most likely — although government officials have been deliberately coy on this point — a swathe of underperforming locally-controlled SOEs in non-strategic sectors will be privatized or forced into bankruptcy.

Several concrete measures show that the SOE reform agenda is not just talk. In late February the government of Guangdong, one of China’s richest provinces, has targeted converting 80 percent of provincial SOEs to a "mixed-ownership structure," with no predetermined minimum state shareholding — code for privatization. Since then, 19 other provinces have followed suit with similar plans. Petrochemicals giant Sinopec has announced it will seek private investment for a share of up to 30 percent in its gasoline and diesel distribution operations. And Beijing has invited Internet behemoths Alibaba and Tencent to apply for banking licenses, which if issued would be a first for truly private companies. All these moves would have been inconceivable a year ago.

On the fiscal front, Finance Minister Lou Jiwei (who helped design the present tax system as a junior official in the early 1990s) used his NPC work report to lay out a remarkably detailed set of proposals for cleaning up local government finance. The centerpiece is reducing unfunded mandates by moving more expenditure responsibility back to the central government. Lou also plans a more flexible transfer system giving localities more leeway in how they use monies from the central government, a host of new taxes including a property tax and an environmental protection tax, and new financing channels including municipal bonds. The latter should provide a safer way to fund needed infrastructure projects than the current jury-rigged system of special-purpose companies financed by land grabs.

The reform agenda is a strong one: its diagnosis of China’s economic ills is compelling, and the proposed cures seem sensible. Moreover, it shows a keen appreciation of the lessons from other financial crises. From the two "lost decades" following the burst of Japan’s real estate bubble in 1990, Chinese leaders have learned that they must deal swiftly with the root causes of excessive debt and enforce productivity-enhancing reforms. Failure to do so could consign the nation to an extended period of economic stagnation.

From the contrasting experiences of the United States and Europe since 2008, China has learned that a single-minded focus on debt-reduction can be counterproductive, and that growth-supporting policies can also help reduce debt. In the years after the crisis, the United States ran huge fiscal deficits and an extraordinarily easy monetary policy in order to sustain growth; the Eurozone economies pushed its weaker members into fiscal austerity programs, in an effort to force debt levels down. It now appears that the U.S. approach worked better: the U.S. economy has continued to grow by around 2 percent a year every year since 2010, and consumer debts — whose explosion triggered the financial meltdown — have returned to their pre-crisis level. Europe, by contrast, suffered a painful "double-dip" recession from which it is only now recovering, and debt levels in many countries still remain very high.

The government’s course is a bold wager: let debt keep rising to support growth, while pursuing structural reforms that will bring down the debt level in perhaps five years. The risk is obvious. Self-interested SOE or local government bosses could block reforms, in which case China will find itself in an even worse debt trap in a few years. On the whole, though, Xi’s government has started to deliver convincingly on its reform promises. More likely than not, Beijing’s bet will pay off.