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HomeChinaChina now has a huge debt overhang—money was invested in ways that...

China now has a huge debt overhang—money was invested in ways that do not generate the funds to pay back the lenders or investors..


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China is in the news for two reasons. One is its increasing assertiveness in the global arena, often in ways that raise concern for the world political order. The other reason is its economic troubles. For three decades, China has been a major engine of growth for the global economy, benefiting its own citizens and consumers everywhere, by becoming the world’s factory. 

All economic growth is driven by investment—the accumulation of physical and human capital, as well as knowledge that is not confined to individual minds. These accumulations are combined productively in various kinds of organisations, such as profit-making firms, or governments that provide goods and services which would be under-produced if only profit motives rule.

When China began its growth acceleration, it did so in the context of a centralised political system that quickly embraced a dictum of “to get rich is glorious.” This strategic guidance was implemented in an institutional environment very different from earlier examples of economic development, where financial, judicial and other governance institutions evolved along with the economy, sometimes providing “organic” foundations for subsequent economic growth. These institutions provide mechanisms for channelling funds from savers to investors in ways that are productive: factories that make clothes and tools, roads that reduce transport costs, health and education services, and so on.

Sometimes, investments are poorly chosen. Since investment requires predictions about the future, there will always be some mistakes in investment choices. Problems arise when these mistakes become too common, especially when individual and institutional guardrails break down: people can become irrationally exuberant, or institutions can pursue short-term gains with the expectation that someone else will bear the cost of their bad decisions. The global financial crisis (GFC) was the result of such phenomena, and the failures of both profit-making and regulatory institutions, especially in the United States, caused pain to people all around the world.

One unusual feature of China’s economic growth before the GFC had been the role played by subnational, especially sub-provincial, governments. They acted as economic entrepreneurs, using tax revenue as well as revenue from commercial or quasi-commercial activities, such as the sale of land, to promote the setting up of factories and to develop the surrounding infrastructure. China as a source of huge quantities of cheap, disciplined labour made it an attractive destination for foreign investment, bringing in know-how and connections to markets as well as money for building factories. Land, in particular, became a vital asset for local governments, which acted as real estate developers of various kinds.

The GFC threatened the stability of the entire economy, and, just as in the US and some other countries, China made funds available to local governments, indirectly and directly, to avoid an economic implosion from the disruption of the mechanisms that allow money to flow from savers and lenders to borrowers and investors. Some of the money came from national tax revenue, which can act as a substitute for voluntary saving if the latter is inadequate. But tax-funded investment has a different set of incentive mechanisms, not always as effective as the discipline—however imperfect—of private capital markets. One of the outlets for the stimulus money became investment in housing, far beyond what the economy could absorb, given the country’s demographics and people’s incomes.

China now has a huge debt overhang—money was invested in ways that do not generate the funds to pay back the lenders or investors. Some of these unpayable debts are in organisations that are not strictly part of local governments, but have been used by them, making it unclear who ultimately is liable. An attempt to introduce a new property tax, which would have been a natural and relatively efficient way of generating local government funds earlier in the process, has been politically infeasible, because it could have a downward shock on land prices, worsening the unsustainability of the debt.

These kinds of problems are typical of speculative booms in private investment. The Chinese case happens to involve subnational governments, which has political consequences in both directions. Bailing out governments can be more acceptable to citizens than bailing out private companies, but the power of political insiders can also be greater, making it harder. This entire process of restructuring and cleaning up debt will require concentrated effort, and will have costs in terms of economic growth. As in all such cases, from Japan to the US to India, the speed of resolution and the distribution of the costs will have implications for future growth.

Meanwhile, the world faces increased risks and uncertainties, and China is in the throes of its separate project of maintain internal political control while projecting its power outside its borders. When China began its strategic shift to the pursuit of economic growth, it played along with the existing world order, while maintaining its internal structures of control. Now, it faces headwinds on both the global and domestic fronts. It is not clear what China’s leadership sees as the end point for its strategy, but it faces a more complex task than it has faced for many decades.

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