Economists and analysts are skilled at complicating what can actually be profoundly simple issues. For all the ink, or zeroes and ones in the digital age, in that has been spilled on what ails the Chinese economy, I personally think it is quite simple: the lack of trade surplus.
I understand that China in 2015 ran a record current account surplus and 2016 is expected to be near but not exceeding the 2015 number but follow me for a minute and I think you will see how everything comes together.
The entire Chinese economy is built upon capital accumulation. Real estate development, industrial upgrading, and airports are all forms of capital accumulation. While this can take the form of both human and physical capital accumulation, in China we accurately think of this more in terms of physical capital. Human capital in China is increasing every year but not at the same growth rate as the 15% growth in bank assets. This skews the growth in capital accumulation towards physical capital accumulation.
We need to note and draw an important distinction about the so called “current account” surplus. In 2012, China changed its current account payment and receipt regulation which has had an enormous impact on the actual flows of currency. Given what we know about the discrepancy between customs reported surplus and bank balances, prior to 2012, there was little difference between these numbers. Post-2012, there are large differences. Using this slightly modified number, from 2004 to 2009, China ran current goods and services surplus equal to an average of 5% of nominal GDP every year. From 2010 to 2016, that number is an average surplus of 0.2% of nominal GDP.
It should come as no surprise, that economic problems started accumulating in 2013 the second year of no cash trade surpluses. Given the time lag, the crunch from the lack of large capital surpluses was almost inevitable.
When China was running large current account surpluses it could easily fund large scale capital accumulation. However, absent large scale cash surpluses that were being paid for, the economic grease in relative quick order simply ground to a halt.
It was in 2009 that the trade surplus dropped from 6.5% to 3.8% and when debt started growing rapidly. By 2012, the adjusted goods and services surplus had turned mildly negative to the tune of 0.3% of nominal GDP. However, rather than restraining credit and investment, China continued to expand credit rapidly. In 2012, bank loans were up 15% and the stock of financing to the real economy was up 19%.
This leads to an important point. The only way for China to push growth and investment in the presence of negative goods and service cash surplus was to borrow intensively.
This is true post 2008 and this is true in 2017. If you do not have the surplus (savings) to pay for the investment then you borrow it. Since the middle later part of last decade, savings has stagnated and gone down slightly. However, fixed asset investment has continued to increase in absolute and relative terms. How do you pay for that? You borrow.
This leads to two undeniable conclusions going forward. First, this explains the crackdown on outflows. If China is not generating significant current account surpluses, in cash terms not just customs accounting, this will continue to push the debt binge even further.
I am personally skeptical the crackdown will matter that much. The crackdown will slow outflows but will generally have no fundamental impact on outflows. Falling ROE and ROI simply do not encourage investors to keep money in China. Furthermore, just the law of large numbers alone would limit China’s ability to run similar surpluses. If China ran the same surplus it ran in 2007, it would have a surplus of nearly $850 billion USD. There are many reasons in 2017 that this is simply not feasible.
Second, debt will most likely continue to rise rapidly for the foreseeable future. The reason is simple in that the Chinese economy is so dependent on investment that should it drop at all, it would have an enormous impact on the economy. In 2016, fixed asset investment was equal to almost 82% of nominal GDP. That is simply an astounding number.
Consequently, if we assume that investment remains high and there is no obvious driver for a rebound in savings that would allow these projects to be funded without borrowing, we absolutely must assume that debt continues to increase. Given that FAI targets have already been announced for most of China that are well in excess of 2016, barring a significant rebound in savings or the current account surplus, neither of which seem likely, we can expect debt as a percentage of GDP to continue to increase significantly. Either investment has to fall, unlikely given growth pressures, or savings has to rise. The most likely scenario is that debt will continue to rise.
At its core, the Chinese economy has depended for more than a decade on capital accumulation. In the face of a declining savings rate and non-existent trade surpluses, with high levels of investment, debt will fund the difference. There is no other way.
I fear at some point, these links will rupture.