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WHY CHINA’S DEBT IS DIFFERENT|
For many years, annual Pew and Gallup polls have reported that most Americans see China as the leading global economic power. Europeans, for the most part, share this view. Those in the rest of the world, however, correctly identify the United States as the world’s top economic power. Perception is important; politicians are greatly influenced by where they sit and the sentiments of their constituents.
Why is there such a dichotomy between the views of developed and developing countries? The answer comes from the preoccupation of the United States and Europe with their huge trade deficits with China as a sign of economic weakness. Overall, the rest of the world generates trade surpluses with China, and many countries realize that economic power comes more from the strength of a nation’s economic institutions and the depth of its human capital than from trade alone.
For the more ideologically inclined, China’s economic ascendancy threatens the tenets of Western political liberalism—grounded in free markets, democracy, and the sanctity of human rights. These concerns often surface as a debate about the roles of the state versus the market, or the priority to be accorded to individual liberties versus collective action. The relative positions of the United States and China have become caricatures, although they may have more in common than many realize in terms of the problems that need to be addressed.
In the West, the debate about the market versus the state took on more urgency after the 2007-08 financial crisis, when major Western economies stumbled badly as China continued steadily apace. Critics of the Chinese model found China to blame for the West’s woes. They warned of its unbalanced growth (as measured by its extremely low share of personal consumption relative to the size of its economy and high outward investment), which would make it harder for the United States and Europe to recover. In the long run, the imbalance would even harm China itself. Thus, under U.S. President Barack Obama and now President Donald Trump, Washington has been urging Beijing to boost consumption if China wants to achieve high-income status—to escape the so-called middle-income trap.
Although “balanced” sounds good and “unbalanced” bad, those perceptions are misguided. Unbalanced growth is an inevitable but unintended consequence of a largely successful long-term development process. A decline in consumption as a share of GDP and a commensurate increase in investment actually comes from the movement of migrant workers from labor-intensive rural activities to more capital-intensive industrial jobs in cities. In the process, the share of consumption to GDP automatically declines even though consumption per person or household increases. In labor-surplus countries like China, farmers consume most of what they produce; thus, the share of consumption relative to agriculture output is high. When the farmer moves to an urban-based industrial job, such as assembling computers, he is paid a wage that is several multiples of what he was previously earning in agriculture; thus, his personal consumption increases considerably. But labor costs (and thus personal consumption) as a share of the value of an industrial product is relatively small compared with the costs of the components and the factory. Thus, the steady transfer of labor from agriculture to industry leads to a decline in the share of consumption to GDP but an increase in consumption per worker. Unbalanced growth has thus led to a rise in household living standards and China becoming a major manufacturing and trading power—much as it once did for Japan and South Korea and, a century before that, in the United States.
Yet China is, in fact, different—not because it is immune to financial pressures, but because of the structure of its economic system. The more optimistic observers point out that most of China’s debt is public rather than private, sourced domestically rather than externally, and that household balance sheets are typically strong. But neither the optimists nor the pessimists recognize that, a decade ago, China did not have a significant private property market. Once that market was created, credit surged into establishing market-based values for land—whose value was previously hidden in a socialist system. The fivefold increase in property prices over the past decade is the consequence.
The question now is whether current asset prices are sustainable. If they are not, a debt crisis is plausible. On that score, housing inventory has declined in recent years and affordability has improved. Many analysts have compared China’s housing prices with other major cities to get a sense of whether they are too high. But usually such comparisons are with much richer cities such as Hong Kong, Singapore, and Tokyo. Few realized that compared to India, prices in China’s megacities are actually much lower.
China’s financial situation does warrant serious attention, but it is not in crisis the way some observers suggest. Although China’s largely state-owned banking system has been too lax in its lending practices, the excessive pressure for credit expansion comes from local governments, which do not have the authority to raise revenue needed to fund the social and infrastructure services to support a rapidly growing economy. They have survived only because they have been able to borrow from state-owned banks to finance these expenditures. Thus, China’s debt problem is not so much a sign of typical banking problems but rather the consequence of a weak fiscal system.