Illustration by Kyle Platts
Illustration by Kyle Platts

We need to keep the impact of financial repression in mind in understanding the Chinese growth model. It is a fundamental cause of China’s rapid expansion and its extraordinary imbalances. State-owned enterprises, like other large-scale investors, have benefited from artificially low interest rates, and it is quite easy to prove that over the past decade they have been value destroyers on a very significant scale.

Studies done by the mainland research organization Unirule Institute of Economics suggest that more than 100 percent, and perhaps much closer to 200 percent, of the aggregate profitability of state-owned enterprises in China over the past decade can be explained by monopoly pricing and direct subsidies. Without these subsidies, according to Unirule, state-owned enterprises earned a negative return on equity equal to 6 percent to 7 percent.

Both monopoly pricing and direct subsidies represent transfers from the household sector to subsidize economic activity. Monopoly pricing occurs through the higher prices charged to consumers. Direct subsidies occur in a variety of ways: Subsidized land and energy prices, for example, are paid for either by various forms of taxation or by government borrowing at financially repressed rates, which effectively shifts the costs to households in the form of repressed deposit rates.

Indirect Subsidies

More important than either are indirect subsidies. The most important of these is the repressed borrowing cost for big, politically connected companies. A 2009 study done by the research organization associated with the Hong Kong Monetary Authority found that the aggregate profitability of China’s entire state-owned enterprise sector over the decade could be explained by the reduction in borrowing costs of about 1 percentage point caused by implicit state guarantees.

Since interest rates were set artificially lower by at least five to six percentage points, and perhaps a lot more, the interest subsidy alone accounts for several times the aggregate profitability of the state sector. These very low interest rates encouraged a cavalier attitude to investment that led to significant nonperforming loans in the banking system over a decade ago and are probably leading to the same now.

After the last banking crisis, ordinary Chinese paid for all this bad debt in two ways. First, and most obviously, the wide spread between the deposit and lending rates mandated by the central bank had the effect of guaranteeing substantial profits to the banking sector. These profits allowed the banks to absorb nonperforming loans.

More important, by artificially reducing interest rates to well below the nominal gross domestic product growth rate, and even to negative real rates, the central bank effectively granted significant debt forgiveness to borrowers every year over the past decade. An insolvent borrower, after all, can easily continue to service his debt if the coupon is set low enough and the principal is constantly rolled over, both of which are the case in China.

We know that the household sector paid for all these bad loans because after 20 years of rapidly rising GDP and rapidly rising household income, China began the last decade with a very low household income share of GDP. At 46 percent of GDP in 2000, this level of consumption wasn’t unprecedented, but it was likely to occur only in the case of large economies that had suffered crises. And normally, after such low household consumption amid such rapid growth for so many years, we would have expected some catching up of the household income share.

Value Creation

How would this catching up take place? As China continued investing at a furious pace, if investment had indeed been value creating in the aggregate, the value creation of some of the earlier investment should have begun to accrue to the benefit of the household sector.

But Chinese workers didn’t begin to see the consequences of earlier investment show up as a higher share of total wealth for them; on the contrary, their share of wealth continued declining, and more rapidly than ever after 2000. From 2000 to 2010, household consumption dropped from 46 percent of GDP, which is already a very low share, to an astonishingly low 34 percent of GDP. This drop occurred because households had been forced to pay for the difference between the real debt-servicing cost of a decade of misallocated investment and the debt-servicing capacity created by that investment.

Short of eliminating this subsidy -- which basically means abandoning the growth model -- it would be almost impossible to get the household and consumption shares of GDP to rise and still maintain China’s high GDP growth. China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption.

Although difficult, transferring wealth from the state to the household sector isn’t impossible. Even if China does nothing, it will eventually reach its debt capacity limits, after which a sudden stop in investment will force up the household share (albeit under conditions of negative growth). The government could reverse the transfers -- either quickly or slowly -- by forcing up real interest rates, the value of the yuan and wages, or by lowering income and consumption taxes. It could privatize state assets and use the proceeds directly or indirectly to boost household wealth. Or it could absorb private-sector debt.

Social Instability

What’s important to remember is that even under the most drastic scenarios, household income growth can be quite robust, which means that fears of social instability as Chinese growth slows are exaggerated. Because rebalancing implies an asymmetry in growth rates of the different sectors -- more specifically a reversal of the process by which household income growth lags behind GDP growth to one in which it leads GDP growth -- slower GDP growth doesn’t mean symmetrically slower growth across the board.

The real cost of the rebalancing, it turns out, falls on the state sector, and we will have to keep this in mind as we consider the choices that China must make. “There are two things that are important in politics,” Republican political operative Mark Hanna reminisced in 1895. “The first is money, and I can’t remember what the second one is.”

I’m not sure what the second one is either, but for the past 20 years, and especially the past 10, the state and business share of a rapidly growing economic pie was also growing, which meant extraordinary growth in the value of assets controlled by the state sector and the economic elite. The household share of the growing economic pie, of course, contracted. But the rapid growth in the pie ensured that household income grew quite rapidly nonetheless, even as the household share of total income declined.

When we reverse this process, as we must if there is to be rebalancing, any slowdown in GDP growth may be minimally felt by the household sector (if the rebalancing is managed in an orderly way), but even a scenario of very high GDP growth must result in much slower growth in the value of state-sector income and assets. Of course, if GDP growth actually slows sharply, which I expect it will, the growth in the value of state sector assets will drop even more sharply and perhaps even turn negative.

This is the fly in the ointment. The change in the growth rate of the state sector will almost certainly be at the heart of the difficulties that Beijing will be forced to address in the next few years. It was always easier to keep political leaders and factions happy when the value of the state sector was growing comfortably in the double-digit range, as it has for much of the past decade. It is likely to be much more difficult as GDP growth slows and the state sector slows even more, growing in low single digits, or even contracting.

Political Base

Minxin Pei, a professor of government at Claremont McKenna College, has addressed this argument. Reducing the power of state-owned enterprises “would make the Chinese economy far more efficient and dynamic,” he has written. “But it is hard to imagine that a one-party regime would be willing to destroy its political base.”

When projecting China’s future, too many analysts have systematically overemphasized the intentions of the Chinese leadership. If the government announces that it plans to accomplish a specific goal -- raise the consumption share of GDP, for example, or double the length of railroad track, or double household income in 10 years -- analysts quickly incorporate that goal into their projections even when it isn’t at all clear how the rulers in Beijing will accomplish it.

I argue that you can discuss as much as you like what China proclaims it will do, but what it actually does will necessarily be constrained by what is economically possible. Pei says you can talk all you want about what economic policies it will follow, but what it actually does will necessarily be constrained by what is politically possible. If you were to superimpose Pei’s political constraints on top of my economic constraints, you would presumably be left with a much more accurate measure of what can actually happen in China.

(Michael Pettis is a senior associate at Carnegie Endowment for International Peace and a professor of finance at Peking University’s Guanghua School of Management, specializing in Chinese financial markets. This is the second of three excerpts from his new book, “Avoiding the Fall: China’s Economic Restructuring,” published this week by the Carnegie Endowment for International Peace. Read Part 1.)

To contact the writer of this article: Michael Pettis at chinfinpettis@yahoo.com.

To contact the editor responsible for this article: Nisid Hajari at nhajari@bloomberg.net.