China just released its first quarter GDP growth number and once again, it refuses to be poked and prodded away from the 6.8 percent annual rate. The last three quarters have seen China grow at exactly this same pace, and over the past 12 quarters, the annual growth rate has been glued to the 6.7 – 7.0 percent range. This is quite remarkable for the world’s second largest economy, one that is still developing. India, another large developing economy, has seen its GDP growth vary a lot more over the same period, rising as high as 9.2 percent and hitting a low of 5.7 percent.
So what’s going on here? Let’s back up and consider how we typically understand GDP.
GDP, or Gross Domestic Product, is the total value of everything produced by all people and companies within a country’s boundaries. GDP growth is a useful because it tells us how living standards and productive capacity in a country are improving, or not. Real GDP growth, which is what we see above, adjusts the number for inflation, allowing for comparisons over time and across nations.
Typically, GDP does not differentiate between economic activity and the value added (or economic benefit added). Which is not a problem because in most economies these are related.
For example, say a company wanted to build a widget and so it borrows money from a bank to build a factory, hire workers, etc. If consumers like the widget and buy enough of them, the company pays back the loan and turns a profit. The actual value added to GDP will be the value of the widget minus the cost of everything that went into its production.
Now if the company cannot sell enough widgets, it will be forced to close its business, and write down the value of the factory and any unsold widgets. The bank that lent them money will also write off the loan, reducing its profits. The company’s production activity initially adds to GDP but these will eventually be reversed.
This simple example illustrates the typical mechanisms linking economic activity and value add. Entities that make productive investments add to GDP. Whereas entities that waste investment go out of business and bad debt caused by the wasted investment is written down, which would be a drag on GDP. So most economies have real constraints on the ability to fund non-productive investments.
Michael Pettis, a Professor of Finance at Peking University (where he specializes in Chinese financial markets) recently wrote a very insightful piece in which he explained why these mechanisms that force GDP to track actual economic performance do not apply to China. In China, economic activity is less subject to budgetary constraints and bad debt is less likely to be written down. So in the previous example, even if there is no demand for the widget, the company could continue producing a loss-making product. This would certainly add to GDP but provides no benefit to the economy. Debt continues to grow as it funds non-productive investments.
GDP growth as a target
In a typical economy, GDP growth is an organic output that is a reasonable measure of how the underlying economy is performing. Pettis points out that it is the reverse in China, where GDP growth is an input, which means its cannot tell you how the economy is performing.
Simply explained, China’s central government sets production targets for the various regions. Regional authorities then engage in non-productive activities that generate losses, thanks to relaxed budgetary constraints and lack of debt write-offs. This results in the GDP target being met.
Pettis gives the following example to illustrate the difference between GDP as an input versus GDP as an output:
“ Suppose one wanted to measure urban literacy as a function of a city’s size, or of the average income of its residents. One way to do so is to look at dozens, or perhaps hundreds, of cities in terms of population, or average income, and compare them with the number of bookshops in each city.
In that case, the number of bookshops, which is a systems output—generated organically by the size of the city, the rate of literacy, the income of residents, and other relevant factors— would serve as a proxy for literacy, while population or income would serve as proxies for whatever variable one wants to measure.
But now assume that the government passes a literacy law that requires that every city must have exactly one bookshop for every 10,000 residents—no more, no less—and there is a government agency whose purpose is to make sure that for every city there is the number of bookshops required by law. To that end, all bookshops become government-owned and operated, without hard budget constraints.
Clearly, the number of bookshops in each city has now become an input to the system of literacy and is no longer an output generated by the organic growth of the city and the underlying need for bookshops. This immediately renders the number of bookshops useless as a proxy for literacy, unless one can find another output measure that can be used to adjust the number of bookshops, perhaps the number of titles on offer or revenue per shop. ”
In China’s case, actual GDP, akin to what we see in other countries, should probably be the reported GDP subtracted by an estimate of the amount of debt that should be written down to zero. Pettis estimates that China’s actual GDP growth is less than 3 percent.
How long can this go on?
This depends on what China’s ultimate debt capacity is. While observers have been warning of a crisis for a long time, China has so far avoided a hard landing. The People’s Bank of China has been warning of excessive debt growth and pushing regulatory policies that promote deleveraging. On the face of it, this looks like it has been relatively successful, with credit growth relative to GDP decelerating. Debt-to-GDP ratio captures the relationship between credit creation and the ability to service that debt. While this is true for most economies, you immediately see the problem with respect to China.
For one thing, it is already hard to accurately estimate the level of credit growth in China. With regulators pushing banks to rein in credit growth on one side, and local authorities pressuring banks to fund more and more nonproductive economic activities on the other side (to meet their own targets), banks appear to have found more creative ways to extend credit in order to get around regulatory hurdles. Pettis notes that recent transactions have been structured in ways that keep credit creation off bank balance sheets.
The other issue is what we discussed above. China’s GDP is not a reasonable measure of debt-service capacity in a way that it normally would be.
So the open question is when China reaches peak debt capacity.
The hard landing scenario would occur if Chinese borrowers are suddenly unable to rollover their debt and a financial crisis occurs. However, China, at least for now, is not that reliant on external debt to fund its growth and so this is less likely.
The soft landing would occur if authorities are able to rein in credit growth and bite the bullet of low growth for some period of time. Ideally, this would occur before we ever find out what China’s maximum debt capacity is.