HONG KONG – In the wake of a global stock market sell-off triggered by economic turmoil in China, the U.S. Federal Reserve recently decided to postpone raising interest rates. Indeed, China is facing the huge challenge of dealing with the risk of a global debt-deflation trap.
In 1933, Irving Fisher was the first to identify the dangers of over-indebtedness and deflation, demonstrating their contribution to the Great Depression in the United States.
Forty years later, Charles Kindleberger applied the theory in a global context, emphasizing the problems that arise in a world lacking coordinated and consistent monetary, fiscal, and regulatory policies, as well as an international lender of last resort.
In 2011, Richard Koo used Japan’s experience to highlight the risks of a prolonged balance-sheet recession, when over-stretched debtors de-leverage in order to rebuild their balance sheets.
The debt-deflation cycle begins with an imbalance or displacement, which fuels excessive exuberance, over-borrowing and speculative trading, and ends in a bust, with pro-cyclical liquidation of excess capacity and debt causing price deflation, unemployment and economic stagnation. The result can be a deep depression.
In 2000, the imbalance was America’s large current-account deficit: The world’s largest economy was borrowing heavily on international capital markets, rather than lending, as one might expect. According to then-Fed Chairman Ben Bernanke, the problem was that countries running large surpluses were buying so many U.S. Treasuries that they were negating the Fed’s monetary-policy efforts.
But, as Claudio Borio, Hyun Shin, and others have pointed out, excessive off-balance-sheet and offshore lending by U.S. and European banks also added pro-cyclical pressure.
As a result, risk-taking and leverage grew, facilitated by inadequate regulation, culminating in the global financial crisis of 2008. To prevent asset bubbles from collapsing and buy time for more sustainable policy fixes, advanced-country central banks implemented massive monetary easing and cut interest rates to zero. Unfortunately, policymakers in most countries wasted the time they were given; moreover, so-called quantitative easing had far-reaching spillover effects.
Within China, a second displacement occurred: the government implemented a $680 billion stimulus package in November 2008 to offset weak demand in its major export markets. While the Chinese authorities had the right idea, two of the policy’s outcomes have complicated the reform process today.
First, instead of reducing excess capacity and encouraging a structural shift to higher-productivity activities, the authorities’ investment-led strategy increased manufacturing capacity further, along with excess capacity in global commodity production.
Second, the stimulus was funded by a debt binge, especially among state-owned enterprises (known as SOEs) and local governments. The private sector, too, built up debt, with its limited access to equity capital driving firms to the shadow banking sector. The result is a debt overhang of 282 percent of GDP.
In short, China now faces the same debt-deflation challenge that much of the rest of the world must address. The question, of course, is how. Some argue that the answer is more of the same: continued monetary easing and additional fiscal stimulus.
Accumulating more debt (at lower interest rates) can indeed buy time for economic restructuring. But it will merely make matters worse if politicians do not use the time to implement effective reforms.
There is no politically painless way out of the debt trap. Indeed, the first step in that process is to face up to losses, both in accounting and in real terms. In the short run, even efforts to spur technological progress and innovation, which might generate recovery through new profits, are likely to have a negative overall impact on employment, owing to the creative destruction of obsolete industries. Recognizing this, some argue that the way to force reform is to allow interest rates to reflect credit risks.
For China, whose net international investment position at the end of last year was a surplus of $1.8 trillion, or 17 percent of GDP, it will be possible to implement internal debt restructuring through debt or equity swaps at the project level. Far-reaching governance and structural reforms in the state and private sectors should follow.
According to the Chinese Academy of Social Sciences, the central and local governments’ net assets amounted to 93 trillion yuan, or 164 percent of GDP, at the end of 2013. Because SOEs and local governments accounted for more than half of the credit issued through the banking system, proper debt restructuring of state-owned assets would strengthen the projects they were funding, by allowing private or professional management teams to improve overall returns.
Such reforms are crucial, because, ultimately, escaping the debt-deflation trap will require China to rejuvenate total factor productivity — an effort that the private sector is better equipped to lead. As the Scandinavian experience has shown, state ownership need not be an obstacle to productivity growth, provided that public assets are professionally and transparently managed, for example, by placing them in the portfolios of pension funds.
The advanced countries have fallen into the debt-deflation trap because they were unwilling to accept the political pain of real-sector restructuring, relying instead on financial engineering and loose monetary and fiscal policies.
Here, China’s one-party system provides a clear advantage: the country’s leaders can take politically painful decisions without worrying about the next election. One hopes that they do.
Andrew Sheng is a distinguished fellow of the Asia Global Institute at the University of Hong Kong and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng, director of the IFF Institute, is a professor at the University of Hong Kong and a fellow of the Asia Global Institute at HKU. © Project Syndicate, 2015.
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