e Denouement: China Enters Lost Decade

Anusar Farooqui*
September

* Department

of Mathematics, McGill University, Montreal QC H A B . Email:

farooqui@math.mcgill.ca

Abstract
Chinas asset price bubble is rapidly unraveling despite Beijings frantic eorts to
stem the tide. Before long, China is likely to enter a full-scale nancial panic;
followed by secular stagnation that may last as long as Japans lost decade.
e
Chinese panic marks the third round of crises since
; the rst being the panic
of
centered at the US; the second, the eurozone crisis of
.
All three have been driven by the systematic unraveling of global imbalances.
We have previously argued that global imbalances are the result of the highsavings strategies pursued by Germany, Japan, and China. What is unfolding in
China and global markets in the summer of
, is nothing short of the denouement of Chinas high-savings strategy. In what follows, I will show why this is to be
expected and argue that China is entering into its lost decade; with vast implications
for global markets and the balance of power in Asia.

eory of large open economies

In an isolated economy without a nancial sector, equilibrium national income, y ,
is implicitly determined by equating desired saving and investment,
I(y) = S(y).

( )

Introducing a money market, we obtain the familiar IS-LM equations with two
endogenous variables: national income and the interest rate.
I(r, y) = S(r, y),

( )

L(r, y) = M(r, y),

( )

where L and M are the demand and supply of loanable funds. In other words, the
LM curve, equation ( ), shows the combinations of national income and the interest
rate for which the money market clears. e simultaneous solution of equation ( )
and equation ( ) determines the equilibrium interest rate r and national income
y .
e Mundell-Fleming model is an extension of the IS-LM model for a small
open economy in an international order with perfect capital mobility; and hence, a
single global interest rate. e economy is small in the sense that developments in
the economy have no perceptible eect on the global interest rate. is assumption
eectively means that the interest rate rw is given exogenously. Assuming that
there is a single currency in the national and international economy, one obtains
the governing equation for national income y,
S(y) = I(y) + X(y),

( )

where X(y) is the net capital outow (net exports or excess savings).
Now consider an isolated bipolar system consisting of two open economies trading with each other. Assume again for the sake of brevity that both use the same
currency. We then have a set of three equations that determine the national incomes
of the two poles as well as the global interest rate.
S1 (r, y1 , y2 ) = I1 (r, y1 , y2 ) + X1 (r, y1 , y2 ),

( )

S2 (r, y1 , y2 ) = I2 (r, y1 , y2 ) + X2 (r, y1 , y2 ),

( )

0 = X1 (r, y1 , y2 ) + X2 (r, y1 , y2 ),

( )

where yi is national income of country i = 1, 2 and r is the global interest rate.

Equations ( ) and ( ) require the dierence between domestic desired savings and
investment to be equal to net exports of the country. Equation ( ) follows from the
balance of payments identity under the bipolar assumption.

Figure : Saving, investment, and trade balance in a bipolar system

r
r
r
IUS S
IChina
SChina SChina
US
XChina X China

r
r
.
a cb

S, I

ca b d

S, I

X X

XUS

It is possible to introduce exchange rates, along with money market (LM) equations for the two countries. We will keep the model straightforward and investigate
the interaction in the absence of monetary intervention and exchange rate movements.
Figure ( ) displays the comparative statics of an exogenous upward shift of the
savings in one country (China) on the equilibrium interest rate and the balance
of payments in the bipolar system described by equations ( - ).
e left panel
shows Chinas saving and investment at given levels of the global interest rate; the
middle one shows the saving and investment in the United States; and the right
panel displays the excess savings of China (XChina ) and the United States trade
decit (XUS ). As a result of the bipolar assumption, the gaps between saving
and investment must match up between the two countries.
us, Chinas initial

excess savings (b a ) and the US initial excess savings (b a ) are both equal in

magnitude to the trade balance (X ). Similarly, |d c | = |d c | = |X |.

An outward shift of Chinas savings curve (from SChina to SChina ) is reected
in the balance of payments, the gure on the right.
e savings shock pushes out
Chinas excess savings curve to the right (from XChina to X China ). e new equilibrium features a larger current account surplus in China (equivalently, a larger current
account decit in the United States). e larger the shift, the large the trade imbalance. China has eectively pushed its unwanted savings out to the United States
and imported demand. is is the essence of Chinas high-savings strategy.
e new equilibrium interest rate is lower than before the exogeneous savings
shock.
is was the source of Greenspans conundrumthe failure of long-term
rates to rise despite monetary tighteningthat Ben Bernanke called the global
savings glut. e lowering of the global interest rate causes an expansion of investment in both the United States and China, both of which are higher than before

the exogenous savings shock (c > a , d > b ).

Chinas high-savings strategy

ere is nothing particularly novel about Chinas high-savings strategy. Other
states, most notably Japan, have followed essentially the same strategy. Namely,
push down consumption and channel the high savings into growth enhancing investments. e basic weapons in the underconsumptionist arsenal are nancial repression, wage suppression, and underpricing of the national currency. Since
,
Beijing has deployed all three with gusto.
China practices a strong form of nancial repression.
e Peoples Bank of
China (PBoC) administers ceilings for interest rates on deposits and oors for lending rates. is ensures comfortable interest rate spreads for banks and keeps the cost
of capital low for rms. In
, the average loan in China was taken out at
. per cent, compared to . per cent in the nineties. e repression of interest
rates is eectively a tax on households and a subsidy for borrowersthe state and
state-backed rms, exporters, and real estate developers. e low rates have allowed
an investment boom of unprecedented proportions.
China has a vast reserve army of workers, around
million strong, who are
underemployed in the traditional sector. is has naturally kept wages from growing rapidly; in accordance with the familiar Lewis model. However, Chinas wage
suppression is also the result of conscious draconian policies. For example, migrant
Chinese workers from the interior, who work illegally in the coastal areas, have no
legal recourse against their employers. And Beijing is always quick to respond with
police power at the rst sign of labor unrest. e result is that real wages have grown
slower than productivity.
When a central bank intervenes to keep the currency undervalued, it accumulates the reserve currency. Chinas stupendous pile of trillion dollars in ocial
reserves attests to the scale of the PBoCs eorts to keep the renminbi down. e
appreciation of the renminbi is no more than what would be natural of a developing countrythe so called Balassa-Samuelson eect. Because the PBoC has
not allowed the renminbi to appreciate at anywhere near the market-clearing pace,
China has continued to accumulate foreign exchange reserves at a rapid clip.
Chinas high savings strategy has driven its consumption rate down to a mindboggling
per cent of GDP, if the World Bank numbers for
are to be believed. By comparison, the United States consumes
per cent of GDP; while
Germany and Japan, both high-savings countries, consume per cent and per
cent of GDP respectively. Meanwhile, Chinas gross investment rate is per cent
of GDP; another record. e gross investment rate in the United States is
per
cent, while the German investment rate is
per cent and the Japanese is
per
cent. However, unlike the other poles in the center of the world economy, China
is a developing country. Its rate of investment ought to be higher. Still, a country

investing nearly half its national income is likely to be misallocating capital on a

massive scale. is is indeed the case, as we shall see presently.
e bottomline is that Chinas savings rate far exceeds its investment rate. is
means that China has been pushing its unwanted savings onto its trade partners
the United States above alland importing demand; in accordance with the theoretical analysis of the previous section. is crucial observation means that while
Chinas growth model may be called export-led or investment-led, in terms of its
impact on the global economy, it is more properly called a high-savings strategy.

e denouement
e collapse of global demand in the aftermath of the Western nancial crises meant
that China could no longer rely on importing demand from its major trade partners; especially Europe. Beijings immediate response was to cut interest rates and
launch a six-hundred billion dollar stimulus channeled through state-owned enterprises (SOEs). Money poured into infrastructure and housing; exacerbating the
overinvestment in these sectors. While the scal stimulus may have been enough
to buoy up investment demand in the short run, a one-o injection was always
unlikely to solve Chinas demand decit problem even in the medium term.
e real solution hit upon by Chinaand here again it was following in Japans
footstepswas to expand debt. Between
and
, Chinas overall debt grew
from
per cent to
per cent of GDP, or about trillion dollars. An estimated
per cent of it is held by shadow banks. Lending by shadow banks has grown at
per cent since
; compared to per cent for bank lending. Meanwhile private
debt-to-GDP ratio rose from
per cent to
per cent. By comparison, US
private debt-to-GDP peaked at
per cent in the depths of the Great Recession.
e unprecedented expansion of debt yielded a supermassive asset price bubble;
most especially in real estate. More than half of Chinas ballooning debt, about
per cent, is tied to property.
Before the Chinese nancial panic began this summer, Chinas stock market
had more than doubled in value in the preceding twelve months.
e Shanghai
Composite Index rose from around ,
in July
, to above ,
in June
.
But the real bubble was not in the stock marketit was centered on real estate.
Since
, land prices have increased vefold. In
alone, real estate prices rose
per cent. e scale of overinvestment in Chinas real estate is truly stupendous.
In just two calendar years,
and
, China produced more cement than the
United States did in the entire twentieth century. China has billion square feet
ve years worth of annual demandof new property coming online. With demand
falling instead of rising, the real estate bubble began to pop at the beginning of
.

Proceeds from land sales plunged

per cent compared to the year before. New
home prices fell for four straight months and are down per cent year on year.
In China, unlike in all other polar economies, the government owns almost
all the land and two-thirds of its productive assets. Local governments enjoy a
monopoly over the supply of land by controlling the opening of agricultural land
to urban development. Proceeds from land sales account for the bulk of the revenues of local governments. For instance, land sales accounted for
per cent of
local government revenues in
. But most of the cash in the coers of local
governments comes from loans secured through shell companies using public land
as collateral. ere is an obvious limit to debt expansion on the backs of overvalued
marginal land: It can only go on so long as the real estate bubble keeps inating.
Once land prices started falling, local government borrowing and debt settlement became dicult; to put it mildly. Beijings response was to push a massive
debt swap. Local governments would issue nearly half-a-trillion-dollars worth of
long-term bonds and retire an equivalent amount of risky short-term debt. While
this is a step in the right direction, the scale of the toxic debt hidden in opaque
o-balance sheet vehicles is unknown.
In
, China announced that private investors may take minority positions
in the roughly one hundred and fty thousand state-backed rms.
is has exacerbated the distortion of the economy in favour of the inecient state sector. e
borrowing costs of state-backed rms is signicantly lower than private rms so
that they have cornered the capital that would otherwise ow to the more productive counterparts in the private sector.

Beijings trilemma
Beijing wants to avoid a full-blown nancial crisis, rebalance the economy away
from dependence on exports, and keep up growth rates.
e hard truth is that
there is no way to achieve all three objectives. Indeed, Beijing will be hard-pressed
to accomplish even one of the above.
e immediate problem facing policymakers in Beijing is the slow-motion bursting of the asset price bubble. Beijing has already tried direct intervention in the
stock market. Less well-known is the manipulation of land prices by local governments
by getting pairs of state-backed rms to buy and sell at inated prices. Both eorts
have largely failed so far. Even if these and other measures do succeed in propping
up asset prices, they will exacerbate the deeper problems facing the economythe
build-up of toxic debt in the shadow banking system, the massive overinvestment
in property, and the misallocation of resources with the attendant slowdown in
productivitywhich will further lower growth rates.

Many observers suggest that China has enough repower trillion dollars
worthto hold the tide in a nancial panic. However, China cannot deploy its
reserves at any appreciable scale without considerably strengthening the renminbi
and absorbing a large negative demand shock through the external account. As
the panic continues to built this autumn, Beijing might very well be forced to take
this route. A massive appreciation of the renminbi would indeed accomplish a
rebalancing and perhaps even avoid a full-blown nancial crisis. But it would be do
so at a considerable cost: Growth rates under this scenario will be sharply lower;
perhaps even negative.
Some have argued that Beijing has demonstrated considerable skill in managing economic shocks. e central government has indeed moved deftly to deal with
demand shocks. As a rule, this has been accomplished by directing state banks to
expand lending and pushing state-backed rms and local governments to expand
investment. But expanding investment is not a solution to a crisis of overinvestment. All that can hope to accomplish is to perhaps postpone the day of reckoning.
And when the crash nally comes, it would be even bigger than otherwise.
Maintaining high growth rates in the medium term will be especially hard. e
chief obstacle to maintaining high growth rates is the considerable misallocation of
resources. e overinvestment in property is likely to take years to work itself out.
State-backed rms have cornered the lions share of resources at the expense of
more ecient private rms.
is distortion is unlikely to unwind by itself due to
the backing of the state. Indeed, it is getting worse as of writing. Both of these distortions will have to reverse for growth prospects in the medium term to brighten.
Growth will also be harder to maintain unless the build-up of toxic debt is taken
care of.
is is best done in one fell swoop. It would require Beijing to transfer
these debts onto its own balance sheet. e central government debt is thereofore
likely to balloonyet again, following in Japans footsteps.
e
-pound gorilla in the room is of course rebalancing the economy away
from its dependence on external demand.
is would require an unwinding of
Chinas high savings strategy. As argued above, Chinas high savings are the result
of nancial repression, wage suppression, and an undervalued exchange rate. In
order to rebalance the economy, China must liberalize interest rates, raise wages,
and let the renminbi appreciate. Rebalancing would signicantly reduce growth
rates down to perhaps per cent per annum. But on the bright side, real household
income would rise at a faster clip; leaving people actually better o despite the
slowdown in the economy. It would also contribute to the global recovery.
e ideal strategy for Beijing is to therefore to avoid a full-blown nancial panic
and rebalance the economy at the expense of growth rates. However, it is hard to
see policymakers in Beijing pursuing this strategy for the simple reason that all the
heavy-weights in the Party have very close ties to the beneciaries of Chinas high

savings strategy. e rank and le of the Party is also unlikely to be anywhere close
to being enthusiastic about a strategy that promises a growth rate of per cent per
annum. Beijings policy response is therefore likely to be muddled and rudderless.
China is unlikely to sustain high growth rates for the foreseeable future. Given
the weight of China in the world economy, the implications for global markets are
dire. e ride ahead will be bumpy. Despite the recovery in the United States, the
Fed will nd it impossible to exit the zero lower bound in September and perhaps
even December. e party is ocially over.

Notes
Including the exchange rate means that we need two equations to determine the equilibrium
exchange rate and national income. e second equation is then the balance of payments.
One can think of country as rest of the world and think of this model as one of a large open
economy; large in the sense that large domestic shocks have a perceptible eect on the global interest
rate.
e recent slowdown in productivity growth even as wages have continued growing temper this
conclusion.
US private debt-to-GDP has declined to
per cent since the nancial crisis as rms and
households have rebuilt their balance sheets.