27 March 2019

See the first part of this report: An Overview of Chinese Debt See the third part of this report: Challenges Posed by Recent Shifts in the Composition of Chinese debt

1. Mao-era socialism

A lot has been said about Mao-era socialism. Neoclassical critics take the view that the rule of the Communist Party held the economy back and prevented China from developing its full potential during that time. But between 1948 and 1958, the economy grew at an average rate of 6% per year (Loong-Yu, 2012), which is perfectly respectable for a country with such a large population, and a land ravaged by the Second World War.

In their book China’s Development: Capitalism and Empire (2012), Michel Aglietta and Guo Bai explain that after the fall of the Qing Empire in 1911 and the establishment of the Republic of China, “all the ingredients of liberal capitalism were formally present: a ruling bourgeoisie, parliamentary elections in 1913, capital opening, and willingness to modernize the country”. Yet liberal capitalism did not arise. Why?

One of the main reasons is that rural-urban relations in traditional China were a huge obstacle to industrialization before 1949. There was a high tolerance of labor surplus in rural China that prevented urban areas from attracting a large, concentrated population of laborers. Additional agricultural production in China was absorbed by the rural population, preventing the concentration of material resources in cities. Lastly, large surplus labor entails low labor costs, which discourages the adoption of capital-intensive modes of production.

This shows that adopting market institutions alone was not sufficient to sustain development. Markets could not have accomplished such rapid and profound change in rural China. But Mao’s rule brutally transformed the countryside and destroyed this traditional rural-urban relationship with the forced collectivization of agriculture. Peasants were forced to give up their family lands to live and work in collective farms, and had to produce a set quota of agricultural products every year.

The Maoist state was determined and used brutal means to impose its power. The central leadership was inspired by two ideas: capital-intensive industrialization in heavy industries, inspired from the Soviet Union, and minimal exchanges with the outside world.

This policy worked wonders during the first years of the Communist party’s rule, marked by post-war reconstruction; industrial production rose 54% between 1949 and 1952 (Aglietta and Bai, 2012). The industrial sector remained the fer de lance of the Chinese state during the Mao-era. Under the planning system, industrial salaries were set by the state and did not rise with productivity gains. Profit margins were thus possible under state planning, and were turned into capital accumulation, which was badly needed at the time. For this system to work, salaries had to be kept from rising significantly, which explains why the government maintained such a tight control on the economy until 1978.

At the same time, companies had an important social role— they contributed to the Chinese welfare model of the time, which was named the “iron rice bowl”. Companies were responsible for housing employees and their families, sometimes operating schools and hospitals. Some of these public enterprises struggled when market mechanisms were reintroduced in China, leading neoclassical economists to call them “zombie enterprises”.

Meanwhile, attempts to profoundly restructure rural China failed miserably. Collectivization after 1949 had completely destroyed the working incentives of farmers and did not lead to significant increases in output and productivity, as farmers were not encouraged to produce food beyond quotas set by the state (Aglietta and Bai, 2012).

In 1956, the party decided to experiment with decentralization and market mechanisms, launching the “Hundred Flowers movement”. This short period was the Chinese equivalent of the NEP [1] —it sadly degenerated into the catastrophic experience of the “Great Leap Forward”. Initially, the state gave up direct control of over 8,100 enterprises, or the equivalent of 88% of the companies under its control; economic planning was relaxed, and local authorities gained the rights to set their own targets for the production of both agricultural and industrial products. But repetitive and incompetent investment on the part of regional governments and a lack of national coordination led to disastrous consequences. Rural China was unable to produce enough food to nourish a growing urban population, having been deprived of a great part of its labor force by an impressive rural exodus. Such an imbalance led to the famine of 1959-1961.

Despite the many tragedies that they brought, the forced collectivization of agriculture and the measures accompanying it profoundly shook rural China from its lethargy. Literacy and health made significant progress thanks to the creation of village schools and the dispatch of “barefoot doctors” that cost virtually nothing for rural populations. As a consequence, between 1952 and 1978, illiteracy dropped from 80% of the population to 16.4%, while health standards improved (Brandt and Rawski, 2008).

But the rural population was still segregated from the urban population by the “hukou” system (household registration system), an imperial form of control revived under Mao. Under the hukou system, rural dwellers cannot move freely to cities, and those who choose to migrate must lead hidden lives without benefitting from any sort of social welfare (Ngai, 2005). In other words, these hundreds of millions of migrant workers constitute a highly mobile, vulnerable and docile labor force. They proved to be a formidable asset for the development of capitalism after 1978.

The hukou system and the fixed production quotas meant that living conditions in the countryside lagged behind living standards in the cities. Farmers had little or no way to make profit by selling their surplus products and were not allowed to move to cities. Rural China had a lot of held back potential and frustrations that were finally unleashed in 1978.

The Maoist state cleared the path for Deng Xiaoping’s successful reforms by creating a strong industrial base, shaking the countryside awake, and creating a vulnerable class of migrant workers that any capitalist enterprise would dream of exploiting. Such an authoritarian and brutal state also benefited private enterprises in later times through its formidable capacity to squash workers’ strikes and crush farmers’ opposition to land grabbing.

2. Deng Xiaoping reestablishes markets in China

In 1978, after more than a century’s endeavors, China had finally succeeded in sustaining a dynamic industrialization process. Deng Xiaoping implemented the first steps of his “reform and opening” policies, reassuring those worried about ideological compromise with his famous earlier quote: “it does not matter whether the cat is black or white, as long as it catches mice” (China Daily, 2014).

Officially, Deng Xiaoping did not reject the Maoist-styled Marxist-Leninist ideology. He only meant to improve the planning economy (Aglietta and Bai, 2012). At the time, the success of authoritarian states such as Singapore, Taiwan and South Korea in sustaining growth and converging with developed economies provided a model for Deng Xiaoping. These countries had developed thanks to heavy state intervention, and not by blindly following the doctrine of classical Western liberalism and the economic policies of Bretton Woods. As such, the reformists in the Chinese Communist Party had no reason to loosen their control on the economy. Indeed: “during the economic transformation, the Communist Party hierarchy did not sit off to one side, frozen in time while everything else in China changed. Rather, the hierarchical political system shaped the process of market transition, and the political hierarchy itself has been reshaped in response to the forces unleashed by the economic transition” (Naughton, 2008).

The party allowed the creation of Special Economic Zones (SEZs) where they could experiment with market mechanisms and interact with foreign investors without contaminating the entire economy. These zones were designed to fuel economic growth with cheap labor (provided by migrant workers from the countryside under the hukou system) and mass exportation. The SEZs quickly proved successful, which led officials to want to deepen reforms.

There were many areas of the economy in need of reform according to the new policies of the regime: the tax system, the banking system, decision-making for investment… The creation of a tax system was paramount. Apparently, under the Maoist planning economy, the concept of tax barely existed (Aglietta and Bai, 2012). State revenues were derived from the profits of the SOEs. This meant that the decline of the SOEs led to a sharp reduction in the central government’s fiscal income, while the dynamic private economy unleashed by Deng Xiaoping could not be taxed for lack of institutions. One of the first tasks of the government was thus to create a taxing system ex nihilo.

To this day, the tax system in China remains extremely centralized, playing a major role in the problems local governments face in finding sufficient funds. Indeed, since 1994, local governments have been required to turn over 50% of the income taxes they collect to the central government. Moreover, they do not have the ability to tax property or impose other local taxes, despite being responsible for the vast majority of social welfare missions in China (such as education and health).

In 1978, the most dynamic part of the emerging private economy was the rural sector. Under the new household responsibility system, farmers had strong incentives to produce more than state quotas (which were drastically lowered), as they could sell their products in domestic markets. During the six years from 1978 to 1984, the average annual increase in the national grain yield was 4.9%, the highest rate since 1949 (Li et al., 2014).

Deng Xiaoping reforms were successful in that they brought prosperity to rural China. But they sometimes proved hazardous. Releasing state-owned enterprises from centralized control did not magically transform their directors into efficient entrepreneurs. Some of the most profitable SOEs had been coopted by local officials and their families, and many privatized companies were in any case in cahoots with regional governments. Corruption and mismanagement led to a sharp increase in inflation, which peaked at 30% in 1988 (Aglietta and Bai, 2012).

One of the first major reforms had occurred at the end of 1979, when the People’s Bank of China was detached from the Ministry of Finance and became a separate entity. However, the newly created central bank “had no experience and no doctrine in monetary policy. It validated the loans that had been issued in creating whatever base money was necessary to keep the banks afloat” (Aglietta and Bai, 2012). As such, it did not pull the breaks on bad loans and credit expansion, and could not prevent excesses.

Hyperinflation and a balance-of-payments crisis plagued the nation in the late 1980s, and contributed to social upheaval and political crisis between 1989 and 1992. Among the crowds in Tian’anmen Square were those who had been harmed by the economic crisis and the hike in the price of rice in the late 1980s. Economic anger was a fuel for the crowds, merging with political dissent stemming from the expectations of a Chinese glasnost and perestroika. Moreover, the deterioration of fiscal balances led to a sharp slowdown in growth in 1990-91, which only worsened the political crisis. Reformers in the CP needed a plan if they were to keep hardliners at bay.

3. The end of “reform without losers”

After Deng Xiaoping’s “Southern tour” in 1992, market reform was revived. The political crisis in 1989 was such that it loomed heavy in the elites’ minds as they shaped the 1994-2008 Chinese growth regime. The deterioration of fiscal balance had contributed to serious social upheaval; consolidating the fiscal position of the central government and strengthening its control over local economies was therefore paramount.

The CP privatized huge swaths of State Owned Enterprises under the “grasp big and let go of small” plan. By 1992, a significant number of SOEs had already suspended their productive activities, only lingering as channels used to transfer basic living allowances and social services to their employees (Aglietta and Bai, 2012). To enable the “letting go” of these SOEs and the downsizing of others, several management decisions were legalized: privatization, bankruptcy declaration, and labor layoff. Layoffs were not limited to special circumstances and could also be no-fault dismissals due to “changing economic conditions”. Very small SOEs and collectively owned entities were usually sold to their workers at preferential rates.

Post-Tian’anmen repression had created the necessary political conditions for these massive lay-offs. Most Chinese workers were too scared to protest.

The remaining SOEs found themselves in monopolistic situations, concentrated financial and material support from the state, and enjoyed strong business momentum. As for the millions of employees dismissed, the upsurge of the private sector meant that most quickly found another job. Many also became self-account workers, sometimes because they had no other alternatives. Generous “xiagang” compensation schemes provided some workers with up to three years of living subsidies based of 60% of their final wages (Aglietta and Bai, 2012). Furthermore, during the 1990s, the Chinese government initiated a program aiming to sell off collective housings to their owners at preferential prices. This was a massive one-off transfer to workers that ensured many did not have to go into debt to buy their housing. It was the last generous offer before the final dismantling of the “iron rice bowl”, the Chinese social security net.

At the time, the debt that worried the Chinese government found its source in China’s four biggest banks. By 1990, the Agricultural Bank of China, the Industrial and Commercial Bank of China, the Bank of China and the China Construction Bank were technically insolvent. After a decade of creating whatever base money was needed to validate faulty loans, they had accumulated staggering amounts of NPLs. The Chinese government disbursed $650 billion to bail them out, funding a series of asset-management companies that took over all the NPLs from the banks and returned them to good health. This first massive bail-out plan was possible due to how insulated the Chinese financial system still was from global finance, and because the CP still had full command of both monetary creation and the banking system.

To support development, the Chinese Communist Party made a drastic shift toward an export-oriented model of development. In 1994, the state severely devaluated the yuan and swept through a series of reforms that precipitated rural economic decline, contributing to the exodus of two hundred fifty million illegal migrant workers, the “mingong”. The era of the “reform without losers” was over. For the Chinese people who had been encouraged to “wade across the stream by feeling the way”, the drop into cold waters was brutal and there were few safety rafts for stragglers.

China became the workshop of the world. It fully integrated in the global production chain (GPC) and acquired a special place in the capitalist globalization in the mid-eighties. The country was attractive for its cheap workforce and stable, repressive labor laws. Over the years, huge amounts of foreign investment poured into joint ventures with SOEs and the emerging private sector (Loong-Yu, 2012). As such, the dynamic export sector, and the rising reserves it built up, made it possible for the central government to plow through the Asian economic crisis of 1997 with debt-fueled investments. Growth remained steady for the 1990s and 2000s, averaging an astonishing 10% of GDP according to the World Bank, though this has been contested by several economists. [2] Foreign reserves rose accordingly to debt, ensuring that if a new bail out was needed (and indeed the major banks were recapitalized on several occasions) [3], the central government had enough to fund it.

4. China’s reaction to the Great Recession (2007-09) and its long term effects

China went on its merry debt-fueled way until the American-born financial crisis of 2007-2008. The world economy brusquely contracted. Over the course of 2008, Chinese exports slumped from 37% of GDP to 24% and Chinese GDP fell from an overheated 14% annual growth at the first quarter to around 6% at the third quarter. [4] The Chinese government speedily reacted to this downfall, implementing a counter-cyclical stimulating plan worth 4,000 billion renminbi, or $600 billion, amounting to some 12.5% of GDP, probably the biggest ever peacetime stimulus (Zhao, 2017). The plan combined additional budgetary spending and active monetary policy. Government spending increased by 26 percent in 2008 against 23 percent in 2007, but the rate at which spending was increasing slowed somewhat in 2009. It was the expansion of bank credit that took over in 2009, with a dramatic increase of 31 percent compared to 12 percent in 2008 (Jetin, 2011).

The plan was to cushion the impact on demand of the fall of exports by injecting massive investments in various sectors of the economy, because it was the only immediate instrument at hand. Domestic consumption could not offset the impact of the crisis because this would have required a wage hike that the government and companies were not ready to allow. Banks were therefore instructed by the government to lend massively mainly to SOEs but also to private companies to finance this wave of investments. Local governments immediately rushed to create financing vehicles (LGFVs) to capture a part of the investments. The central authorities ordered regional authorities to build roads, bridges and other public works to keep workers busy and the economy afloat. Interest rates were slashed. This set off a borrowing binge that sent the number of NPLs in the economy skyrocketing. Chinese non-financial debt, which was stable around 140% of GDP between 2002 and 2006, rose steadily from 145% in December 2007 to 256% of GDP ten years later, at the end of 2017. [5]

The plan was a success on the short term. Growth rate returned to 10% in 2010 thanks to a leap in the investment rate, which reached 48% that year, up from 41% in 2007 before the crisis. [6] But it could not halt and reverse a deep-rooted trend which is the structural decline of Chinese economic growth.

All emerging economies experience two stages in their historical process of development. The first stage consists of a high growth rate, based on the mobilization of existing national resources, the recruitment of a previously underemployed labor force, and capital accumulation in fixed assets. This may be called an extensive growth regime. It is usually conducive to an acceleration of growth and to deep, profound change, with intense internal migration from rural to urban areas and away from farming into industry and services.

When all resources, the labor force, and productive capital are fully employed, and if they are able to increase productivity gains with the establishment of an efficient national system of innovation, emerging economies shift to a second stage of development. If not, they will fall into what is called the middle-income trap. But even if emerging economies avoid this trap and adopt what we may call an intensive growth regime, annual economic growth will inevitably slow down on the long term. China was precisely shifting from an extensive to an intensive growth regime when it was impacted by the Great Recession. This makes the transition more difficult, because the prolonged slowdown of the global economy, and in particular of global trade, deprived China from an important component of demand, high net exports. Figure 2 shows that in 2007, net exports registered an exceptionally high level of 9% of GDP up from 2% in 2000.

Figure 2: The structure of Chinese demand (% of nominal GDP).

Source: Author’s calculations with data from the National Bureau of Statistics of China.

In 2017, it had returned to 2% of GDP. However, the investment rate was still at 44% of GDP, above its pre-crisis level, a boon for China. Though it was an important asset for growth, the average growth rate nonetheless declined to 7% over the period 2011-2017, down from an average of 10.5% over the period 2000-2007. [7] Worse, the efficiency of capital declined despite the surge of investment, as shown by the rise of the incremental capital output ratio (ICOR) [8] as shown in Figure 3.

Figure 3: A declining profit rate and efficiency of investment in China (2000-2017).

Source: Author’s calculations with data from IMF, Investment and Capital dataset, World Development Indicators, the World Bank, and National Bureau of Statistics of China.

Figure 3 also reveals that the profit rate peaked at 18% in 2007, fell down to 16% during the crisis, recovered briefly in 2010 thanks to the stimulus plan, but resumed its decline and was down to around 14% in 2014. As a consequence, companies’ share of internal financing, that is the amount of financing fueled by their own profits, declined markedly (Ma and Laurenceson, 2016). They borrowed heavily from central and local banks in order to sustain or expand their activities. Should the current debt-fueled growth continue unabated, corporate companies may not be able to pay back their debt, banks will accumulate NPLs and may need to be recapitalized at a cost of up to tens of trillions of yuan.

This financial stress will be particularly acute in areas of the economy that are prone to speculative booms and overcapacity issues, such as the real estate market. After more than ten years of breakneck expansion, China’s real estate market is contracting. In 2015, land sales decreased in both volume and proceeds, plunging by 30% compared to the prior year (Chen, 2015). This slowdown is happening both because premium quality land has already almost all been sold off, with only second-rate plots remaining, and because of a drop in demand. This means that real estate in 2018 suffering an excess in supply, with ghost towns haunting every region of China (Cai, 2017). Local governments have had to resort to buy their own lands to keep the prices up (Chen, 2015).

The IMF also warns that Chinese economy is still over-reliant on investments in heavy industry and real estate, a legacy from the Mao era. In 2017, investments in infrastructure represented 22% of the total fixed-capital asset investments in China which is more than in 2009, when the Chinese government was deploying its counter-cyclical stimulus plan (Leplâtre, 2017). This is a problem because the heavy industry and infrastructure sectors are riddled with under-performing assets and rife with corrupt relations with local governments.

With its main drivers facing difficulties, the Chinese economy is therefore increasingly fragile. Gone are the times where double-digit growth pushed the economy onwards. Though official numbers claim around 7% growth for the 2015-2017 period, many reckon that it is probably at around 4% (Ma and Laurenceson, 2016), which in Chinese terms is almost a recession. In this situation, it is going to be especially difficult to clean up the economy and resolve bad debt issues.

One mitigating factor is that China’s non-financial corporate debt is primarily domestically owned. The use of cross border funding remains relatively low, accounting for 10% of non-financial corporate debt in 2014, though it has been gaining importance over the past few years, as we will see in the upcoming part of this report. This partially reflects China’s high savings rate and current account surpluses, which set her apart from many other emerging economies, where foreign currency-denominated debt is sizeable. China has therefore still substantial room of maneuver to bail-out its financial system should a crisis occur, like it has done in the past.

But the Chinese economy is nonetheless much more vulnerable to foreign markets than before. Over the years, the government has been influenced by pro-capitalist economists in their ranks who advocate for classical liberal policies, claiming that the central government should end capital controls and allow the renminbi to become a free-floating currency (Aglietta and Bai, 2012). Beijing has been listening to this advice. Just before the 2015 Shanghai stock-exchange crash, the government had pushed for the renminbi to be included in the IMF’s international reserve currency basket, which implies more internationalization and more flexibility of the renminbi.

More debt, slower growth and a currency more prone to speculation contributed to the 2015 stock-market crash. At the time, companies faced negative returns on new capital projects and very low interest rates in the bank, which discouraged them from both conventional investment and reduced the incentive to save money in the banks. This encouraged enterprises to borrow money cheaply and speculate in stocks. The pecuniary surge in the stock market led to a surge in the price of real estate shares. Even the better-paid portion of the Chinese working class bought shares, investing their whole life savings into what seemed a lucrative deal. The crash wrought havoc on these vulnerable families. Tens of millions of Chinese workers have been affected (McCormack, 2015).

The event that triggered the crash is the decision by Chinese authorities to restrain margin lending. Investors could no longer easily borrow money to buy shares on the stock markets and their prices tumbled, sparking nationwide panic (Kaiman, 2015). The government ordered the central bank to buy shares in an attempt to stabilize the stock market and the authorities of the stock exchange were instructed to severely curb speculation by prohibiting short selling. Despite these drastic measures, the authorities were at pain to stop the fall of asset prices.

This crash once again illustrates the difficulties that the authorities are facing. The state cannot easily control a complex economy, in which financial markets and the financialisation of companies have gained so much importance, with the traditional instruments of the past. A financial crash can happen in China like in Western capitalist countries, but the Chinese state is less prepared to deal with the political turmoil created by massive credit incidents. Yet recent shifts in the composition of debt signal that the government may soon be confronted with a crisis. These shifts will be analyzed in the upcoming part of this report.

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