The Great Rebalancing

"China is having a heart transplant.You're probably going to be fine in the long run, but it's going to weaken you, and it's got to be well executed"
                                                                                         
                                                                                                     ---Raymond Dalio


Despite the phenomenal economic growth that China has achieved in the last few decades, or perhaps as a consequence of it, the Chinese economy has fallen into serious imbalances. In the next decade or two, the best outcome is a significantly slower growth to correct the problem before higher growth could resume. There are other worse possibilities, like the lost decades that the Japanese had gone through, or more remote, a financial crisis like Brazil had experienced in 1997-1999.

To see how this could have happened, let's channel Michael Pettis and consider the following scenario. Say you are in charge of a farm with 100 able bodied workers eking out a living. All of these people till the land, but yield was terrible, and life was hard on the farm.

One day, you realize that people spend two to three hours a day going to and from the fields. You came up with a scheme. The farmers would loan their hard earned savings to the collective. You had instructed your right hand man Joe to take all the money to buy construction material and make him work to fix the roads. Since Joe could no longer work at his plot of land, you collected a small share of the harvest from each family to pay off the monthly payment of the loan and also allow Joe to feed his family.

The idea was a success. The travel time has been cut to an hour and a half per day. The farm was more productive. Since the amount of crops collected from each household was a bit arbitrary, Joe was living better than the people who still do the farming. The farmers did not mind, since their lives were better than before, even after giving up a share of their crop.

The farm book keeper, who had read some book about economics, started adding the roads built as part of the output and told everyone that production of the crop and the roads combined had exceeded last year by 5%

Doubling down on your success, you started adding more people to build things. Since the irrigation was bad, you borrowed more money from the farmers and added a few more people to build the irrigation canals. Some of your friends got the job since it pays more than farming.

Farm productivity soared and people have never had more food in their recent memory. By now, thirty people, some your relatives and your friends, are working on the more lucrative construction jobs. There was just one problem, the farm is running out of projects to do. The crops, after getting all the care, water and fertilizers they need, are not yielding more. Travel time has been further cut to 20 minutes and any improvement is now marginal. Yet, the construction workers, seeing how lucrative the jobs were, have lobbied you to add more of their relatives and friends on the job.

Since the construction projects are not increasing the amount of crops produced, the obvious thing to do is to stop many of the construction projects so the saving of the farmers is not wasted. Since this would result in people losing their construction jobs, you need to find a way for them to return to farming their land. If people were starving, they would be willing to return to do farming work. But life on the farm was good, so the construction workers resisted returning to till their plot of land again.

More people joined the construction crew and try to find more reason to do construction. By now, fifty people, half of the able bodied folks at the farm, are working construction. A third reservoir was built, though the second one was already not very useful. The farm book keeper had told you with glee that production, counting the farm yield and construction, have increased by more than ten percent from last year, but you know that the building of the third reservoir was a big waste of manpower and money so must be marked down in the future. Also, if people switch from construction to farming, the production number would go down more, but that was the right thing to do.

You tried to get the construction crew to work on the neighboring farms, but it had created trade imbalances. Your neighboring farms got mad at you and pass laws to reduce the number of construction crew that are allowed to work on their farms. Though cheer leaders in your farm proudly show off the shiny new roads and reservoirs, and told everyone that the trade imbalances were a result of the hard work and thrift of your farmers, you knew that the real reason is you had too many people in your farm working construction and not enough growing food.

If the trend continues, 100% of the farmers will work as construction and everyone would starve. The solution is still blindingly obvious. You need to reduce the number of people doing construction and return them to do farming, but they don't want to see their life style reduced so they dig in their heels and refused to go. Some of them pointed out that the village next door spends even more money and people doing construction. You argued with them that the next village are artisans and craftsmen. They have a need to maintain their equipment. They are wealthier because they had better skills and laws as a town of craftsmen. Someday, you can transform your farm into more like them, but until that day comes, building a third reservoir and other roads etc are still a waste of manpower and money.

Exacerbated, you start crafting a baseball bat and threaten the construction workers with violence if they don't stop working on construction and return to till their plots of land. Folks inside and outside the farm started calling you a tyrant and a dictator.

Similar to the farm above, China is overly reliant on debt driven capital spending to boost their GDP, capital spending that are increasingly non-productive. The accumulation of such non-productive spending overstates past GDP growth, which must be written down in the future as slower growth. Japan in the nineties, had 17% of the world's GDP,  today, they are something like 4%. Such is the impact of writing down these non-productive use of capital. Something similar will happen to China in the coming years or even decades. China needs to go through some gut wrenching transition from an investment and debt driven economy to a more consumption driven economy. The persistent trade deficit and high debt accumulation as a result of having too big a piece of pie devoted to capital spending cannot continue for very much longer. Like the farm, China was not in great danger of an abrupt default since the money was owed by the farm to the farmers. The most likely danger is slower economic growth due to unproductive spending and a scenario of the lost decade like Japan. The leadership seems to be aware of this problem, but executing is extremely difficult due to the power of the vested interest groups, namely the local governments. Part of the reason Xi Jingping wanted to accumulate more power and longer time is that he needed the power and time to fix this mess. We should all wish them luck. In a sense, the trade war that is happening now may present the Chinese government an opportunity if they use this as an excuse to slow down the economy and deleverage. A further slowdown of the economy will itself be a sign that Xi Jingping has finally succeeded in gaining control of the vested interest groups and finally able to implement the reforms.