Armstrong taylor debt and distortion; risks and reforms in the chinese financial system (2016)

Debt and
Distortion
Risks and
Reforms in
the Chinese
Financial
System
pau l
armstrongt ay l o r


Debt and Distortion



Paul Armstrong-Taylor

Debt and Distortion
Risks and Reforms in the Chinese Financial System


Paul Armstrong-Taylor
Nanjing University
Nanjing, China

Debt and Distortion
ISBN 978-1-137-53400-2
ISBN 978-1-137-53401-9
DOI 10.1057/978-1-137-53401-9

(eBook)

Library of Congress Control Number: 2016942868
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Preface

As China’s economy and financial system have grown, so too has the importance of understanding their development. Unfortunately, the Chinese financial system is unique, complex, and rapidly changing, all of which aspects make
it a challenging subject to grasp. Almost every day, a new financial problem is
revealed, an innovative product released, or a critical reform announced. Even
for someone who follows these developments closely it can be hard to keep
up. Surely, only a fool would write a book, a medium with unavoidable lags
between creation and publication, on such a rapidly shifting subject. A shortage of such fools may explain the lack of such a book.

Perhaps I am such a fool because this is such a book. But before you close it,
let me explain why I believe that a book, specifically this book, can offer something that other media cannot. While a book cannot deliver commentary on
daily events, it does offer a chance to step back and see the broader trends and
forces that might be obscured by a focus on the latest news. If it can’t show the
trees, it can offer a map of the forest.
To construct such a map, I focus on a few key underlying distortions that
can explain much of the Chinese system’s uniqueness, complexity and rapid
evolution. Most of China’s financial problems are manifestations of such
underlying distortions, most Chinese financial innovations are attempts to
bypass or exploit these distortions, and most of China’s financial reforms are
attempts to correct these distortions. These distortions have been around
for a while and, unless addressed by reforms, will not go away soon. They
will continue to shape China’s financial system and drive reform for many
years. Writing a book on these distortions is, I hope, not entirely foolish, and
reading such a book may be of value to even a wise reader.

v


vi

Preface

This book should be of interest to anyone who wants to understand the
broad trends in the Chinese financial system. This might include business
people, financial professionals, government officials, regulators, and those
generally interested in world affairs. Even those who do not intend to work
with China directly can benefit from understanding how changes in China
will impact the rest of the world, and I believe this book can provide that
understanding. The book is written at a level that should be accessible to those

without specialized knowledge of China or finance, but even those with such
knowledge will, I hope, learn something. This book is not intended to provide
practical business or legal guidance, but could provide a valuable complement
to such guidance.
Finally, I would be remiss if I did not acknowledge the help of a number
of people without whom this book could never have been written. A book on
such a wide-ranging subject as this cannot be written without leaning on the
work of others. Much of what I know about China’s financial system has come
from reading the work of others. There are too many to list individually, but
the bibliography should give an idea of the scale of my debt.
I was fortunate that Peter Baker, my editor at Palgrave Macmillan, was
willing to walk a new author through the unfamiliar process of writing and
publishing a book. I am grateful for his patience.
The Hopkins-Nanjing Center has been a lot more to me than an understanding employer. My time at the Center has been rewarding on both a personal and professional level. My colleagues have helped me enormously with
this book, among so many other things. I have been fortunate to have had the
opportunity to teach some talented and motivated students, and my discussions with them, both in and outside the classroom, have helped me develop
many of the ideas in this book. In particular, I would like to thank Antoine
Cadot-Wood for sharing some difficult-to-find statistics and Sean Linkletter
for feedback on an early draft of this book.
Finally, I would like to thank my family for their support from the other
side of the world. I fear I am not the most filial of sons.
Of course, any errors are my sole responsibility.
Nanjing, China

Paul Armstrong-Taylor
November 15, 2015


Contents

Part I

Current Economic Model

1

1

Growth Model
How Did China Grow So Fast?
Why Can This Growth Not Be Sustained?

2

Financial Risks
Minsky’s Theory of Financial Crises
Japan
USA
China

11
12
13
16
19

3

Financial Repression
What Were the Effects of Financial Repression?

Transfers Wealth from Households to Firms and Government
Excessive Investment
Depressed Consumption
Inefficiency
High Asset Prices
Why Did Investors Not Move Money from Deposits to Other
Investments?
Shadow Bank Products
Stocks
Bonds
Real Estate

25
27
27
28
29
30
31

3
3
6

32
32
33
34
34
vii

viii

Contents

International Investment
What Would Be the Effects and Risks of Liberalizing
Interest Rates?
Deposits
Loans
Asset Prices

35
36
37
39

4

Government Guarantees
Role of Financial System in Managing Risk
Government Guarantees and Moral Hazard
Effect of Government Guarantees on Financial Risk
Solvency Risk
Liquidity Risk
Systematic Risk

41
42

45
47
47
49
51

5

International Distortions
Undervalued Currency
Problems
Restrictions on International Capital Flows
Advantages of Closed Capital Accounts
Disadvantages of Closed Capital Accounts

55
55
55
58
59
60

6

Overview

63

Part II

Domestic Reforms

35

65

7

Banking
Liberalizing Interest Rates
Competition for State-Owned Banks
Better Incentives for Bank Officials
Improved Risk Management

67
67
70
73
75

8

Shadow Banking
Trust Companies and Wealth Management Products
Purpose
Risks
Benefits
Reforms
Informal Lending and the Wenzhou Crisis

81
84
84
85
86
87
88


Contents

Wenzhou Model
Wenzhou’s Financial Crisis
Lessons from Wenzhou
Wenzhou Reforms
Loan Guarantee Firms
Purpose
Risks
Reforms
9 Stock Markets
Advantages of Equity over Debt
Immaturity of China’s Stock Markets
Volatility
Corporate Governance
Capital Controls
Government Intervention
Unlocking the Potential of the Stock Market
Reduced Government Involvement
Corporate Governance
Capital Controls

ix

89
89
91
92
94
94
95
97
99
99
101
101
104
107
108
110
110
112
114

10

Bond Markets
Bonds over Banks: Market Forces and Liquidity
Characteristics: Large but Illiquid
Risks: Challenges to Banks and Government Control
Reforms: Finding the Middle Path

117
117
118
121
122

11

Local Government Debt
Causes, Scale, and Characteristics
Conflict Between Central and Local Governments
Centralization of Tax Revenue
Distorted Incentives
Scale and Characteristics of Debt
Local Government Debt: A Nexus of Financial Risk
Solvency and Liquidity Risk
Links to the Financial System
Links to the Real Estate Market
Risks to the Broader Economy
Balancing Local Government Debt Reform
with Economic Growth
Stock and Flow Problems

125
125
125
126
127
129

131
131
133
133
135
135
135


x

12

Contents

Development of Local Government Bond Market
Funding Gap
Implications of Reform

138
140
141

Real Estate Market
Does China Have a Real Estate Bubble?
How Would a Real Estate Crash Affect China’s Economy?
Households
Local Government and Corporate Risk
Reducing Risks from the Real Estate Sector
Reduce Real Estate Risk

Insulating the Financial System from Real Estate Risk

145
145
148
148
150
153
153
155

Part III
13

International Reforms

159

Exchange Rate Liberalization
Renminbi: From Undervalued to Overvalued?
Pre-2008
2009 Onwards
Letting Go: Moving to a Floating Exchange Rate
Loosening Control over the Exchange Rate
Relationship Between Exchange Rate Liberalization
and Other Reforms

161
162
162

164
166
166

14

Renminbi Internationalization
Benefits and Barriers to Internationalization
Trade Settlement
Investment and Reserves
Short History of Internationalization
Challenges of Managing Risk with International Currency
Impact of Internationalization on China and the World
Domestic
Politics
International

169
170
170
172
174
176
179
179
182
183

15

Capital Account Liberalization
Treacherous Tides: Risks of International Capital Flows
Financial Freedom and Political Commitment:
Benefits of an Open Capital Account

185
186

167

188


Contents

16

xi

Tentative Steps: Progress to Capital Account Liberalization
Portfolio Flows
Direct Investment
Unofficial Capital Flows
Policy Laboratories: Free Trade Zones

189
189
190
193
195

Asian Infrastructure Investment Bank
and the New Silk Road
Infrastructure Investment
Global Financial Power
Domestic Rebalancing
Conclusion

199
200
202
203
204

Part IV

Politics

207

17

Political Conflicts over Reforms
Conflicts Within the Chinese Communist Party
Reform and the Party’s Power
Reform and the Personal Finances of Officials
Broader Conflicts over Reforms
Losers from Reform
Winners from Reform
Greater Influence of Losers

209
209
209
210
211
211
212
213

18

Strategies to Overcome Opposition to Reform
Anticorruption Drive
Anticorruption Drive and Financial Reforms
Anticorruption Drive and Legitimacy of CCP
Effectiveness of Anticorruption Campaign
Effect of Reduced Corruption on Economic Growth
Centralization of Power
Process and Benefits of Centralizing Power
Costs of Centralization of Power

215
216
216
216
217
218
219
219

220

Part V
19

Risks and Consequences

Domestic Risks
Level and Distribution of Debt

225
227
229


xii

Contents

Foreign Debt
Domestic Debt
Quality of Investment
Asset–Liability Mismatches
Liquidity Risk
Currency Risk
Corporate Governance and the Regulatory Environment
Corporate Governance
Regulation
Ability of Government to Manage Financial Risk
Preventing a Crisis

Containing the Effects of a Crisis

229
232
235
238
239
240
241
241
242
245
245
247

20

International Consequences of Reform
Consequences of Economic Transition
International Impact of Financial Crisis
Trade Links
Financial Ties

249
250
252
252
253

21

The Future
Exaggerated Pessimism
Short-Term Risks, Long-Term Benefits

255
255
258

Appendix: Financial Decision Making
in the Chinese Government
Major Central Government Institutions
Chinese Communist Party
State Council
Central Leading Groups
Central Discipline Inspection Committee
Ministry of Finance
People’s Bank of China
Financial Regulatory Commissions
National Development and Reform Council

261
261
261
262
262
263
263
264
264

265

Index

267


Introduction

In 1992, Deng Xiaoping toured China’s southern provinces and committed
to opening China’s economy to the world. This policy transformed China’s
economy and affected almost every part of the global economy. Whether
we look at British supermarkets, Peruvian mines, American universities, or
French fashion houses, we see China’s influence.
Despite their importance, Deng’s reforms did not liberate the financial system, and government intervention remained the norm. Interest rates were
suppressed to support investment, and the renminbi’s exchange rate was controlled to support exports. The financial system remained dominated by the
state-owned banks, with foreigners largely excluded, and stock and bond markets remained underdeveloped. In many ways, China remained a planned
rather than a capitalist economy.
In 2012, twenty years after Deng, Chinese president Xi Jinping embarked
on his own southern tour. The symbolism was deliberate. Xi is planning
the most radical transformation of China’s economy since the early 1990s.
Financial reforms are at the core of Xi’s vision. Interest rates and exchange rates
will be liberated, restrictions on international capital flows will be relaxed,
and state-owned banks will face more competition from private competitors,
shadow banks, and stronger markets. China, he promised, will become truly
capitalist at last.
These reforms will impact the structure of the entire economy. Resources
will shift from state-owned firms and governments to private firms and households, leading to a shift from investment to consumption. Higher interest
rates will reduce capital-intensive infrastructure projects and promote service
and knowledge industries that use capital more efficiently. The discipline of

the market will dominate while the influence of government recedes.
xiii


xiv

Introduction

As China changes, many of the global trends of the last 20 years will slow or
reverse, and new trends will replace them. Until now, China has been a trade
partner; in the future, it will be a financial one – both as a source and destination of capital flows. While past reforms boosted China’s manufacturing
exports, future reforms will allow service imports. Emerging markets may suffer from China’s reduced demand for raw materials, but developed countries
will benefit from its growing demand for services.
This book takes a systematic look at China’s financial system: how it has
worked in the past and how it will work in the future, why reforms are needed
and what risks they bring, and how these reforms will affect China and what
their impact will be on the rest of the world. We will analyze the core forces
underlying China’s transition and how these forces are manifested in a wide
range of areas.

Outline of the Book
Part I of the book shows how China’s existing financial system supported
China’s impressive growth and why, despite this, it needs to be reformed.
China grew through investment and, to a lesser extent, exports, and the
financial system was distorted in ways to promote these. High interest rates
may have choked off investment, so interest rates were kept low. Rapid
appreciation of the renminbi may have choked off exports, so the exchange
rate was managed. Risk may have discouraged investment, so the government guaranteed investment. In short, the distortions were not seen as problems: they were part of a deliberate policy to promote growth. As long as the
economy was growing at 10 % per year, the costs of the distortions could be
absorbed.

However, there are limits to investment-led growth. Previously countries
have grown quickly for a period of time using a similar strategy, but none have
been able to maintain the growth forever. Eventually, good investment opportunities start to run out, and the returns to further investment fall. Maintaining
growth requires ever larger investment and ever more borrowing, but servicing that borrowing becomes increasingly difficult. Low interest rates and government guarantees that supported the growth in borrowing and investment
in the past now become liabilities  – encouraging unsustainable increases in
debt. With no reform, widespread defaults and a financial crisis are inevitable.
Reform, as the Chinese government has acknowledged, is necessary.
Broadly speaking, those reforms involve eliminating the distortions of
the existing system. However, reform is also risky. Raising interest rates and


Introduction

xv

eliminating government guarantees increases the risk of defaults on existing
debt. Discouraging excessive investment, while necessary, will also lead to a
slowdown in growth, which carries both financial risks (it becomes harder to
service existing debt) and political risks (it reduces the benefits going to vested
interests). Reform, then, is both essential and fraught with challenges. The
rest of the book explores these themes in more detail and attempts to outline
the path reform should, and hopefully will, take.
Part II takes the themes of the first part and applies them to particular
financial sectors.
One of the main points of this book is that the formidably complex web of
reforms across multiple sectors becomes much easier to grasp once you see that
many of these reforms are reflections of the same basic themes. Understand
the themes, and most of the reforms make sense. However, while the reforms
across different sectors may rhyme, they do not exactly repeat; applying
themes requires care. Furthermore, reforms in one sector affect other sectors.

For example, reforming the banking sector will affect the shadow banking
sector and vice versa. These interrelations must be taken into account when
considering what type of reforms to undertake and, in particular, the order
in which reforms must occur. The correct reforms applied in the wrong order
can lead to crisis.
Part III looks at the international aspects of China’s reforms.
International reforms, such as liberalizing the exchange rate and freeing capital flows, will have the most direct effects on the rest of the world.
However, international reforms must be consistent with, and mostly subsequent to, domestic reforms. Premature opening of China’s financial system
would be disastrous. Most importantly, China cannot fully open its capital
markets until domestic interest rates are liberalized. If it attempted to do so,
capital would simply flow abroad to bypass the domestic restrictions, leading
to a loss of domestic liquidity and potential crisis. On the other hand, limited
opening is possible and may be helpful in increasing the pressure for reform
in domestic sectors.
An understanding of the Chinese financial system and reforms helps to illuminate several issues that have attracted attention. A reserve currency requires
open capital markets and a large and liquid government bond market. China
has neither of these things and will not have them for some time.1 Therefore,
there is little chance that the renminbi will become a reserve currency soon.
The Asian Infrastructure Investment Bank (AIIB) has been very controversial
1

It also requires a willingness to allow foreigners to accumulate large amounts of domestic assets, usually
by running persistent current account deficits. There is little sign that China is prepared to do this, either.


xvi

Introduction

for political reasons, but its economic importance is likely to be minor. China

already invests heavily in overseas infrastructure projects and would do so
with or without the AIIB. If anything, the AIIB, as a multilateral organization, will place additional constraints on how China directs this investment.
China’s commitment to foreign infrastructure investment is best seen as a
way to extend its investment-focused growth model while bypassing the constraints of diminishing returns in the domestic economy.
Part IV looks at the politics of reform.
The principal goal of the Chinese government is to maintain power. In
addition, and consistent with this, it is cautious and risk averse. Both of these
principles are reflected in its focus on “stability.” These principles combine
to create the incentive for financial reform. Failure to reform is likely to end,
sooner or later, in a financial and economic crisis. Economic instability could
easily lead to political instability and so is to be avoided. Reform is, therefore,
essential.
However, financial reform brings political challenges of its own. The existing elites have benefited from the existing system. It has brought them political power and financial wealth. Financial reforms threaten these benefits and
therefore will face entrenched, powerful opposition. Xi Jinping, China’s president and leader of the reforms, understands that to enact his reforms, he
will need to subdue or crush this opposition. His extensive anticorruption
campaign is designed to achieve these goals. Certain opponents, most notably
Zhou Yongkang and his power base, have been publicly convicted of corruption and removed from power. Others may be spared as long as they do not
oppose Xi’s policies. Some have puzzled over why Xi is loosening control over
the economic and financial system while concentrating political control in his
hands. Properly understood, this is not puzzling at all. The financial reforms
require the centralization of political control. Without this, any reforms would
stall – as happened under Hu Jintao.
Part V looks at the risks and effects of reforms, both domestically and
internationally.
Reform is necessary but not without risk. Understanding why requires understanding the role of debt. Reforms are necessary to prevent new debt from building up by removing the subsidies that support borrowing. However, removing
these subsidies may increase defaults on existing debt. Reform too slowly and the
debt will continue to rise; reform too fast and you could trigger a crisis.
Finance is an interconnected system: changes in one part ripple through the
system and may cause unintended effects elsewhere. For example, developing
a bond market allows large companies and local governments to borrow at

lower interest rates, but it leads to the loss of customers and interest income


Introduction

xvii

for the banks, which may cause them to take more risk (as happened in Japan
in the 1980s). Increasing competition in banking, for example, by allowing
Internet banking, might improve efficiency. However, with deposit guarantees, banks must compete on interest rates and may search for higher-return,
and therefore higher-risk, projects. Poorly regulated liberalization, therefore,
could lead to increased risk.
However, China does have some advantages in managing these risks. First,
the government retains control over most of the financial system, which gives
it more tools than Western governments have at their disposal for responding
to problems. The subprime crisis was exacerbated by the refusal of banks to
lend to each other. If banks cannot borrow when they need to, they are forced
to hoard cash. This sucks liquidity from the real economy and exacerbates
recessions. The Chinese government can simply order banks to lend (to each
other and to the real economy) and so avoid such a liquidity crisis. Such intervention is counter to the direction of reform but might be temporarily justified to address a crisis. Western governments and central banks used similar
tools to intervene during the subprime crisis.
If China does suffer a recession or a more serious crisis, it is not clear that
the impact on the rest of the world will be severe. Japan in 1990 was similar
in many ways to China now. It was the world’s second largest economy and
was coming off a period of rapid growth fueled by debt. It ran current account
surpluses and had a bank-based financial system that was somewhat insulated
from the rest of the world. Japan suffered a major financial crisis, after which
it barely grew for 15 years, but its domestic problems did not infect the global
economy. On the contrary, the 1990s proved to be a time of rapid growth in
many parts of the world. My own research suggests that this episode illustrates

some general themes: economies like those of Japan and China tend not to
transmit their economic problems to the same degree that the US does.
While the risks of a financial crisis may be overplayed, the effects of successful financial reforms will be significant. Rebalancing will change China’s
economy and the way it interacts with the rest of the world. As China moves
from investment to consumption, and from construction and manufacturing
to services, the composition of its imports and exports will change. Demand
for commodities will fall, which will impact economies that have grown on
Chinese demand, including many emerging markets; this has already begun.
On the other hand, demand for services, such as finance, healthcare, and education, will increase, creating opportunities for economies strong in these areas.
Finally, as China opens its financial system, there will be more opportunities for
investment to flow into and out of China. Recently, China’s outward foreign


xviii

Introduction

direct investment (FDI) surpassed its inward FDI. China as an investor will be
a theme of the next few decades.
Finally, in Chap. 21, I reflect on China’s future. Much of the recent
pessimism about its prospects is exaggerated. While growth is certainly slowing and the reforms discussed in this book carry short-term risks, the longterm prospects remain bright.
Despite its past successes, China’s economy in general and its financial
sector in particular urgently need to be reformed. President Xi Jinping has
committed to these reforms and, I believe, possesses the political power to
overcome the vested interests that stifled his predecessors. Many challenges
remain, and the risk of some form of financial crisis within the next 10 years is
high. However, on balance, the positive effects of reform will far outweigh any
negative effects. Within a decade, China could become a truly market-based
economy with stable growth prospects.
While some commentators have portrayed China’s rise as a threat to the

West, it will bring great opportunities. The 1992 reforms created an economy based on investment and manufacturing with a vast appetite for raw
materials. This led to a commodities boom that greatly benefited commodities exporters, including many emerging markets and Australia. The benefits
to the USA and Western Europe were less clear, however, as Chinese products often seemed to be competing against domestic industries.2 China’s new
economy will be based on consumption and services, areas where Western
economies are particularly strong. For the USA and Europe, therefore, the
opportunities of this second wave of reforms may, therefore, be even greater
than the first wave.

2

There were exceptions. Germany’s strong economic performance is at least partly based on China’s
demand for its high-quality manufacturing exports. And, of course, consumers in all countries have
benefited from cheap Chinese imports.


Part I
Current Economic Model


1
Growth Model

How Did China Grow So Fast?
China’s growth over the last 35 years is unprecedented. It has created more
wealth and lifted more people out of poverty in a shorter time than any other
country in history. In this chapter, we explore the economic system that made
this possible. This is a necessary prerequisite for analyzing the financial system for three reasons. First, the financial system evolved to support the economic system that brought this growth, and it is impossible to understand
the financial system without understanding the system it was designed to
support. Second, we need to understand why such a successful system needs
to be reformed and, by extension, why the financial system needs to change

to accommodate that reform. Finally, financial reforms will undermine the
existing drivers of economic growth and replace them with new drivers. This
transformation will be difficult and risky, and the challenges and dangers will
need to be understood in advance and incorporated into the reform plans.
China grew by investing and exporting  – a path trodden previously by
Japan, Korea, and Taiwan. To grow, an economy must expand both the
amount it can supply, or its productive capacity, and the demand for its products. Ideally, supply and demand need to grow at similar speeds. If supply
grows faster than demand, the result will be excess capacity and unemployment; if demand grows faster than supply, the result will be inflation.
Investment boosts growth in two ways: it expands the productive capacity
of the economy and provides demand for inputs to the investment process.
For example, investing in the construction of a car factory boosts the amount

© The Author(s) 2016
P. Armstrong-Taylor, Debt and Distortion,
DOI 10.1057/978-1-137-53401-9_1

3


4

P. Armstrong-Taylor

of cars that can be produced and provides demand for construction. Exports
provide an additional source of demand. If supply grows faster than demand,
the excess production can be exported.
A simple example might provide further insight. Consider an economy
with just one person. We will call him Robinson Crusoe after Daniel Defoe’s
castaway. To begin with, Robinson Crusoe is very poor. He has limited tools
or understanding of how to survive, let  alone prosper. He tries catching

fish with his hands. It is difficult, and he doesn’t catch many. But being a
resourceful fellow, he figures he could catch more fish with a net. He takes a
break from fishing to make his net from some sticks and pieces of material
washed up on the beach. This takes a couple of days, and during this time
he doesn’t catch any fish and goes hungry. However, once the net is finished,
he can catch many more fish than he could with his hands and he will be
able to eat heartily.
Robinson Crusoe’s meager fishing project may seem a long way from
China’s vast manufacturing economy, but they both developed in the same
way: by investing. Robinson Crusoe is more productive because of the investment in his net; the Chinese factory worker is more productive than his peasant farmer because of the investment in production lines. Both had to sacrifice
consumption in order to make this investment: Robinson Crusoe had to go
hungry for a few days; the factory worker, and others like him, had to save,
giving up some consumption, to fund production.
This is the key feature of the Chinese growth model: high investment
funded by savings and low consumption. Since 1978, China has invested 35
to 50 % of its gross domestic product (GDP) (the USA invests about 20 %
of its GDP).1 This level of investment over such a long period is unprecedented. Even more remarkably, this investment rate has continued to climb.
In 2013, China invested 49 % of its GDP – the highest rate of investment
by a major economy in history. This investment has built factories, roads,
railways, buildings, even entire cities.
But it is not just investment in things that can boost productivity.
Investment in skills can help, too. Robinson Crusoe could catch more fish by
learning how to fish better. During this learning process, he might catch fewer
fish because he has to try lots of mostly ineffective techniques to find the right
one. However, over time, he learns the best techniques and catches more fish.
This is also a process of investment: sacrificing some current consumption for
higher future productivity.

1

World Bank.


1 Growth Model

5

The Chinese have traditionally valued education. Under the emperor, the
civil service examination provided one of the few opportunities for the poor to
improve their prospects. These days, the National Higher Education Entrance
Examination, known as the gaokao, serves the same role. In 2014, almost 7
million Chinese graduated from college, up from 1.1 million in 2001.2
The combination of investment in tools and skills has transformed
Chinese productivity. Workers get paid their productivity, more or less, so
the increase in productivity can be tracked by tracking wages. According to
the Economist Intelligence Unit, average hourly earnings in the manufacturing sector increased from $0.40 in 2000 to $2.10 in 2012 – an annual
growth rate of 14.6 %.3
Aside from investment, exports also played an important role in China’s
growth. To see why, let us return to Robinson Crusoe. At some point, his nets
and fishing skills will be so good that he will be able to catch more fish than he
needs. When that happens, there will be little point in continuing to get better
at catching fish. Investment can continue to expand supply, but there is not
much point in expanding supply if there is no demand. Crusoe could continue
to become more productive at other things (maybe getting better at building
shelters), but this has drawbacks. He loses the advantages of specialization and
economies of scale that he could have had in fishing. If only he could sell the
fish to other islanders. The proceeds of these sales could be used to consume
something other than fish or for further investment in productivity.
Suppose you own a Chinese television factory in 1992. You have invested
in a production line, so your workers are productive. You are ready to produce

thousands of TVs a day. But there is a problem: to whom are you going to
sell? There aren’t enough Chinese rich enough to buy your products. You have
solved the supply problem but still face a demand problem. The solution, of
course, is to export to developed countries where there are many people who
can afford your televisions.
In 1980, Deng Xiaoping designated Shenzhen as a special economic zone,
an area in which market reforms and openness to international trade could
be tested. At the time, Shenzhen was a small village, but it had an important
advantage: it bordered Hong Kong. Foreign investors, attracted by tax breaks
and low wages, began to invest. In 1992, Deng Xiaoping toured Shenzhen
and reaffirmed his commitment to economic reforms and China’s engagement
in international trade. Growth in foreign investment in and exports from
Shenzhen accelerated. By 2012, Shenzhen was exporting $271 billion worth
2
3

Lynch (2014).
Economist Intelligence Unit (2014); all monetary values are given in US dollars unless otherwise noted.


6

P. Armstrong-Taylor

of goods, more than Australia and the most of any Chinese city for the 20th
straight year.4 Shenzhen is a typical, if extreme, example of the role of exports
in China’s growth model. In 2013, China exported more goods than any
other country (40 % more than the USA).

Why Can This Growth Not Be Sustained?

Much of China’s investment has been funded by debt. This growth has brought
benefits to more than a billion Chinese and indirectly benefited many others
around the world. While it is true that China’s investment has grown quicker
than consumption, consumption has also grown very fast. If a country can
grow both investment and consumption, why shouldn’t it continue to do so?
Isn’t an economy based on debt-funded investment more sustainable than
one based on debt-funded consumption (as many Western economies seem
to be)? With investment, at least the rise in debt is matched by a rise in assets.
These are important questions that strike at the heart of why China needs
to reform. In this section, I will explain why China’s current growth model is
unsustainable and why it needs to be reformed.
Debt-funded investment can create sustainable growth. If a company borrows money to invest in a factory, this produces growth. The new factory will
allow the company to produce more output and employ more people than it
did before. Is this growth sustainable? To know this, we must know whether
the profitability of the factory will be sufficient to pay back the interest on the
loan. Suppose a firm must pay 10 % interest on its loan, and the factory earns
a return of 15 %. Then the interest and, over time, principal of the loan can
be paid back from the profits of the factory. Debt levels will be stable or falling
while the company is growing. This type of debt-funded investment can lead
to sustainable growth.
The same principle is true in the case of the macro economy. As long
as investment returns are higher than interest rates,5 borrowing to finance
growth is sustainable. This may have been the case in much of the developed
world following the 2008 financial crisis. Interest rates in the USA, Japan, and
much of Europe were historically low, so even investment projects with very
modest returns could produce sustainable growth. Indeed, borrowing for such
investment will actually reduce debt-to-income levels in the long run. This is
4

Department of Foreign Trade and Economic Cooperation of Guangdong Province.

The interest rate must be adjusted for risk. Some projects are much riskier than others, and so the investment return on such projects must be sufficiently high to compensate lenders for that increased risk.
5


1 Growth Model

7

one of the key arguments against the austerity policies that were pursued in
many countries after the crisis.
Unfortunately, debt-funded investment can also create unsustainable
growth. Returning to our company, suppose that it can still borrow at an
interest rate of 10 %, but now the return on its investment in the factory is
only 5 %. It could still borrow to build the factory (provided someone would
lend it the money), and so it could still grow its output and employment.
However, now the profits from the factory would be insufficient to pay back
the interest on the loan, let  alone the principal. The factory owner faces a
tough choice. He could pay back the loan from the profits of other factories.
However, if this money is used to repay the loan, it cannot be used for further
investment, and so the firm’s growth would be slower than it otherwise would
be. Alternatively, the owner could take out another loan to pay back the first
loan and potentially to make further investments as well. This would allow the
firm to grow. However, the owner would soon find himself back in the same
situation of having debts he cannot pay and having to either cut investment
(and growth) or take out still more debt to cover the old debt. Eventually, the
second option will become impossible because no one will be willing to lend
to him. At this point, the growth of the firm will have to slow sharply in order
to pay off past debts. In an extreme case, the firm may go bankrupt and have
to shut down completely.
The same principle that we applied to the company also applies to an entire

country’s economy. Investment will always lead to growth in the short run,
even if its returns are very low. However, only investment with high returns
will lead to sustainable growth. If returns are too low, growth must eventually
slow: the only choice is whether the growth starts slowing early and gradually
or late and suddenly.
In the 1980s and 1990s, investment returns in China were high and interest
rates were low. Investment funded by borrowing could generate rapid and sustainable growth. Since around 2010, however, returns have fallen below interest
rates. Despite this, investment has remained high, which has generated unsustainable growth, overcapacity and bad debt.
Why did this happen? First, making a lot of investments itself tends to reduce
investment returns. Suppose that the company from our previous example
began with a range of possible investments it could make. What investment
would it make first? If it was trying to maximize its profits, it would invest in
the project that promised the highest return first. The next time it had (or borrowed) some money, it would invest in the next-highest-return project and so
on. Each successive project would have lower returns than the previous one.
The more investing the company does, the lower its returns.