Stop viewing China as a normal market economy.

Over on X, I’ve started a debate with two of the international economists I most respect, Brad Setser and Michael Pettis.? I agree with both on many things and have the highest respect for each.? But I think both are leading the US and Western policy institutions into an irrelevant and costly distraction by analyzing China as a normal market economy that values the current global order.? It isn’t and it doesn’t.? Markets make the same mistake.

Brad’s post that provoked me echoed Michael Pettis’ advocation for China to issue more central government debt to fund consumption because its central government is “small.”? I disagree both on the economics – that China has significant central government debt capacity – and, more importantly, on the focus of “rearranging the deck chairs” of China’s debt structure funding its Titanic industrial policies that are the real problem.

Starting with the economics, all national debt, even private debt, is best seen as either subordinated debt of the central government or the “subsidiary” debt of the government “Holding Company,” making it all contingent liabilities of the central government.? There are two reasons for this.? First, few governments will allow systemic defaults in their private sector, especially in the banking system as it performs a critical economic function. Hence, excessive debts of other sectors of the economy are effectively “off-balance sheet” or “subordinated” debt of the central government. This is especially true of provincial/local government debt.? Second, all debts, public and private are paid from the same income stream: GDP. Both local and central governments rely on (senior) tax claims on the profits of firms and the wages of households, the sum of which equal GDP.? All debts public and private are paid from that revenue stream.

Just as in the case of HoldCo/Sub debts, local/private government debts are not pari passu (of equal seniority w/o an explicit guarantee of the central govt), because the legal entity separation allows for the central govt to restructure it independent of its own (“senior”) debt. ?But that doesn’t make the central government’s debt immune from the problems of the contingent claims on it from provincial and local governments, and the private sector.? As in the HoldCo/Sub case, unsustainable debts of the subsidiaries affect the credit risk, and thus debt capacity of the central government “HoldCo.”

Nowhere is this more true than in China, which is better viewed as “CCP, Inc.”? Nothing in China is independent of Chinese Communist Party (CCP) rule: all levels of govt, the state-owned enterprises (SOEs) responsible for 2/3rds of GDP, the state banks that monopolize households’ savings and direct it to favored industries, and even private companies that are required by law to have CCP cadres within them to align the companies goals with the CCP’s objectives.

Hence it simply makes no economic sense to say “China’s central government debt is small” when its “sub” debt at SOEs, local govts, banks, private companies, and households is staggering. ?China has a massive debt problem, full stop.? That said, as my old friend Brad has amply documented, China is a net creditor and a (growing) net saver that owns its own debt. ?Thus, it doesn't face any acute default risk since the CCP is never going to make a margin call on itself (sorry Kyle Bass).

My main policy difference with Brad, as noted, is that pushing China to fund its industrial policy via the central government rather than local governments and state banks is an irrelevant distraction from the real problem: the scale and mechanism of Chinese industrial policy.

The scale and mechanism of Chinese industrial policy has been one of Michael Pettis’s key contributions to our understanding of China’s economy.? He rightly points out that it is the structure of China’s economy that represses household consumption, forces the created excess saving through state-banks, and then directs it to favored industries through subsidized lending and loss forgiveness that is the problem, not the structure of China’s debt.? But Michael Pettis still makes the same mistake that Brad and the vast majority of media, economists and market participants do: viewing China’s economy and policy in market economics terms.

CCP China is not and never has not been a market economy.? It has bells and whistles set up to look like one, but everything is centrally directed for the purpose of ensuring the domestic and geopolitical security of the CCP.? This is why it is a mistake to view its policies in economic terms: their intent is not about economic efficiency or about raising the standards of living of Chinese households.? The rise in the latter has been a fortunate side effect of China’s policy, not its aim.? Hence why the CCP still practices severe consumption repression to fund massive industrial policies that result in huge economic losses associated with widespread overcapacity.

The entire purpose of China’s economic model of consumption suppression and state direction of excess savings is to fund the industrial policy it needs to elevate China’s industrial and technological capacity (while simultaneously undermining the West’s through uneconomic exports) with the ultimate goal of challenging the West and replacing its post-War order with its own: the return of the “Middle Kingdom.”

By distracting ourselves with how it structures its debts, whether it plays by the rules, or whether reports its data correctly, we are playing into the CCP’s con that China is a market economy that has any desire to support or be part of the “rules-based” Western order. They self-evidently don’t.

If you’d like to read more the aims of China’s industrial policies, how they impair global welfare and productivity growth, the implications for globalisation and market, or my views on debt sustainability, please see the articles linked below and consider subscribing to Thematic Markets : ThematicMarkets.com

“Incompatible drag ” (free): How China’s industrial polices are suppressing both global productivity growth & welfare, why, & the coming global economic bifurcation.?

“Global entropy: Enter the dragons ” (free): My (long) framework analysis of why the world order is on the precipice of a potentially chaotic #ComplexityCascade (tipping point) & why the global economy is headed towards complete bifurcation.

“May you live in interesting times, The Wheel of Fortune ” (paid): Why the world is far closer to a war over Taiwan than markets realize.

“Debt reality versus perceptions ” (paid): my detailed framework for analyzing whole-economy (“HoldCo”) debt sustainability & analysis of both the national & government debt sustainability of 57 economies.

#China #Debt #Sustainability #GlobalEntropy

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