Archived

The article is a elaborated summary. Read the entire technical analysis Who Paid for China’s Last Debt Cleanup, and Who Will Pay for the Next?

China’s banking crisis in the 2000s was resolved by transferring the costs to households through financial repression—a decision that recapitalized the banks while exacerbating the structural imbalances that continue to shape the Chinese economy today …

The banking cleanup succeeded because households, largely without realizing it, recapitalized the financial system. This is why the common claim that China resolved its banking crisis at little cost is so misleading. China certainly paid the cost. It simply allocated that cost primarily to households through negative real deposit rates rather than explicitly to banks or to the fiscal authorities. Because the transfer occurred gradually and indirectly, it appeared as though the losses had simply disappeared …

By sharply reducing the household share of GDP, Beijing also automatically increased the producer share. Manufacturers benefited from lower financing costs, cheaper capital, and higher investment, while households lost purchasing power. Manufacturing competitiveness improved dramatically, but domestic demand weakened relative to production …

Once household income had been suppressed, maintaining rapid growth required either ever-higher investment or ever-larger trade surpluses. As productive investment opportunities gradually diminished, investment could be sustained only by rapidly rising debt. What had initially been a mechanism for recapitalizing the banking system eventually became a mechanism for generating another debt problem …

This history matters because China once again confronts an enormous debt overhang. If policymakers attempt to resolve today’s debt burden in the same way they resolved the last one—by once again transferring resources from households to producers and governments—they may stabilize the financial system temporarily, but they will also deepen the very structural imbalances that have made China’s adjustment so difficult and contributed to the rapid accumulation of debt over the past fifteen years …

The problem today is that the politically easiest solution—forcing households indirectly to absorb the losses—is far less available than it was twenty years ago. China’s household share of GDP, along with its consumption share, was already unusually low when the banking cleanup began. Today it is lower still, among the lowest ever recorded for a major economy. Further transferring income from households to producers and governments would only deepen the structural imbalances that lie behind China’s excessive reliance on debt and external demand …

There is no painless solution. The remarkable achievement of the early-2000s banking cleanup was not that China found a way to eliminate the costs of resolving bad debt. It was that it found a politically acceptable way to hide those costs. The challenge today is that the costs are likely to be much harder to hide.

[…]