China’s debt problems have emerged so much more rapidly and severely this year than in the past that, combined with swirling rumors about the country’s leadership, a growing number of analysts believe that this may be the year that China’s economy breaks. As always, I am agnostic. There is no question that China will have a difficult adjustment, but it is likely to take the form of a long process rather than a sudden crisis. In this essay, I lay out, as methodically as I can, the dynamics that have driven the Chinese economy for over a decade.

When we consider the Chinese economy as a system, it turns out that the problems China faces are easier to understand than most analysts suggest. Like any deeply unbalanced economy or system, China’s imbalances must reverse, and one way or another, they will, but there are various paths by which this reversal can occur.

My July 2018 article in Barron’s sets out one case of how events force China to choose among these paths. If the global trade environment forces a contraction in China’s current account surplus, I argue, by definition, it also forces a contraction in the gap between Chinese savings and Chinese investment. This means that either the country’s investment share of GDP must rise or the savings share must decline (or some combination of the two). There are literally only four ways that either of these outcomes can happen. Consequently, there are also only four ways that Beijing can respond, each of which would drive the economy to one of the four possible outcomes (or some combination of them):

Notice that all four paths either raise investment or reduce savings, thereby reducing the country’s excess of savings over investment. This is what is meant by a contraction in the current account surplus.

MORE INVESTMENT MEANS A GREATER DEBT BURDEN

In terms of the first path, an increase in investment technically can occur in two forms. The additional investment can be productive. For that to be true, such an increase would have to result in a rise in debt-servicing capacity equal to or greater than the rise in associated debt-servicing costs. Or, to put it another way, the present value of the future increase in production generated by the investment must be equal to or greater than the cost of the investment. If that is the case, the increase in investment is sustainable and will not add to the country’s debt burden, even if it expands the country’s debt. By contrast, if the investment is not productive, it automatically increases the country’s debt burden. This means that either debt rises faster than debt-servicing capacity or that debt-servicing capacity is forced to decline, usually because productive resources were deployed nonproductively.

As an aside, if a nonproductive investment is not written down, it also results in what is effectively a capitalization of what should be an expense. In other words, an illusory increase in wealth is recorded. This is the main difference between money borrowed to fund consumption and money borrowed to fund nonproductive investment (aside from the fact that the former at least gives you temporary pleasure): neither increases wealth (that is, productive capacity) or income, but until it is correctly written down the latter allows you to report higher wealth and income that is wholly illusory. It would be as if you spent $100 on dinner and then rather than record an expense that is deducted from your total income, which would leave you $100 poorer after dinner, you instead record an asset, leaving your total wealth unaffected.

In China’s case, it is by now well agreed upon that a significant amount (and perhaps nearly all) of most public-sector investment in the past few years has been nonproductive; there has been no rise in the country’s debt-servicing capacity commensurate with the rise in debt. If Beijing were to engineer a further surge in investment, it is extremely unlikely that doing so would not result in an increase in the country’s debt burden.