How Should China Address Its Debt-Deflation Challenge?

China faces "a debt overhang of 282% of GDP" and tough political choices are required to break free from the debt-deflation trap, according to two Asian financial authorities.

But Andrew Sheng and Xiao Geng say China has an advantage over other global economies which also face a deflation risk: the world's most populous nation has a one-party system. In other words, China's political leaders can make economic policy decisions without fretting over the next election.

But what steps should China's leaders take to confront the nation's deflation risk?

Sheng and Geng address that question in this excerpt from a September 24 Project Syndicate article titled, "China in the Debt-Deflation Trap":

China now faces the same debt-deflation challenge that much of the rest of the world must address. The question, of course, is how. Some argue that the answer is more of the same: continued monetary easing and additional fiscal stimulus. Accumulating more debt (at lower interest rates) can indeed buy time for economic restructuring. But it will merely make matters worse if politicians do not use the time to implement effective reforms.

There is no politically painless way out of the debt trap. Indeed, the first step in that process is to face up to losses, both in accounting and in real terms. In the short run, even efforts to spur technological progress and innovation, which might generate recovery through new profits, are likely to have a negative overall impact on employment, owing to the creative destruction of obsolete industries. Recognizing this, some argue that the way to force reform is to allow interest rates to reflect credit risks.

For China, whose net international investment position at the end of last year was a surplus of $1.8 trillion, or 17% of GDP, it will be possible to implement internal debt restructuring through debt/equity swaps at the project level. Far-reaching governance and structural reforms in the state and private sectors should follow.

... the central and local governments' net assets amounted to ¥93 trillion, or 164% of GDP, at the end of 2013. Because SOEs [state-owned enterprises] and local governments accounted for more than half of the credit issued through the banking system, proper debt restructuring of state-owned assets would strengthen the projects they were funding, by allowing private or professional management teams to improve overall returns.

Such reforms are crucial, because, ultimately, escaping the debt-deflation trap will require China to rejuvenate total factor productivity -- an effort that the private sector is better equipped to lead. As the Scandinavian experience has shown, state ownership need not be an obstacle to productivity growth, provided that public assets are professionally and transparently managed, for example, by placing them in the portfolios of pension funds.

You can read the entire article by following the link below: