Thread by @adamkwolfe

China’s not in a balance sheet recession. It has a different kind of problem than Japan in 1990 or the US in 2008, even if the outcome may look similar – subpar growth, weak inflation, etc. An unapologetically technical🧵1/

Richard Koo coined the term “balance sheet recession” to describe how a decline in the value an economic sector’s assets that pushes it into some sort of insolvency then forces that sector to pay down its debt, leading to lower investment and growth. 2/

But none of the broad economic sectors in China is paying down its debt or even deleveraging in terms of its debt-to-GDP ratio. Plus, lower interest rates mean the debt-to-GDP ratio could rise further. 3/

Here’s what a balance sheet recession looks like in the flow of funds. A sector’s net financial balance is its savings less investment. The balances must sum to zero. If a sector saves more than it invests, another must invest more than it saves. 4/

In the late 80s, Japan’s corporates borrowed to bid up the value of existing assets. When the value of those assets fell, companies had to deleverage. 5/

Before 1990, Japan’s households net savings (gross savings less investment, meaning house purchases mostly) equaled about 10% of GDP. Those savings were then mostly intermediated into corporate investment in excess of their savings. 6/

Once firms started paying down their debts, a portion of HH savings was no longer being intermediated into someone else income or investment. That led to weaker household income growth, and then a fall in household savings rates. 7/

But the sectoral financial balances in China don’t look anything like Japan. Or at least they didn’t as recently as last year, which I’ve had to estimate from other data in the national accounts. 8/

The corporate sector’s borrowing rate has decline since 2017, when policymakers rolled out the financial deleveraging campaign. But that’s been offset by larger fiscal deficits and a somewhat larger current account surplus. 9/

Now. Wait a minute, I hear you saying. That doesn’t look like the chart of China’s sectoral financial balances that Richard Koo and others have been showing. Instead they present the financial balances this way, which looks like a balance sheet recession. 10/

The previous chart is also from the official data, and Koo and others aren’t manipulating it in anyway, but I still think it misrepresents China’s economy. That’s because there are two ways to calculate the net financial balances. 11/

This chart overlays the previous two. The methodology I used is shown in solid lines, while the alternative data source that Koo and others have used is shown as dashed lines. 12/

The solid lines above are calculated from the same sources that go into China’s GDP. This is called the non-financial flow of funds, or the physical flow of funds. It’s the capital account in the standard system of national accounts. 13/

The dashed lines try to estimate the same thing, but purely from financial transactions data. This is sometimes called the financial flow of funds, and it’s the financial account in the system of national accounts. 14/

These two methods should give you the same results, but most countries struggle to reconcile the accounts fully. In China’s case, the financial flows method seems extremely problematic to me for two reasons. 15/

Most obviously, China’s financial system remains only partly regulated and the ultimate ownership of financial assets is extremely opaque. So the data is hard to take seriously anyway. 16/

But, also, the dashed lines don’t match up well to things that we know happened. There doesn’t seem to be any increase in corporate borrowing until 2012, even though the fastest period of leveraging up happened in 2009-12. 17/

These problems are more obvious when we split out financial and non-financial corporates. According to the data from the financial flow of funds, net borrowing from the non-financial sector has held basically steady over the past decade. 18/

And all the apparent deleveraging happened in the financial sector, which includes the central bank. So the data that Koo and others are using to show a net repayment of debt by corporates doesn’t even show that anyway. 19/

Needless to say, I think the physical flow of funds, or the capital account data, is better than the financial flow of funds data, at least in China. And I think the purported evidence of a balance sheet is mostly based on flawed data. 20/

But the physical flow of funds also point to where China’s problems lie. That’s because we can see each sector’s gross savings and investment. Here’s a breakdown of the economy’s overall investment by macroeconomic sector. 21/

The problem is that the crackdown on residential property has resulted in a sharp fall in housing sales. And I don’t think those sales are ever coming back. 22/

That’s a problem because residential housing investment mostly accrues to households through those sales. So if housing sales have fallen, but the household’s gross savings rate has not, then household net financial balances must be increasing. 23/

Higher household net savings must be absorbed by the corporate or government sector, or else the current account surplus will widen as it lends the savings to foreigners. But it’s not clear to me that any sector can really absorb these savings. 24/

The Ministry of Finance’s balance sheet is squeaky clean, but the rest of the government is bumping up against debt constraints. So more MoF debt is likely to be offset by a decline in local debt issuance. 25/

Property developers really must deleverage. That’s been partly offset by the government’s pivot to manufacturing in 2020, but there’s unlikely to be enough corporate investment & credit demand to absorb higher HH net savings. 26/

And the rest of the world probably can’t either. China’s trade surplus as a share of its GDP may be lower than in 2008, but it’s now a larger share of global GDP. A further rise seems unlikely. 27/

So, assuming policymakers don’t want to reflate the housing market like they did in 2016, the only solution is to restore HH confidence to bring down the savings rate. But nothing the government has announced seems likely work. 28/

If not, the household net financial surplus will continue to get stuck in the financial system and won’t be intermediated into new demand. Which will lead to lower incomes and eventually lower savings, sort of like what happened in Japan after 1990. 29/

Which is the great irony. China's policymakers launched the crackdown on property to reign in a housing bubble they feared could lead to a Japan-like balance sheet recession. But in doing so, they may have sowed the seeds for a different kind of economic collapse. 30/30