Thread by @michaelxpettis

1/15
Kenneth Rogoff says: "There is, for example, a terrific chapter in which Ray Dalio brutally critiques Japanese policymakers for failing to force debt writedowns after the country’s early 1990s financial crisis.'

via @ftft.com/content/e1b99a…

2/15
"Instead," he continues, "they allowed debt overhang to hamstring the financial system and sap two decades of growth."

I haven't read Dalio's book, but this is an extremely important point, and one that Beijing should note.

3/15
Beijing has an enormous of debt that is ostensibly backed by the book value of associated assets (most Chinese debt was used to fund investment), but the economic value of these assets are not worth nearly as much as their book value.
ft.com/content/630f82…

4/15
We've already seen this in the property market, where the value of the assets plunged relative to the value of the debt, but this is an even bigger problem in infrastructure investment and has become a rapidly-growing problem in manufacturing investment.

5/15
One way to understand this is to recognize that there are huge losses on China's collective balance sheet that result from the difference between the asset's book value and its real economic value.

6/15
As long as debt and a large portion of the debt-servicing cost can be continuously rolled over, Beijing can pretend that these losses don't exist.

But these losses are real, and ultimately there is no way the associated debt can be serviced.

7/15
The problem is that these losses distort both economic behavior and the functioning of the financial system in ways that will increasingly undermine growth. In finance theory we refer to this process as "financial distress costs".

8/15
Until the losses are recognized and written down, which means until they are allocated, China will find it impossible to maintain acceptable GDP growth rates without rapidly-increasing amounts of government debt to fund more problematic investment.

9/15
This means that the longer China postpones recognizing and allocating the losses, the more debt it takes to generate each unit of growth, and the more debt it takes, the worse the associated financial distress costs. It is a vicious circle which, at some point, must stop.

10/15
We are already seeing this process, and by the way, this is why China's growing trade surplus is so important for stability in the near term. It is one of the ways China can externalize a part of the financial distress costs.

carnegieendowment.org/posts/2025/02/…

11/15
Dalio seems to be saying that Tokyo made a huge mistake in its failure to write down the bad debt quickly, and the consequence was decades of slow growth. In the early 1990s, Japan comprised 17% of global GDP. Two decades later, it was less than 7%.

12/15
Dalio is almost certainly right, and Japan is far from being the only example of a country whose economy suffered from the failure to recognize growing amounts of bad debt. There are a huge number of historical precedents.

13/15
So then why not write it down quickly? The problem is that writing down bad debt is just another way of saying that the associated losses must be allocated to some sector or other of the economy—households, businesses or governments.

14/15
But this is politically hard to do. While it makes sense economically to write it down quickly and efficiently, doing it quickly can be economically and socially very disruptive. That is why governments typically try to postpone the resolution as long as possible.

15/15
But while "extend and pretend" may be good for short term stability, it also causes the costs of bad debt to rise until they can no longer be hidden or postponed, and the longer it takes, the worse the longer term impact on the economy.