China’s balance sheet recession

China is in the midst a balance sheet recession. This has important implications for its recovery path and the effectiveness of monetary and fiscal policies.

The country’s current slump is not your run-of-the-mill recession. In the most common type of recession cycle, central banks respond to an overheating economy by hiking interest rates. The resulting demand slowdown is usually stronger than intended, leading to a recession.

These recessions tend to be shallow and short-lived.

A long, cold winter

Balance sheet recessions are an altogether different animal in that they follow many years of debt-financed overinvestment. Because imbalances have built up over years, sometimes decades, these recessions tend to be deep and protracted.

They can lead to financial crisis, but don’t have to.

Once people realise that past investments are worthless, they start repairing their balance sheets – hence the name – by saving and paying down debt. This desire to save makes people relatively immune to interest rate cuts and leaves fiscal policy as the only game in town.

History lessons

To explore the difference between common and balance sheet recessions, we looked at recessions for a set of 18 advanced economies in 1970-2006.

Our sample predates the global financial crisis, which together with the great depression occupies a space of its own. We found 13 common recessions (excluding the 1970s oil shocks) and nine housing busts – the most common type of balance sheet recession.¹

The typical output path for common recessions (dark blue) and balance sheet recessions (light blue) is shown above. The common recession is shallower, and GDP returns to its pre-recession trend i.e. growth fully recovers. The balance sheet recession is deeper, and GDP never returns to its previous trend. Also, before settling at its permanently lower level, growth undershoots.

In balance sheet recessions, growth never fully recovers, as it was artificially boosted by overinvestment. It undershoots because the housing overhang needs to be digested.

As argued convincingly by my colleagues Matthew Rodger and Ben Bennett, China will likely avoid a financial crisis. But such a crisis is definitely a downside risk in any housing bust. Our sample includes two housing busts that were accompanied by financial crisis: Sweden and Finland in the 1990s (broken line). As the chart illustrates, such a scenario is associated with multi-year GDP contractions, usually brought about by a credit crunch.

Risks to our forecasts

The above analysis informs our growth forecasts for China. We expect China to grow 3.5% next year, a far cry from the 6%+ logged before the housing bust and COVID-19. It is also way below the Bloomberg consensus of 4.5%. As 3.5% broadly conforms with our estimate of China’s potential growth, we don’t assume any undershoot associated with China’s massive housing overhang.

In our base case the Chinese authorities prevent such an undershoot through fiscal stimulus. Failure to support the economy in this way poses another downside risk to our forecast.

In contrast, our forecast could be too pessimistic if the authorities administered a massive stimulus like the ones seen between 2008 and 2015. This is unlikely in our view. The current leadership ranks national security above growth, and debt-financed stimulus is seen as undermining the former. Also, local governments, the usual conduits of fiscal stimulus, are constrained after the collapse of land sale revenues.

Peak China pessimism?

What are the implications for investors? We hear a lot of talk about peak pessimism regarding China, suggesting a long position could potentially make sense again. The concept of peak pessimism makes sense when dealing with a mean-reverting process.

When a country is in a multi-year adjustment towards lower growth, however, the concept is less useful.  Neither should investors get carried away by announcements of interest rate or reserve requirement cuts – they seldom work in balance sheet recessions.

What is now essential is fiscal stimulus.

1. We use the housing booms and busts identified in Agnello and Schuknecht (2009), Booms and Busts in Housing Markets, ECB working paper 1071.