A simple primer for understanding China’s downturn

I’ve covered these ideas before a number of times, but now the Chinese slowdown is common knowledge, so let’s put them in one place:

1. You can’t invest 45-50 percent of your gdp very well forever.  It’s amazing how long China’s run has been, but it is over.  The quality of their marginal investments is now low and that means their growth rate will be much lower too.  The low hanging fruit is gone, at least for the time being.  They might later on resurrect some new low-hanging fruit through institutional reform, we’ll see if they end up stuck in the middle income trap but right now they are at a sharp discontinuity.

2. There is no simple way to switch to a “consumption-driven” economy without the growth rate both falling and staying permanently lower.  Structural reforms are absolutely called for, but in this context they represent a surrender to a lower rate of growth and thus they are especially difficult to pull off in a politically sustainable manner.

3. The Chinese have been growing at ten percent or nearly ten percent for about thirty-five years.  More than a generation of Chinese is used to treating the risk premium as if they don’t have to worry about it.  I shudder to think what economic and also political decisions have been made on that basis.

4. The Chinese economic response to the dwindling of their low-hanging fruit is sharp rather than smooth because there is a sudden revision of expectations, as people realize the risk premium isn’t zero after all.  And seeing the others see that causes the new set of beliefs to spread pretty quickly.  That is a very painful process for a macroeconomy, and it is not well captured by simple AD-AS analysis, although of course it has implications for both AD and AS.

5. I would not so quickly infer that the Chinese government is stupid when it comes to economics.  It is true their actions do not correspond to what professional economists would recommend.  But they are painted into a very unpleasant corner and have lots of interest groups to feed.  Their observed response is possibly explained by some kind of public choice-constrained, nested game, internal conflict-driven seventh-best response.  They were smart a few years ago, and they are still smart now.  That doesn’t mean they will end up doing a good job.

6. Avoid mood affiliation!  You can be a pessimist about the Chinese recession now without being a) a pessimist about China in the longer run, or b) a pessimist about Chinese political stability.  Those are separate albeit related questions, and you are not forced to have the same mood response to all of them.

Keep this primer on hand at all times.  It is more useful than trying to twist the C + I + G tautology into a series of causal statements about China.


All spot on and this is the best line: "The Chinese economic response to the dwindling of their low-hanging fruit is sharp rather than smooth because there is a sudden revision of expectations, as people realize the risk premium isn’t zero after all."

I see a loose parallel to the US subprime crisis which I think was a similar kind of shock and adjustment, not just for the US but for the whole world, as the US had its own air of economic infallibility.

That's funny because that's the point that I don't grok at all. When I hear "as people realize the risk premium isn't zero after all", I have no idea what the cagey professor is trying to say. I think of a risk premium as a premium for taking a risk. The obvious application is the stock market versus other, safer investments. A risk premium of zero suggests to me that the return on a volatile investment is not expected to be greater than the return on a safe investment. Is Tyler saying that's what Chinese people used to think, but now they don't think that anymore? I can't believe that's what he's saying, but my Tyler Decoder Ring is failing me badly right now.

Replace "is not expected to be" with "doesn't need to be".
Capital has been over-allocated to risky projects because safe discount rates were applied to risky projects (probably in the view that they were safe, or at least safe for the decision maker)

First, in a screaming hot economy the returns are nowhere near benchmark + risk premium. It is a different world, and no one would touch anything that unprofitable because you don't have to. The risk reward calculations are in a different realm; you can lose money easily, but you can make it back as easily. Someone who reads the market, sets up deals where they don't get screwed, has good connections and a bucket of money to work with can do very well. (a friend thought Bush was an idiot because he lost money in Texas during an oil boom).

But when things start slowing down, what worked yesterday to get return doesn't work anymore. Yesterday there was foreign money desperate to set up production or buy something, now that foreign money either isn't there or is a lot more careful. The higher costs of labor, the exchange situation, the political risk, and those persistent former friends who are rather insistent on getting paid, or are avoiding you when they owe you money. The deal you made six months ago under the old assumptions now is losing money.

People learn quickly, and all the turmoil is everyone adjusting to different expectations. The question is how deep everyone got and how long it takes so that the normal flow of the economy gets started again, albeit on a different plane.

Thanks, but I'm still not sure I'm grokking.

The Shanghai composite closed at 2,985.435 on 11/12/2010 and, a little over two years later, it closed at 1988.117 on 11/30/2012. That's a 33% drop. Sounds harrowing.

When was this golden age of milk and honey of which you speak?

The stock market doesn't represent the Chinese economy. Nor the US economy for that matter.

Almost every company that I deal with is not publicly owned. That includes some very substantial firms.

I understand. Thanks again. I still am no closer to understand what Tyler is saying here, but that's probably my fault.

Go back to 2003, then 2004 then 2006, then 2007. What was the 'risk premium' for someone buying a house? Not in retrospect, but when you were there. I knew people who were dumbfounded that they made more money on their house than they did working for two years. Money was available to borrow, prices were changing month to month in some markets, all up up up.

Then they peaked in 2006. And started going down slightly in 2007, getting harder to sell.

That is what Tyler is talking about. The expected returns based on previous results over a period of three decades suddenly changing. People having their whole working life where returns were positive, not only a little better, but with the right connections and a bit of smarts very good. How would someone in that situation value risk? They can't, their whole experience was very little, in fact those who were careful lost opportunities to make serious money.

Then it changes. Nothing is the same, the flow of cash is not the same.

Have you ever been in business when for some reason your cash flow just stops? Not dropping slightly, but stops?

The double digit month on month changes that we have seen over the last while are a sign that such things are happening to lots of folks.

Yeah, I get all that. Your scenario seems more applicable to the US market between 1982 and 1999.

China has not had a 30-year uninterrupted party. Forget the 33% drop between 20010 and 2012. The Shanghai index was above 6,000 in 2008 and fell by two-thirds in 2009.


I love Tyler, but he can be aggravatingly cryptic. I think he enjoys it. So much for the 'simple' primer.

He is probably saying, inarticulately, that there should be a non-zero risk premium in the pricing of Chinese assets. I.e., that Chinese equity isn't T-Bills.

As you say, a straightforward reading of the words he wrote implies that we should expect returns on Chinese equity to go up from here. Which isn't consistent with the rest of the commentary.

Say you buy an asset with a 6% coupon. You think 6% is risk-free and the risk premium is zero. Then you learn otherwise. Seemed clear to me.

Who defaulted, in your example?

Somebody else defaulted (or, rather, Chinese equity crashed) and made you realize you were incorrectly valuing the 6% coupon asset you still hold that didn't default (yet). You thought it was risk-free, and now you don't. So you revalue it discounting the future cashflows at, say, 12%. You now realize it's worth much less than you thought only a short while ago.

OK, thanks, but as I noted above, Chinese equity crashed pretty bad between 2010 and 2012. Ancient history?

I'm not saying I agree with Tyler. He seems to be assuming everyone is a moron.

I was just trying to parse his language, which I thought was pretty unclear.

It's a shorthand, mangled way of saying several related things:
1) That people who saw something that had a risk premium, assumed the actual risk was zero (i.e. that there was a risk arb), and allocated their money accordingly are going to have an unpleasant experience
2) To the extent such people are loss-averse rather than risk-averse, the experience of realizing a loss (repeated on a wide scale) could cause a rapid change in investment behavior that will stick for a long time (think of say, people who refused to ever again invest in stocks after 1929, 1986, or 2000)
3) Going forward, companies/assets will have to offer higher risk premiums in order to attract capital, since loss-averse capital they previously had access to is no longer available to them
4) There will be a lot of dislocation as companies dependent on low cost of capital get squeezed out. What Warren Buffet refers to with his aphorism, "Only when the tide goes out do you discover who's been swimming naked."
5) "A lot of dislocation" is the sort of phrase that makes Chinese policymakers turn white

Tyler is mostly right as usual, but is he getting more arrogant? Does thinking about a problem for years boost one's confidence when the situation arises? (reference: https://youtu.be/uMAmjsAKAO0 - 47:25 min mark)

Both are serious questions...

> we’ll see if they end up stuck in the middle income trap

Isn't that more of a resource economy idea? I don't see how it applies to China. Unless the thinking is that their huge population of workers was a 'resouce'.

> You can’t invest 45-50 percent of your gdp very well forever

you can invest it well when you can see the future. Luckily for China they had a 'future' to follow: the west. Since they have not caught up with the west on a per capita basis, I think that they can still invest well.

Their problem may be that their affluent geographical areas have caught up with the west and they don't (for whatever reason) have much incentive to grow the lagging geographical areas. In this case, I agree, they are going to have a hard time.

Amen; imitation of market outcomes of others is the key to central planning.

Yes, but what happens when China is all caught up? And how can you even measure such a metric?

Agreed: even if there are fewer "low-hanging fruits," Chinese living standards are so low that there must be a large number of positive-NPV investments, more than enough to absorb a 40+% investment rate. The principle limit is the lack of effective governance. Anything else is just an excuse to consume seed stock, and that's true across all cultures and across all time periods.

Regarding #6 given China's demographics and the extent of environmental degradation I would say that if you are pessimistic about the current recession then you should be pessimistic about China's long run growth as well. The point is that the current recession will last for a very long time and if I recall correctly China's working age population has been declining since 2012.

#5 http://www.businessinsider.com/r-china-market-chaos-blamed-on-exodus-of-regulatory-turtles-2015-8?IR=T "China market chaos is being blamed on the exodus of 'sea turtles'"

"Just at the time they needed people with both domestic and international experience, those most internationally experienced people were forced out," said Liu Li-Gang, China economist at ANZ.

http://www.ft.com/cms/s/0/130a0cb2-e504-11e3-9b2b-00144feabdc0.html#axzz3kYwpIpTN "The mating rituals of China’s sea turtles"

Good sentencesTM:

"They were smart a few years ago, and they are still smart now. That doesn’t mean they will end up doing a good job."


Greater concern is that the demographers are right, and in the second half of this century China will experience a 400 million population decline. Woe unto thee whose population declines. As for today, what's striking are (1) the similarities between China and the U.S., including a high level of inequality and a financial asset bubble, (2) the dissimilarities between China and the U.S, including investment in infrastructure and productive capital in China and disinvestment in infrastructure and productive capital in the U.S., and (3) the number of people in the US. who don't recognize (1) and believe the U.S. is better off than China because of (2). Woe unto thee who don't invest for the future. Attitudes about others are often shaped by their similarities and differences, those with similarities considered the greater threat and those with differences not; hence, attitudes about China.

Note that like the U.S. as their population ages they will face a tidal wave of Alzheimer's Disease. Because of the one-child policy, a very large number of these people won't have anyone to take care of them. How are they going to handle this?

If 1 is true, then the costs described in 2 may be overstated, because investment driven growth is no longer a plausible alternative to consumption driven growth.

the next low hanging fruit is pollution control. the public health costs are enormous and might be dumped on the state if they don't act fast.

Air pollution is a tough one because they need electricity and China has the third largest coal reserves, after the U.S. and Russia. Until about 5 years ago, China was a net exporter of coal. Getting China off coal will be hard, and that's where a lot of the air pollution comes from.

Water pollution is a very serious problem in China. Allocation of water rights is similar to the crazy perverse incentives used in California. Much of rural consumption is unmeasured and the incentive is to use it all rather than risk having it taken away. Before any transition to multiparty democracy, China must use the authoritarian power of the state to rationalize water allocation, because it'll never happen under democracy. Unfortunately, the state seems to fear rural unrest if they tamper with the present system, so they're not making the major reforms that are needed.

The economic improvements have helped what, 1/5 of the chinese population? That is a huge number but there are plenty of people still living in poverty. 'Public health costs' are not an issue when you let them die and just have a bunch more brought in from the country side.

You have to think like a communist.

Dear Professor Cowen,

I admire you insouciance in #6, taking the "Chinese recession" as a fait accompli.

Are you using the "two straight quarters of declining GDP" definition here? If so, I think this is a very bold prediction and you will almost surely be wrong.

On the other hand, I'm not sure that's such a meaningful definition. Sumner, as usual, with an interesting perspective on this:


It didn't seem to me that Tyler was trying to "call" a recession. It sounds like he was stating the obvious, that it is a dramatic slow down in growth and that it might well be recessionary.

Tyler just a week ago: "You can think that China is in for a very bad recession, as I do."


Again, that's not "calling" a recession. Tyler can believe that China is in for a very bad recession in the next few years, but be reluctant to call this the start of a recession. I would assume that Tyler knows that such predictions are more luck than genius. Ergo, he's not calling this a recession, but it's quite obviously a slowing and volatile economy and he's commenting on it as such.

Honestly, why does this matter?

Consider this hypothetical: "You can think that JWatts is being obtuse, as I do."

Now if I were to say "Wait a minute! I didn't 'call' you obtuse." I believe you would be justified in accusing me of talking like a sausage.

Why does this matter?
1. Well, in many respects, of course, it matters not a jot what some guy like me types on the Internet.
2. I like people with the guts to make predictions, which seems to be clearly what Tyler is doing here. I want to understand what exactly he is predicting.
3. I'm not sure what definition of 'recession' underlies this prediction. The standard definition is, I think dumb (see Sumner link). I think this is a worthwhile topic in its own right, and I am trying to be charitable to Tyler in suggesting that he may be using a non-standard definition of 'recession' here.

According to the standard definition, Japan is flirting with recession, but people aren't losing their jobs. I've heard in China's context that growth <4% may be considered a recession. I do know that the Chinese authorities fear unrest associated with increases in unemployment. Perhaps Tyler is using a non-standard definition of 'recession' in China's case (see, I'm trying to be charitable.)

"Consider this hypothetical: “You can think that JWatts is being obtuse, as I do.”

I'd tend to just assume that you were being passive-aggressive or maybe pretentiously insulting.

"Why does this matter? ...2. I like people with the guts to make predictions, which seems to be clearly what Tyler is doing here. I want to understand what exactly he is predicting. .. (see, I'm trying to be charitable.)"

You aren't being charitable, you are being confrontational. Maybe you don't realize it, but go back an read what you wrote.

"I admire you insouciance in #6, taking the “Chinese recession” as a fait accompli." That's a pretty hostile statement.

"If so, I think this is a very bold prediction and you will almost surely be wrong. " That's also confrontational and hostile.

I'm not picking a fight and I don't strongly care. Also, you are generally a pretty level headed poster. But, Tyler rarely responds, and very rarely responds to confrontational posts. So, he's probably not going to answer. You can always send a politely worded email about the topic.

Welcome to the internet, guys.

You two are both usually pretty level headed and should just let this one slide.

Lighten up, Francis. I was being playful in my response to you. I still think (hostile and confrontational trigger warning) you were talking like a sausage.

Tyler's a big boy. Don't confuse plain speaking with hostility. Cripes, with all the ankle-biters constantly going on about cheap chalupas and whatnot, cracks about his wife, about how he's nothing but a suck-up to the Washington social circuit, you'd think someone could distinguish honest questioning from that kind of crap.


Beware the Chinese Urban Revolt of 2019!


The misery of the Euro has spread. Raw materials from various African countries used to go to Chinese factories to become manufactured goods sold on to the eurozone, China's largest market. Europe's AD has gone way down, and now the worst economic decision of all time has spread around the globe.
I expect the markets to, at best, move sideways until the rules of the Euro are changed.

Hmmm, that could well be true.

Great post.

#3 especially is interesting -- what decisions did people make on that basis? Remembering the dot-com boom, and the giant surplus of Aeron chairs in its aftermath...

Also, we should really all take a moment to celebrate the great run China had. The rise of 1.3 billion people out of horrible grinding Maoist near-starvation poverty into middle income status is the greatest humanitarian story of our age, perhaps in all of human history.

Between urbanization and China's one child policy the demographics of an aging population can only worsen China's economy over time. The migrants to the cities will not return to the countryside when they are older as they won't have children there to care for them; and they will not have produced a sufficiently large enough work force to support the aged population. Shades of Japan.

"The Chinese have been growing at ten percent or nearly ten percent for about thirty-five years."

3+ decades of uninterrupted massive growth without any recession or even year or two with lesser yearly growth. Even when their lead trading partner had several little recessions and a large one.

Totally believable!

From the Tyler primer point of view, it doesn't actually have to be true. If investors assumed it was true enough and thus ignored any kind of "growth isn't always going to be super awesome!" risk premium, then it will have had an impact.

More to your point, a sane investor should have be skeptical about the numbers and should have built in a risk premium. But those sane investors (and they surely existed) were out bid by the "growth is going to be super awesome!" bidders.

I do not always agree with you. However, this primer is a masterpiece of somebody with a sound understanding and the proper skills to communicate that understanding.

How is this a "masterpiece"? "China grew fast for a while but now it's probably not going to grow as fast" is not exactly brilliant analysis.


Not what I said, smart ass.

I am a short-term China optimist, long-term China pessimist.

So basically, you are troll.

I am not sure about the Tyler Cowen declaration that an economy cannot switch to a consumption mode without a decline in growth rates.

What happened to the United States after World War II?

In classic macro economic terms, the US "malinvested" terribly during World War II.
Egads, the useless planes and Liberty ships converted to scrap.

Additionally the Chinese still have control over their own central bank which prints money that is accepted in an economy that is suffering from a too-low rate of inflation.

Really the China problem does not seem too hard to solve. QE by the PBoC.

Demographics? Bad. Forget about retirement.

Can't the Chinese government just tell the people to go consume for the motherland?

This assumes that much of the investment was rational, or even informed by rational incentives. There's substantial evidence that much of the infrastructure spend was less than efficient - it looks like Malaysia/Thailand circa 1996 on a grand scale. Commissions, paybacks, and good old graft, were probably significant drivers for much of the 'development'. Add a substantial level of state-owned enterprise and undemocratic governance, and it's really hard to see how applying capitalist macro analysis models to the Chinese economy is going to give any reasonable approximation of reality

Calling to all newbie’s in trading out there. For only 14 days I’m impressed of my learning in knowing how to trade. I challenge you to Google Superior Trading System and see for yourself that what I am telling you is true.

Comments for this post are closed