La no solución china

1/14 A scholar at the Global China Initiative says that the developing world can use the example of China's AMC's to resolve its bad debt with "market-based" solutions. I think there is a lot of confusion about how that actually happened.

2/14 In the early and mid 2000s the four AMCs purchased huge amounts of bad debt from the Big Four Chinese banks in two tranches, paying 100% of face in the first tranche and 50% of face in the second. The debt was barely worth 20% of face at the time.

3/14 The AMCs could do this because the purchases were themselves financed (with ten-year bonds) by the very banks that sold them the bad debt. The bad debt wasn't resolved, in other words. It was just transferred from the banks' loan portfolios to their bond portfolios.

4/14 There is a myth that the AMCs then used clever financial engineering to resolve the bad debt through liquidations, reassignments, and other market-based transactions over the next 10-20 years (most of the funding was extended for another ten years after it came due).

5/14 But that's not what happened. The real way the debt was resolved was through massive financial repression. China's average nominal GDP growth rate during this period was 16-20% annually, and the GDP deflator was 8-10%.

6/14 Lending rates, however, were set by the PBoC during the period at an incredibly low 6-7%. Every year, in other words, the stock of debt dropped by roughly 10 percentage points relative to the stock of assets just because of artificially repressed lending rates.

7/14 Meanwhile deposit rates were set at 2-4%, so that households, who were funding the whole business, lost 6-7% of their savings in real terms every year. Households, in other words, subsidized both the recapitalization of the banks and the real reduction of the debt burden.

8/14 This means that it wasn't the AMCs that resolved the debt, but rather the hapless household depositors who were forced to pay for the massive clean-up. One side effect was that household consumption, which was a very low 48% of GDP in the year 2000, dropped to...

9/14 an astonishing 34% of GDP ten years later. This was no coincidence. Forcing households to absorb most of the cost of the bad debt also caused a very sharp decline in the household share of GDP. The moral of the story is not that the AMCs don't work.

10/14 The moral is that the bad debt was resolved in the same way that bad debt is always resolved: by directly or indirectly allocating the losses associated with the debt to some (unwilling) sector of the economy. The AMCs were little more than a useful accounting mechanism.

11/14 The key to resolving developing-country debt, in other words, is not the mechanism used, but rather the highly political decision about who will take the loss associated with writing down the debt to a manageable level. "international" AMCs will not address this problem.