Layoffs, redistribution and Chinese tail risks

China aims to lay off 5-6 million state workers over the next two to three years as part of efforts to curb industrial overcapacity and pollution, two reliable sources said, Beijing’s boldest retrenchment program in almost two decades.

– Reuters on Tuesday

Rising unemployment that leads to social instability in China = scary and anathema to China’s leaders.

SO, also from Reuters with our emphasis:

China’s leadership, obsessed with maintaining stability and making sure redundancies do not lead to unrest, will spend nearly 150 billion yuan ($23 billion) to cover layoffs in just the coal and steel sectors in the next 2-3 years.

The overall figure is likely to rise as closures spread to other industries and even more funding will be required to handle the debt left behind by “zombie” state firms.

Hmmm. A longer timeline and funding? That almost sounds like… good news?

Yup, but it all depends on how these earmarked funds will themselves be funded.

Before we get to that though, let’s take a trip to the northeastern rustbelt where these layoffs are, probably, mostly going to occur. We shall take that trip in the company of Deutsche’s excellent Zhiwei Zhang who begins by noting that those provinces have already suffered what could be called a hard landing.

Crucially they didn’t suffer that hard landing because of some sudden financial shock. They suffered because of the structural nature of their economies – we’re talking old industry heavy with SOEs and populations facing a demographic trend even more extreme than the rest of the country.

Here’s Deutsche putting all of that — hard landing and structural causes — in multiple graph form. We’ll meet you after you’ve had a good look at the contrasts between the northeast and the rest of the country:


The real point that Zhiwei Zhang is trying to make, however, is actually that household income and consumption in the northeast have held up pretty well compared to the falls he graphed above.

As he says:

Urban household income in the Northeast grew 7.3% in the first three quarters of 2015 (Figure 10). While this was also lower than the average of other regions, the gap is much smaller than what we saw for the IP, FAI, imports or local government fiscal revenue. In addition, considering nominal GDP growth of the region dropped from 5.4% in 2014 to 1%, the slowdown of income growth compared with 2014, -1.5 percentage points, seemed quite modest. The shock to consumption in the Northeast was also relatively mild, as indicated by the growth of both retail sales and urban household consumption (Figures 11 and 12). The Northeast, again, had lower growth than other regions. But like household income, the gap was much smaller than seen in some other indicators such as investment.

The reason why it held up? The government footed the bill in various ways, as it is doing while shuttering some of the overcapacity as detailed by that Reuters piece, but also and more dangerously/interestingly by simply increasing credit in those regions faster than elsewhere.

From Deutsche:

… who is helping to cushion the shocks to household income and consumption? Households’ own smoothing behavior, through dissaving, might to some extent explain the relatively small drop in consumption growth, but what about the robust income growth of 7.3%? One source, not surprisingly, must be direct support from the government, and we suspect a large chunk of such support must be transfers from the central government. We doubt the fiscal capacity of the local government, because its budget revenue dropped by more than 20% in 2015 (Figure 3). Besides, we did not observe a bump in the Northeast’s local government fiscal spending in 2015 (Figure 13).


Another likely source of cushion is “indirect support” from the government. Figure 14 shows growth of loan stocks by regions in 2014 and 2015. In contrast to what one might expect from weak economic performance, credit growth in the Northeast actually accelerated in 2015 from 13.8% to 15.3%, and was faster than all other regions. In fact, the Northeast was the only region with an appreciable pickup of credit growth in 2015.

The sharp contrast between weak economic activities and strong credit growth shows that, banks in the Northeast likely supported, through renewed lending, the weak corporate sector regardless of economic viability, which helped to avoid unemployment and bankruptcy. In this case, it is the government’s priority of maintaining social stability that overrode profitability considerations.

So they bumped up credit to provide space for an economic slowdown. Hmmm. Yeah. That seems like something which can’t go on forever and reminds us of the larger macro narrative in China at the moment — even if recent RRR cuts might well be seen as credit, growth neutral there is a trend at work that’s hard to ignore:

Charts from UBS

A final chunk from Zhiwei Zhang on that:

Such government support, however, can only be a short-term remedy rather than long-term solution to the structural challenges facing the northeastern region, and it comes with dear efficiency costs. The central government started to talk openly about addressing the risk of “zombie companies” in late 2015. This is regarded as a key part of the “supply side reforms”. One way to judge how serious the government is about the “supply side reforms” is perhaps to see if such credit support to the northeastern region will be contained in 2016.

We suppose the point of this piece is that, as we said above, all of the support being offered by the centre has to be funded somehow. So that means an increase in debt. Whether that debt increase is a permanent or temporary tool becomes the key question.

As Michael Pettis said via email while chatting to us about the Reuters piece:

… at least superficially it provides almost a textbook example of what we have been saying all these years. Remember that I’ve been arguing that every policy choice Beijing faces ultimately boils down to choosing among a higher debt burden higher unemployment, and wealth transfers to households. Maintaining these useless factories means allowing the debt burden to rise. Closing them down means forcing up unemployment, unless Beijing can create another equivalent source of unlevered demand. Because the only other such source that matters in practice, consumption, is constrained by China’s already low household income share of GDP, which should decline even further as workers are laid off, I think the only meaningful and sustainable way to prevent unemployment from rising is to engineer wealth transfers to ordinary households.

So I guess that in 2016 we need to see an aggressive and credible program to implement this process, and if we do, while there is still no way to prevent GDP growth from slowing sharply, China will nonetheless be returned to a sustainable growth path, and China’s very difficult adjustment will be made manageable. The plan described in the article is unambiguously part of such a process. The important question, of course, is how the RMB 150 billion is funded. At first it will occur through a rise in debt, but while more debt is always worrying, we shouldn’t be overly pessimistic because I think there is simply no way to carry the frictional costs of what will inevitably be an enormously complicated adjustment without an initial increase in debt.

If China follows the Japanese strategy of transferring wealth to households almost wholly in the form of permanent increases in government debt, even if it isn’t eventually forced into a debt crisis (because poor countries cannot absorb the high debt levels that rich countries can), it will nonetheless be doomed to at least one or two decades of stagnation and low growth, and maybe even more. But if the rise in debt is only temporary, and China quickly begins to liquidate government assets in order to pay down debt, then this will indeed represent almost a textbook example of a successful rebalancing.

Let’s see if they pull it off.

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