China's 'Likonomics': Believe It When You See It

Prime Minister Li Keqiang vows to overhaul the country's economic model -- but will he be able to?
Likenomics2.jpgChinese Prime Minister Li Keqiang. (Tobias Schwarz/Reuters)

Move over Shinzo Abe. There's a new eponynomics craze in town: Likonomics. This is not the economics of Facebook "likes"; it's what Barclays Capital has christened the policies of China's premier, Li Keqiang. (We think it really should be Liconomics or maybe LiKenomics, but it's probably not worth quibbling about.)

Like Abenomics, Likonomics is based on three pillars:

1) Ending fiscal stimulus by diminishing state-led investment.

2) De-leveraging in order to slash debt.

3) Structural reform, including relaxing controls on utility prices and liberalizing interest rates.

Barclays says that implementing these will put the country on track to hit 6-8 percent GDP growth for the next decade (link in Chinese). Li himself says the country's on track to hit its 7.5 percent target for 2013. Here are some thoughts on why both expectations are bonkers:

Since the Chinese government seldom issues bonds, "fiscal stimulus" actually just means "lending." And in China, lending is one of the only sources of growth for most of the economy -- it now depends on the gush of lending to grow.

Or, at least, to look like it's growing.

GDP measures economic activity. But it doesn't capture the economic value -- meaning, the future money-making potential -- of that activity. Say someone borrows $30 million to invest in opening a steel factory. That $30 million is counted toward GDP -- since it purchases labor and materials to make the factory -- even if no one buys the steel produced and the factory earns no money. Investors still have to pay off their initial debt. But with no revenue, they have to take out more loans to cover that.

That's clearly happening in China's economy now. More and more money is needed to generate slower and slower growth. Here's a look at how the broadest measure of money supply, M2, tracks with GDP growth (looking at money supply should capture some degree of the liquidity pumped into the economy from shadow lending -- loans issued that aren't recorded on bank balance sheets  -- which isn't captured in official loan data):

m2graph.jpg

Ending the stimulus -- i.e. lending -- will make that appearance of GDP growth impossible to sustain, especially at the 7.5 percent that Premier Li promises. And probably not even at the 6 percent lower bound Barclays projects.

As Michael Pettis, economist and expert on the Chinese economy, recently wrote, consumption can power GDP growth of 3-4 percent each year --  but there's a caveat. "[I]t is not clear that consumption can be sustained if investment growth levels are sharply reduced," he writes. That's because people need jobs -- ultimately supported by Chinese lending -- to be able to keep spending. And as we explore more below, Likonomics as Barclays has framed it poses big risks to job providers.

China as a whole needs to deleverage -- meaning, to slash the proportion of borrowing in relation to output -- in order to start making productive investments again. In that general sense, Likonomics is on the money.

But in order to pay off debts, companies have to be making money. If they don't, they default.

That's a big problem in China right now. Growth is already slipping fast, leaving businesses generating less and less cashflow to cover their debts. Cutting lending will start to expose this insolvency even more. Untold numbers of local government investment platforms, real estate developers, and factories, to name a few, will go under.

True, postponing writing down bad debt will only make things worse. But a chain-reaction of defaults will cause growth to implode. And waiting for unproductive assets to start making money again could take years -- even decades. That's what Charlene Chu, an expert on Chinese debt at the ratings agency Fitch, was referring to when she recently warned of "Japanese-style deflation." In other words, with far more factory capacity than it needs, consumption will fail to keep up with production, driving prices down. Meanwhile, companies left standing will use profits to pay off their debts, which will suppress wages, restraining consumption even more.

Gwynn Guilford is a reporter and editor for Quartz.

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