China's growth has been on a credit- and debt-heavy path for most of the past decade. Before the Global Financial Crisis (GFC) in 2008, productivity and net exports provided meaningful support to investment-led growth. In contrast, most of the post-GFC period growth has been supported by sharply rising bank lending and debt creation. As a result, in the span of a decade, China has moved from being a low credit and debt economy, to a relatively high credit and debt economy.
This change of growth drivers hasn't gone unnoticed. S&P Global Ratings has commented regularly on the sustainability of the macroeconomic trajectory and the need to lower official growth and credit targets (see note 1). Multinational institutions, most notably the International Monetary Fund, have called into question the sustainability of the economy's current path as well (see note 2). Private financial institutions have weighed in, occasionally in more strident language, including widespread forecasts early last year of a "hard landing." Most recently, even the Chinese authorities have highlighted the need to "deleverage" and slow credit growth, at least implicitly recognizing credit and debt sustainability concerns.
While there now appears to be agreement on the existence of a "credit gap" in China, there is no consensus on its consequences. (We will use the term credit below with the understanding that China has both excess credit and excess debt levels; these are indeed intertwined, and both need to be put on more sustainable paths.) Will a period of sharply lower credit growth, possibly including deleveraging, and output growth be required, as many external observers claim? Or are there "Chinese characteristics" that would allow for a smooth adjustment, as is the view from Beijing? In our opinion, framing these questions requires two variables: the size of the credit gap and, more important, the amount of time the Chinese authorities have to close the gap. Using a simple but powerful model, we show that either camp's view could be correct. But the key to the outcome is the reform effort of the authorities.