How can this be normal?

Twenty-nine countries with roughly 60 percent of the world’s GDP have monetary policy rates of less than 1 percent per annum. The world is awash with debt, with sovereign, corporate and household debt of over $230 trillion or roughly three times world GDP.

To finance their large debt and deal with deflation, both the European Central Bank and Bank of Japan are already experimenting with negative interest rate policies. If these do not work, look out for helicopter money, which means central bank funding of even larger fiscal deficits.

Either way, at near zero interest rates, the business model of banks, insurers and fund managers are broken. Deutschebank’s CEO has recently warned that European bank profits will struggle more as negative interest rates play into deposit rates. No wonder bank shares are trading below book value.

The problem with the current economic analysis is that no one can ascertain whether exceptionally low interest is a symptom or a cause of deep chronic malaise. Exceptionally high debt burden can only be financed by exceptionally low interest rates. The Fed now feels confident enough to raise interest rates, which means that the U.S. asset bubbles will begin to deflate, spelling trouble to those who borrow too much in U.S. dollars, which would include a number of emerging markets.

As Nomura chief economist Richard Koo asserts, the world has followed Japan into a balance sheet recession, with the corporate sector refusing to invest and consumers and savers too worried about outcomes to spend. The solution to a balance sheet (imbalanced) story is to re-write the balance sheet, which most democratic government cannot do without a financial crisis.

Like Japan, China’s dilemma is an internal debt issue of left hand owing the right hand, since both countries are net lenders to the world. This means that foreigners cannot trigger a crisis by withdrawing funds. The Chinese national balance sheet is also almost unique because the financial system is largely state-owned lending mostly (about two-thirds) to state-owned enterprises or local governments. The Chinese household sector is also lowly geared, with most debt in residential mortgages and even these were bought (until recently) with relatively high equity cushions.

Unlike the US Federal Government which had a net liability of $11 trillion or 67 percent of GDP at the end of 2013, the Chinese central government had net assets of $4 trillion or 42 percent of GDP. In addition, Chinese local governments had net assets of another $11 trillion or 123 percent of GDP, compared to U.S. local government net assets of 45 percent of GDP. Local governments hold more assets than central or federal government because most state land and buildings belong to provincial or local authorities.

Thus, unlike the U.S. where households own 95 percent of net assets in the country, Chinese households own roughly half of national net assets, with the corporate sector (at least half of which is state-owned) owning roughly 30 percent and the state the balance. In total, the Chinese state owns roughly one-third of the net assets within the country, compared to net 4 percent for the U.S. Federal and state government.

Skeptics would argue that Chinese statistics are overstated, but even if the Chinese state net assets are halved in value (because land valuation is complicated), there would be at least $7.5 trillion of state net assets (net of liabilities) or 82 percent of GDP to deal with any contingencies.

Furthermore, unlike the Fed, ECB or Bank of Japan, the People’s Bank of China derives its monetary power mostly from very high levels of statutory reserves on the banking system, which is equivalent to forced savings to finance its foreign exchange reserves of $3.2 trillion. Thus, the central bank has more room than other central banks to deal with domestic liquidity issues.

What can be done with this high level of state net assets, which is in essence public wealth? My crude estimate is that if the rate of return on such assets can be improved by 1 percent under professional management, GDP could be increased by at least 1.5 percentage points (1 percent on 165 percent of GDP of net state assets).

How can this rewriting of the balance sheet be achieved? There are two possibilities. One is to allow local governments to use their net assets to deleverage their own local government debt and their own state-owned enterprise debt. This could be achieved through professionally managed provincial level asset management or debt restructuring of companies.

The second method is inject some of the state net assets into the national and provincial social security funds, as a form of returning state assets to the public. People tend to forget that other than the painful restructuring of state-owned enterprises in the late 1990s, which led to the creation of China’s global supply chain, the single largest measure to create Chinese household wealth was the selling of residential property at below market prices to civil servants. The size of the wealth transfer was never officially calculated, but it paved the way for boosting of domestic consumption by giving many households the beginnings of household security.

The injection of state assets into national and social security funds was not achieved in the 1990s, because the state of provincial social security fund accounting was not ready. But if China wants to boost domestic consumption and improve health care and social security, now is the time to use state assets to inject into such funds.

At the end of 2014, Chinese social security fund assets amounted to 4 trillion yen, compared with central government net assets of 27 trillion yen (Chinese Academy of Social Science data, 2015). Hence, the injection of state assets (including injection by provincial and local government) into social security funds as a form of stimulus to domestic consumption and more professional management of public wealth is clearly an affordable policy option.

In sum, at the individual borrower level, there is no doubt an ever increasing leverage ratio in China is not sustainable. But the big picture situation is manageable. If the policy objective is to improve overall productivity (and GDP growth) by improving the output of public assets, the timing is now.

By Andrew Sheng

Andrew Sheng is Distinguished Fellow, Asia Global Institute, University of Hong Kong. -- Ed.

(Asia News Network)