from : Warwick Powell substack.
Genuine expertise and understanding of the Chinese monetary system. NOT your usual Wall Street/Fed twaddle.
Credit Creation and the Fallacy
of ‘Financial Repression’
Rethinking China's Economic Model:
Critique of Hard and Soft Budget Constraints
Sep 13, 2025
Context: the dominance of
mainstream economic discourse across the western commentariat results in a
one-dimensional perspective on China’s economic development, its institutions
and policy focus. Such a perspective revolves around a series of core tropes
including ideas of ‘balance’ (consumption v savings; households v enterprises),
which are often misappropriated, misspecified and mobilised in normative terms
that imply error or impending crisis. This short essay continues my own
reflections on the shortcomings of mainstream framings, suggesting alternative
interpretative frames. This essay addresses two fallacies: (1) the hard budget
constraint fallacy; and (2) the household financial suppression myth. For a
fuller piece on an alternative frame to understand China’s economic model and
experience, check out my earlier
essay ‘ China’s economic model revisited’.
In debates over China’s growth
model, critics frequently invoke two lines of argument, amongst others: first,
that Chinese enterprises, particularly state-owned ones, and local governments
face soft budget constraints, allowing them to absorb inefficient
capital and delay market discipline; and second, that households are financially
repressed by deliberately low deposit interest rates, effectively
subsidising enterprise borrowing and investment.
Both claims stem from a flawed
understanding of how (fiat and fiduciary) monetary systems function,
particularly in economies where bank credit plays the central
role in financing investment. These critiques rely on a ‘loanable funds’ view
of finance and overlook the endogenous, elastic and purposive nature of credit
creation. As such, they mischaracterise how investment is financed, how household
welfare is shaped, and how the state interacts with economic structure.
Let’s break these down.
Dogmas cloud the ability to see the
world in alternative ways. The fallacies of mainstream economics rank is some
of the most implacable of dogmas.
The Hard Budget Constraint
Fallacy
The notion of soft budget
constraints originates from János Kornai’s analysis of socialist
economies, where enterprises were shielded from bankruptcy and inefficiency was
perpetuated by guaranteed state support. Critics of China’s economy have
reappropriated this idea, suggesting that state-linked firms, local governments
and public investment vehicles behave irresponsibly due to expectations of a
bailout. This line of thinking presumes a standard of ‘hard budget constraint’
grounded in the belief that financial resources are scarce, must be allocated
efficiently, and are best governed by market prices including interest rates
and bankruptcy risks.
This framing implicitly accepts the
loanable funds model of finance, [the plain wrong theory, see Steve Keen] where banks merely intermediate pre-existing
savings from one sector (e.g., households) to another (e.g., enterprises). In
such a model, allowing firms or governments to access credit without strict
market discipline indeed risks waste and inflation, as scarce savings are
misallocated. But this model bears little resemblance to how modern banking
systems operate, especially in a financially sovereign state like China.
In fact, banks create credit ex
nihilo; that is, new loans create new deposits (as opposed to the idea that
it’s deposits that create loans). Fiduciary money is brought into existence via
this mechanism. (It is removed from circulation via loan repayments.)
Enterprise finance does not rely on a fixed pool of savings; rather, it is a
forward-looking commitment of purchasing power - what I
have called a claim on future embedded energy in the context of a
thermodynamic model of value, production and circulation - enabled by banks and
often steered by state priorities. The budget constraint on firms, therefore,
is not an externally imposed scarcity but a function of productive potential
and policy goals. A financially enabled enterprise is not ‘soft’ by default;
its viability must be assessed in terms of real economy outcomes. Thus, we
should be asking: does it generate output, incomes, employment or technological
advance in ways that are positive in terms of Energy Return on Energy Invested?
These are the real constraints and possibilities, not accounting-based
financial flows.
Thus, the criticism that Chinese
investment is excessive or unproductive because it escapes hard money budget
logic overlooks that productive credit precedes income rather
than follows it. The very purpose of investment-led growth is to expand
capacity, generate employment and lift household incomes. The state’s role is
not to impose artificial scarcity on capital but to direct credit - directly
and indirectly - toward long-term structural transformation and the creation of
energy surpluses. Judging this system by the standards of a capital-constrained
firm in a market-clearing model is fundamentally misplaced.
Banks create credit ex
nihilo. These are balance sheet and ledger adjustments, unconstrained by
deposits. [If you don't know this, then you are one of the mass of deluded western economists! Wake up and learn the facts!]
Local Government Debt and
Vertical Fiscal Imbalance
A frequently cited related concern
in critiques of China’s development model is the rising debt levels of local
governments, particularly through local government financing vehicles (LGFVs).
These entities are often portrayed as extensions of the ‘soft budget
constraint’ problem, undertaking investment with poor oversight, low
accountability and the expectation of a bailout. However, this framing again
misses the institutional and structural context in which such debt arises, and
more importantly, misrepresents the role of credit in an economy undergoing
large-scale transformation.
The proliferation of local
government debt is best understood as a response to a persistent vertical
fiscal imbalance: since the 1994 tax-sharing reforms, the central government
has retained the majority of revenue-raising powers, while local governments
remain responsible for the majority of infrastructure, social services and
development expenditures. This creates a structural disconnect; localities are
tasked with delivering high-growth, high-modernisation outcomes without
sufficient fiscal capacity, which manifests as a case of institutional vertical
fiscal imbalance. Put plainly, those with the bulk of the spending obligations
don’t have the bulk of the revenue powers. In the absence of direct transfers
or tax decentralisation, local governments have resorted to off-balance-sheet
borrowing through LGFVs to fund essential investments in transport, housing,
water and industrial zones.
This debt is not primarily
speculative or wasteful, but rather a mechanism of state-led credit
creation in a constrained fiscal environment. LGFV debt is often
backed by land collateral, future revenues or implicit guarantees, and much of
it has supported tangible capital formation. In this sense, it functions as
a quasi-fiscal tool that blurs the boundary between public and
private finance, enabling the mobilisation of long-term investment under
conditions where orthodox fiscal tools fall short. In balance sheet terms, as
has been recognised in IMF
studies, Chinese local governments exhibit robust balance-sheet positions
when assets are considered. For instance, LGFVs reported total assets at
approximately 120% of GDP, versus liabilities around 75% of GDP by 2020. Other
IMF studies that analyse the broader government balance sheet -
encompassing financial assets and liabilities - also suggest that the net
financial worth (assets minus liabilities) remains positive. Liabilities is one
side of the ledger, assets is the other; and on these terms the asset base is
solid. Liquidity challenges are related to the structure of taxing powers
versus spending powers.
A further conceptual misstep in
mainstream discussions of local government debt is the tendency to treat these
obligations as if they were analogous to household or private firm liabilities,
that is as debts owed by one entity to another in a hard contractual sense. In
reality, what we are dealing with is a network of interlocking public-sector
balance sheets, in which distinctions between central and local entities are
administrative rather than economically absolute. There is no consolidated
‘sovereign’ balance sheet akin to a unified federal system with vertical fiscal
transfers and debt pooling mechanisms. Instead, China’s fiscal structure
functions as a decentralised developmental network, in which credit is deployed
across tiers of government in pursuit of long-term national objectives.
Much of what is labelled ‘debt’ is,
in substance, a form of internally generated and recycled claims within the
public system - assets and liabilities that, while formally separated, are
functionally coordinated and, in extremis, can be realigned through
administrative and financial mechanisms. This means concerns about ‘default’ or
‘unsustainability’ are often misplaced: what matters is not the headline debt
ratio, but the capacity of the system as a whole to generate and reallocate use
value over time. Judging sub-sovereign public debt by private-sector
metrics thus misrecognises the embedded nature of China’s fiscal-capital system
and its evolutionary coordination logic.
Critically, I would argue, this is
not a flaw in China’s financial system, but a feature of a development model
where investment precedes returns (which I
have discussed in more detail separately), and localities act as agents of
national development goals. This is what Keyu Jin has called the “mayor’s
economy”. The challenge is not the existence of such debt, but rather how to
better align fiscal architecture with development responsibilities, improve
transparency and accountability and ensure that credit continues to serve
socially productive and sustainable ends.
In recent years, central
authorities have undertaken a series of reforms aimed at managing these
imbalances and improving the quality of local government financing. The
introduction of a local
government bond system in 2015 allowed for the gradual replacement of
opaque LGFV debt with more transparent, on-budget municipal bonds, subject to
clearer approval and oversight mechanisms. At the same time, bond
swap programs were implemented to restructure high-cost or short-term
LGFV liabilities into longer-term official debt, easing refinancing pressure.
Furthermore, reforms to the central-local
transfer system, including expanded equalisation transfers and
performance-linked funding, have been designed to reduce over-reliance on
land-based finance. Pilot
programs for real estate tax in cities like Shanghai and Chongqing also
reflect moves toward giving local governments more stable and endogenous
revenue sources. These efforts aim not to eliminate local government debt per
se, but to embed it within a more sustainable and rule-based fiscal
framework, recognising that strategic local investment remains a critical
pillar of China’s developmental statecraft.
The development-oriented framing of
local government financing and debt has been confirmed by remarks from Minister
Finance Lan Fu’an at
a press conference on 12 September 2025. In response to a question from
Reuters about local government debt financing and hidden debt, Lan observed:
“Debt reduction is a means to an
end; development is the goal. We adhere to the dual approach of debt reduction
and development, effectively promoting a virtuous cycle of economic development
and debt management. First, it has enhanced local development momentum. Debt
reduction has unblocked the capital chain, freeing up more financial resources,
time, energy, and policy space for local governments to address bottlenecks,
pain points, and difficulties in economic development. Second, it has
accelerated the exit of financing platforms. By the end of June 2025, over 60%
of financing platforms had exited, meaning that over 60% of these platforms'
hidden debts had been eliminated, accelerating the reform and transformation of
these platforms.”
Note that the progressive
restructuring of local government debt structures has seen the dramatic
reduction of financing platforms (the LGFVs) involved in the sector. It’s also
worth pointing out that the financing of local governments is viewed through the
lens of development, where debt management is largely about ensuring the
freeing up of cash flows and other resources in the name of ongoing regional
development.
The Household Financial
Repression Myth [and this is where the supply of mortgage finance hits home, so to speak. It had been let rip a bit too much]
The second, related critique is
that households are financially ‘oppressed’ by artificially low deposit
interest rates. This argument holds that the Chinese financial system
deliberately suppresses returns to savers so that cheap credit can be extended
to enterprises, effectively transferring income from households to firms. Here
again, the framing is drawn from an orthodox model in which the interest rate
is an inter-temporal price, balancing savers’ patience and investors’ demand
for funds. If deposit rates are low, households supposedly lose purchasing
power, and consumption is suppressed relative to investment.
This is a textbook example of
mistaking relative shares for absolute outcomes, and of ignoring the endogenous
nature of money. First, real household incomes and consumption have risen
dramatically over the past two decades. Most household income is derived from
wages, self-employment and to a much lesser extent transfers, rather than from
financial interest income. Even in developed economies, interest income
constitutes a small share of household earnings.
Second, the logic of ‘financial
repression’ assumes that households are net creditors, losing income through
low deposit returns. But in a credit-driven system, household income is
an outcome of investment and production, not a pre-existing
fund diverted elsewhere. By financing enterprise investment in infrastructure,
manufacturing and urbanisation, credit expansion has enabled employment growth
and income expansion, which in turn support higher household consumption and
savings in absolute terms. If enterprise credit leads to productive expansion,
the result is a rising tide of income, not a zero-sum transfer. Chinese
household incomes have increased over 700% in the past decade or so, in real terms.
They continue to rise.
Moreover, the supposed link between
deposit rates and loan rates is overstated. Banks do not need prior deposits to
lend; they lend first and in doing so, create money. The deposit rate does not
determine the cost of enterprise capital in any strict sense, because deposit
rates don’t function as some inter-temporal preferences governing mechanism.
Investment as an autonomous demand
driver spurs real income growth, which underpins consumption and further
investment.
Understanding the Structural
Logic of Investment-Led Growth
The deeper issue here is that both
the hard / soft budget debate and the financial repression narrative reflect a
misunderstanding of how capital accumulation and circulation occurs. In systems
like China’s, where financial systems are coordinated with national development
goals, the role of money and banks is not to passively
intermediate between savers and investors (which is a neoclassical economics
myth in any case), but is instead an instrument of public policy and structural
transformation.
The constraints that matter are not
financial bookkeeping entries but real economy constraints: energy
availability, human resource capability, technological capacity, ecological
sustainability and social stability. Investment in infrastructure, industrial
upgrading and regional integration is not ‘soft’ simply because its returns are
indirect or long-term. Nor is household welfare undermined because deposits
yield low interest if real wages, employment and consumption are rising.
From a thermodynamic and ecological
perspective, as noted by critics of the diminishing returns narrative,
investment is always necessary to manage entropy, maintain systemic resilience
and upgrade energy efficiency. [New (to me) ideas here, but Steve Keen certainly talks about this important factors --ecology and entropy. Obviously the same 'didn't see it coming' economists are clueless about this too] The idea that productive investment eventually
exhausts its usefulness presumes a closed equilibrium model with fixed resource
endowments. But real economies are open systems, entropic by nature, and
require continuous reinvestment to stabilise social and material order.
Conclusion
Critiques of China’s development
model that hinge on arguments and claims about hard budget constraints and
household financial repression ultimately fall short because they are grounded
in a flawed understanding of money and credit. They assume a world of scarce,
pre-allocated financial capital where market prices enforce discipline and
efficiency. But modern economies, especially those with monetary sovereignty
and policy-coordinated banking systems, operate on very different real logics.
Credit is not a fixed resource; it
is an enabling mechanism. Enterprise finance is not constrained by household
saving; it drives household income, which in turn delivers consumption capacity
and savings as a residual. Investment is not a luxury but the necessary
condition for thermodynamic renewal, entropy management, structural
transformation and long-term welfare. By reframing our understanding of money
as a tool of production and circulation, not as a store of value, we can move
past the twin fallacies of financial repression and hard / soft budgets, and
better understand the logic of dynamic development.
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