At the National People’s Congress meeting in early March, the Chinese Government set its annual growth target at 6.5 per cent, a couple of notches lower than the actual performance of 6.7 per cent in 2016. In the first half of this year growth in gross domestic product (GDP) reached a better-than-expected 6.9 per cent. But the analysts remain divided over China’s medium-term economic outlook.
The debate about China’s growth slowdown since 2010 continues to rage. Some think that the drop is cyclical. Others believe that trend growth has shifted down a gear. Neither assessment pays sufficient attention to the structural shifts that the growth slowdown is making necessary.
The most important structural shift in China is that many of the industries – the labour-intensive manufacturing and resource-based heavy industries – that supported strong economic growth over the past few decades have lost their competitiveness. Exports and investment were the main drivers of Chinese growth, while consumption was relatively weak. New industries such as services are not yet strong enough to provide the same momentum.
Can the “new economy” offset the slowdown of declining industries and continue to sustain a relatively high rate of Chinese growth? Success in this transition will depend on lifting technology and productivity in the new growth sectors.
There are barriers.Chinese leaders have warned about rising financial system risks several times over the past year or so.
This is because in the past couple of years a range of financial market risks have emerged: in equity and bond markets, in shadow banking, in property markets, in digital finance and in foreign exchange markets. The Shanghai A-share Index rose from about 2,000 in May 2014 to 4,500 in May 2015, before collapsing below 3,000 in May 2016. The ratio of commercial bank non-performing loans has jumped by 75 per cent over the past two years. The property market has also gone through three cycles since 2009, of growing severity. There are also risks of capital flight and currency depreciation. The prevalence of these risks across the financial sector is a signal of systemic problems.
China remains the only major emerging market economy that has not experienced a serious financial crisis, protected by continued rapid economic growth and government guarantees.
And it will be increasingly difficult for China to maintain that no-crisis record. The country’s current macroeconomic conditions look more and more like what the Bank for International Settlements calls the “risky trinity”: rising leverage ratios, declining productivity and shrinking policy flexibility. These trends might make the government less able to contain financial risks than in the past.
The growth slowdown and structural shifts have led to a significant deterioration of corporate balance sheets and produced large numbers of zombie companies that do little more than waste resources. Zombie companies are at the heart of China’s current economic problems: they impede industrial upgrading, lower financial efficiency and increase financial risk.
How can the government maintain its no-crisis record?
Since July 2016, President Xi Jinping has advocated pushing “supply-side reform”. Although it’s not always clear what this is supposed to mean, supply-side reform implies prioritising measures to lift productivity rather than measures to pump up demand. The objectives of supply-side reform are to help achieve growth sustainability and maintain financial stability. On the former, the key is promotion of industrial upgrading – letting go of old industries and developing new ones. On the latter, the key is to get financial risks under control by eliminating old risks and containing new ones.
The trickiest issue is how to deal with zombie companies. Those zombies which enjoy underlying competitiveness but suffer from temporary market setbacks need measures such as mixed ownership, forced mergers and acquisitions and debt for equity swaps. But for others, bankruptcy is the only option.
The framework of financial regulation needs to be revamped to preserve financial stability. Regulators are not really independent, so their primary responsibility for financial stability is often compromised by other policy considerations. Regulators also lack an effective coordination mechanism because of fragmentation of authority, which often leads to regulatory overlap or regulatory vacuum. Macro-prudential regulation remains immature and needs significant improvement to contain systemic financial risks.
Despite uncertainty about recovery in property markets and manufacturing investment, there are two important reasons for optimism despite all China’s economic problems.
The growth outlook has brightened somewhat in the industrial economies, especially the United States, Japan and the European Union, and that could lead to increased demand for China’s exports. And as Chinese leaders emphasise the importance of stability ahead of the Party Congress in November, local governments are strongly motivated to support growth. The Chinese economy will likely achieve its 6.5 per cent growth target in 2017, even if some of the downside risks materialise. But in the medium term, just meeting growth targets won’t suffice; getting tough on structural reform will be the only way to cut through in resolving China’s mounting economic woes.
by Yiping Huang
Yiping Huang is professor of economics and Deputy Director at the National Centre of Development Studies at Peking University.