China’s risky economic reorientation could allow it to sustain its economic rise but a botched transition could wreak havoc.
2016 has been a year of anxiety. Political upheavals, geopolitical maneuvering, and fears for the future have dominated the headlines. The world economy has been no exception. The IMF and the World Bank have revised their global growth forecasts downward for 2016 and the world economy looks set to remain sluggish next year. A greater concern is the deep vulnerabilities in some of the most systemically important economies. Eurozone countries have yet to address the structural deficits behind the continent-wide financial crisis and the rise of populists threatens to impede potential solutions. The US economic recovery is also at risk from president-elect Donald Trump’s protectionist sentiments.
It is China however that provokes the deepest worries. The foremost driver of global growth is expanding more slowly than at any time in the past 25 years. China is transitioning from an export and investment-led economy to one fuelled primarily by domestic consumption. This massive reorientation is necessary but risky: success will allow the country to sustain its economic rise into the next decades, but a botched transition could wreak havoc on China and the world economy at large.
THE GREAT RECALIBRATION
Such a massive shift entails dislocation for Chinese workers. Employees in manufacturing and construction will have to move to the service sector – no easy task for lifelong factory workers. Beijing fears the social unrest that could result.
In January 2016, the China Labour Bulletin, an NGO, recorded the highest number of strikes since it began counting in 2011. To combat this trend, the state has propped up failing state-owned enterprises (SOEs) by ordering state-owned banks to continue offering them loans. This has resulted in a high concentration of non-performing loans (loans that are in or close to default) in the SOE sector.
Many of the at-risk firms are in sectors that may have already experienced peak demand – China’s building boom is largely over – so the worst-off SOEs might never be able to pay back their debts. But Beijing cannot let them go bust: the implicit debt guarantee for state-owned firms has become a pillar of the Chinese financial system. Allowing a few firms to collapse might cause contagious panic among banks with bad loans to ailing firms.
The government therefore keeps these “zombie firms” in business, which has resulted in corporate debt rising to 165% of GDP. Some of these loans are in the shadow banking sector, which operates outside of banking regulations and potentially hides an explosive quantity of risk. More and more of this corporate debt is also becoming short-term, which indicates that firms are taking out loans to repay the interest on existing long-term debts.
The regular rolling over of huge debts creates the constant need for liquidity (assets such as cash that can be quickly bought and sold). This renders these companies vulnerable to a credit crunch. If banks suddenly curbed new lending due to an economic shock, the indebted corporations might need bailouts or face default.
ADDICTED TO DEBT
China can ill afford a 2008-style bailout program. Since the global financial crisis, Beijing has been using debt-driven investment to fuel demand and keep the economy humming. This has resulted in total debt rising from 155% to 260% of GDP from 2008 to 2016.
If the economy stutters, the government could pile on even more debt to fund stimulus measures However, Beijing has been using fiscal stimulus continuously since the crisis, which has reduced its effectiveness. Before the financial crisis, one yuan of debt would produce one yuan of growth but now the ratio is 4:1. Despite this, in the first half of 2016 investment in infrastructure and property development actually increased, which is not sustainable.
China’s debt-investment problem is like an amphetamine addiction: a drug that once provided a major boost becomes less and less effective to the point where a larger dose is needed to get the same hit. And like overcoming an amphetamine addiction, China’s debt detoxification will be painful.
Structural reforms will require letting certain firms go bust and creating unemployment, which also entails a hit to economy. The alternative is to accept mounting debt which becomes an ever-heavier drag on growth. Beijing has chosen the latter option for the time being. While President Xi Jinping has tried to launch supply-side reforms (to curb overcapacity), local government resistance has impeded central government reforms.
Beijing does have some tools to deal with the next economic crisis. China has the world’s largest foreign exchange reserves – $3 trillion – giving it ample firepower to fight currency depreciation. China is also a net creditor, and it has fewer external liabilities than many other emerging economies. The government has a history of prudent economic management, and it still controls the biggest banks and the largest debtors, so it has leverage. Beijing is also slowly liberalising the financial system and putting safeguards in place, but it remains reluctant to begin the deleveraging (debt reduction) and painful structural reforms that the country truly needs.
CHINA’S ECONOMY IN THE COMING YEAR
China looks set to maintain economic stability through 2017 by postponing solutions to its structural problems. However, these problems mean that it will no longer drive world growth as strongly as before, and the country is becoming increasingly vulnerable to external shocks. Its financial system and stock markets are slowly developing linkages with those of other major economies, which increases the chance for contagion. The stock market turbulence at the beginning of 2016 quickly spread globally; an 18% fall in the Chinese stock market caused the Dow Jones Industrial Average to drop by 8%.
China’s newfound economic heft also creates spillover effects for entire countries. Commodities exporters from Australia to Zambia suffer when China imports less metal ore for construction (it accounts for over 40% of world demand), and economies linked to the country through the East Asian supply chain like Singapore and Vietnam are also highly exposed.
China has gone from being the backbone of global growth to potentially one of the weakest systemic pillars of the world economy. The true health of China’s economy is hotly debated by economists largely because the opacity of its financial system hides the true depth of its debt problems. However, one thing is clear: the Chinese economy will remain vulnerable to economic shocks in 2017.