MILAN – Uncertainty about China’s economic prospects is roiling global markets – not least because so many questions are so difficult to answer. In fact, China’s trajectory has become almost impossible to anticipate, owing to the confusing – if not conflicting – signals being sent by policymakers.
In the real economy, the export-driven tradable sector is contracting, owing to weak foreign demand. Faced with slow growth in Europe and Japan, moderate growth in the United States, and serious challenges in developing countries (with the exception of India), the Chinese trade engine has lost much of its steam.
At the same time, however, rising domestic demand has kept China’s growth rate relatively high – a feat that has been achieved without a substantial increase in household indebtedness. As private consumption has expanded, services have proliferated, generating employment for many. This is clear evidence of a healthy economic rebalancing.
The situation in the corporate sector is mixed. On one hand, highly innovative and dynamic private firms are driving growth. Indeed, as a forthcoming book by George S. Yip and Bruce McKern documents, these innovations are occurring in a wide range of areas, from biotechnology to renewable energy. The most visible progress has come in the information technology sector, thanks to firms like Alibaba, Tencent, Baidu, Lenovo, Huawei, and Xiaomi.
On the other hand, the corporate sector remains subject to serious vulnerabilities. The rapid expansion of credit in 2009 led to huge over-investment and excess capacity in commodity sectors, basic industries like steel, and especially real estate. The now-struggling pillars of China’s old economic-growth model bear considerable responsibility for the current growth slowdown.
Despite these challenges, the reality is that China’s transition to a more innovative, consumer-driven economy is well underway. This suggests that the economy is experiencing a bumpy deceleration, not a meltdown, and that moderate growth can reasonably be expected in the medium term – that is, unless the financial system’s problems intensify.
As it stands, non-performing loans are on the rise, owing largely to the weaknesses in heavy industry and real estate. While official sources report that NPLs account for 1.67% of loans held by commercial banks, the Chinese investment bank CICC estimates the figure to be closer to 8%. If so, the banking sector – and the wider economy – could suffer considerably.
Whether it does depends on the decisiveness of the policy response. As in the late 1990s, after the Asian financial crisis, China may need to rely on the large state balance sheet for loan consolidation, debt write-offs, and bank recapitalization.
But the concerns do not end there. Net private capital outflows remain substantial, and show no signs of slowing. As a result, the reserves held by the People’s Bank of China (PBOC) have declined by roughly $500 billion over the last year, with particularly large declines of some $100 billion in each of the last two months. These outflows, together with volatility in the stock and currency markets, have left investors and policymakers increasingly worried.
Unfortunately, a clear explanation for this behavior has yet to emerge. Some blame it on the combination of progress toward opening the capital market and an overvalued exchange rate, anticipating that net inflows will resume once the currency resets closer to market level. Others suspect the influence of inside information: The capital exodus is a signal that economic conditions and growth prospects are much worse than official figures imply.
Still others cite the impact of President Xi Jinping’s intensive anti-corruption campaign and, more generally, declining official tolerance for heterodox views. Those who feel directly threatened by the anti-graft campaign might be inclined to take their money out of China. But many others may be doing so for fear that, far from giving the markets a more “decisive role” in the economy, the government may be moving to assert greater control. Capital tends to flow to places where rules are clear and stable.
Given China’s systemic importance in the global economy, uncertainty about its plans and prospects is bound to send tremors through global capital markets. That is why it is so important that the Chinese government increase the transparency of its decision-making, including by communicating its policy decisions more effectively. Consider the soothing impact of PBOC Governor Zhou Xiaochuan’s recent statement (following a long and baffling official silence on exchange-rate policy) that the central bank would keep the renminbi “basically stable” against a basket of currencies and the dollar.
But the principal unaddressed problem affecting China’s financial system is the pervasiveness of state control and ownership, and the implicit guarantees that pervade asset markets. This leads to misallocation of capital (with small and medium-size private enterprises struggling the most) and the mispricing of risk, while contributing to a lax credit culture. The absence of credit discipline is particularly problematic when combined with highly accommodative monetary policy, because it can artificially keep zombie companies afloat.
To resolve this problem, China’s leaders must segregate the state balance sheet from the credit allocation system; but there is no clear roadmap for doing so. Moreover, they should build on efforts taken to open up the capital account, thereby improving the efficiency of capital allocation over time, though this process is undoubtedly complicated by the capriciousness of cross-border capital flows.
China’s current bout of economic volatility is likely to persist, though increased transparency could do much to blunt it. Add to that the smart use of state resources, together with sure-footed reforms, and China should be able to achieve moderate yet sustainable long-term growth.
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Comment Commented edward maran
China pursued an export driven growth model and the results with remarkable for as long as it lasted. Ultimately, China's size and the economic stalling of the developed world forced an adaption to a domestic growth model sooner and faster than was desired. How could consumption rise when income growth was facing major headwinds? The answer, of course, was increased debt and government spending. But the leverage increased too rapidly and now that adds to the headwind. In addition, numerous wealthy Chinese have a sensible desire to move at least part of their wealth outside the country. China needs global growth to rise so that it can transition to a more domestic driven model under less adverse conditions. We cannot expect China to be an engine for global growth and the uncertainty is very real and very high. Read more
Comment Commented Steve Hurst
Investment is driven by data. Whilst prospects clearly exceed questionable data - giving a safety margin - then investment continues. When it doesnt it stops. The fear of capital loss demands coitus interruptus. Without data there is no foundation to decisions. The problem now is a question of credibilty, and once credibility is lost it takes a time to rebuild. The situation is a self fulfilling prophesy Read more
Comment Commented Stefan Siewert
Forecasting the future is difficult. As mentioned, China has a complex $11 trillion economy with a myriad of opposing non-linear trends that make it extremely difficult to identify the relevant patterns.
Let us be heretic, take the long-term view within a thinking experience and assume that there is no possibility of a transformation to new growth model that is a continuation of the current trajectory.
The following factors might be taken into account:
First, after stagnating for 250 years at around $600 GDP per capita, China’s growth started to explode, with the 1971 reforms and WTO accession as milestones, but not game changers. If history is any guide, the probability of a reverse to the mean is high.
Second, the political system has not experienced major shocks and replacement of elites during the last seven decades. Policy makers are socialised during a growth phase and it remains to be seen how the cope with storms. It is the rule of the thumb that authoritarian societies accelerate growth during their golden eras, but loose out when switching to new growth models, giving democratic regimes an overall higher performance, when taking into account not years, but decades and centuries.
Third, China is a clear winner of globalisation. Its rise is closely linked with new pattern of trade, the emergence of global value chains and technological revolutions, like IT and containerization. There are no similar technological determinants on the horizon that would benefit China in a similar way as it did in the past. In opposite, it cannot be excluded that global growth reverse previous “natural” advantages of China’s economy.
Fourth, China’s growth model is as much an internal achievement as induced by foreign capital, particularly US companies that outsourced labour-intensive, and later capital and environmental intensive production to China. These activities created a windfall that was successfully reinvested as well a beneficial incentive structure. Today, it is difficult to identify a similar impulse. There is no or limited experience of identifying an appropriate growth model without an active foreign partner.
Fifth, China’s competitiveness is still low, with strength in low-margin business, like railways equipment, and high-risk activities, like e-commerce in retail, see recent McKinsey analysis. The benefit of the old growth model might disappear faster than the surplus of an emerging new growth model, contributing to demanding political processes about the distribution of possibilities and resources.
Sixth, as in all other countries, the most needed reforms are politically the most demanding ones. When during a Golden era all factors are supportive, the opposite occurs during transformational phases.
All in all, independently on the quality of decision-making, it cannot be excluded that the new growth model requires conditions that need to be build up during one or more decades, as it did during the transition period from a planned to a market economy and as it happens currently in the European Union. In this case, Japanification will be the most optimist scenario for China.
As said before, forecasting is a risky business. It might all be wrong. Read more
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