China's contradictions will catch up with it

How long until the country faces up to its financial instability?

May 16, 2016
Chinese President Xi Jinping arrives to speak at the Diaoyutai State Guesthouse at the Conference on Interaction and Confidence Building Measures in Asia (CICA) in Beijing, China, Thursday, April 28, 2016 ©Kenzaburo Fukuhara/AP/Press Association Images
Chinese President Xi Jinping arrives to speak at the Diaoyutai State Guesthouse at the Conference on Interaction and Confidence Building Measures in Asia (CICA) in Beijing, China, Thursday, April 28, 2016 ©Kenzaburo Fukuhara/AP/Press Association Images
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I have just returned from my annual visit to China, the mission being to get a feel for the economy, which is in an increasingly fractious period right now. Many economists do this, yet it’s unclear whether we come away with a better idea as to what will happen, or whether we simply confirm what we already know, that China is a nation of extraordinary contrasts. You can see this in its geography, its urban areas and the urban-rural divide. You can see it in the air, the yellow smog that hangs over its cities one week, and deep blue skies the next. You can see it when you snake your way though the hutongs—tranquil ancient alleyways and courtyards—in Beijing’s residential neighbourhoods before they empty out into six or eight-lane expressway systems. This may seem like a strange segue into China’s political economy, but bear with me.

It’s hard to know where to start, but the biggest contrast facing China is between the past and the present-and-future economy. After an unprecedentedly fast period of development from the 1990s until 2011, it is now in the midst of a protracted economic slowdown, and possibly nurturing a future financial crisis. During the go-go years, it brought 800m people out of poverty. Today, it is one of the world's worst countries for income inequality as measured by its Gini co-efficient—a scale ranging from 1, where all income resides with an individual or family, to 0.1, where it is equally divided among the population. The World Bank estimates that in 2012, China's score was 0.49 (a score over 0.4 means that income inequality is severe). Income per head in Shanghai is about the same as in Portugal, but in some provinces, smaller cities and in parts of the countryside, it can be about 10-20 per cent of this level.

While these structural contrasts are important, it is the contemporary ones that are capturing attention, especially as the economy slows down. In the northeast of the country, where coal, steel and other heavy industries figure prominently, officials now admit there is a recession. Liaoning is the latest province to report negative growth. But growth in the coastal provinces and around the Pearl River Delta still seems to be steaming away at around 7-8 per cent, according to official data. The government says it plans to shut down overcapacity in coal and steel at the cost of maybe 6m jobs, but it has made a mere RMB100bn (roughly £10bn) available to those who “might” be unemployed. It remains to be seen if the government is willing to carry out its plan in a time of rising economic tension.

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The government still insists that supply-side reforms are being implemented as part of the strategy to rebalance the economy and yet much of the reform bonanza announced at the end of 2013 has run aground, been diluted or faced opposition from vested interests. Recently, the long-running crackdown on media, activists and critics was tightened further, with new restrictions on the activities of NGOs. Quite how the authorities plan to build an economy in the information age without permitting the free flow of information is a question no one in authority is prepared to answer.

New, innovative enterprises are being created in the private sector, but their significance is overshadowed by the much publicised debt and cash flow problems that run deep in the local government, state-owned enterprise and property sectors. China’s service sector is now growing faster than manufacturing, but it still has a preponderance of financial services, real estate, traditional wholesaling, and transportation. What the country needs are newer, more dynamic professional, IT, business, health and education services, which at present are still rather immature, constrained, and restricted to foreign participants.

Reform has occurred in the financial sector. Yet the sorry tales of 2015 and 2016 bear witness to the fact it hasn’t always worked as planned. Repeated outbreaks of speculative behaviour in the stock market, the currency, and more recently the corporate bond market and commodity markets have ended in disappointment and falling prices. And in one area at least, the planned opening up of capital transactions, policy has actually been reversed this year after it became clear that too much capital was leaving the country.

After about $1 trillion of capital outflows in 2015, including about $400bn of capital flight, flows and the RMB have stabilised again. But capital was almost certainly still leaving China in March and April, months where currency reserves were reported to have risen, a relief after sustained declines. The government may succeed in keeping the RMB out of the headlines and in managing its stability for a while, but it is at the mercy of more volatile capital outflows. And these outflows are being fuelled partly by low levels of confidence and partly by excessive credit creation.
"The surge in debt in China has focused a lot of minds, and is unquestionably the country's Achilles heel."
For the moment, it looks as though the economy is stabilising with property transactions and prices rising again. This more becalmed period may last a while longer, but most observers are pretty sure that it is principally down to a prior surge in credit expansion, which is stronger than the boom that was allowed in 2008-09, and to which the government is turning a blind eye.

The surge in debt has focused a lot of minds, and is unquestionably China’s Achilles heel. Left to its own devices, it will eat up any reform initiatives that try to improve efficiency and raise productivity. By considering other published figures along with conventional credit data, it is possible to show that credit is growing at about four times the rate of GDP measured in cash terms. More and more credit is being produced purely to help existing borrowers service their debt. But no credit boom can go on forever. Given the build-up in bad debt and the increasing volatility of deposit-taking in the show finance sector then, absent a change in policy, some sort of denouement is likely within three to four years. The cost is likely to be an extended period of very low growth.

On which note, the People’s Daily, one of the Party's official newspapers, ran a curious full-page interview in early May with “an authoritative source” who insisted that Chinese economic policy could not continue on its current path, leverage and credit creation were not the way forward, and supply side reforms were urgently needed. People have speculated about the identity of the source, and whether he has top-level clearance. The important questions, though, are what were the motives and purpose behind this attack on government policy? And does it portend as major shift in policy?

All this underlines that Chinese economic policy is not well anchored or co-ordinated. There may be much more resistance to Beijing from local and provincial governments than commonly thought, or more factional unrest within the Party. This could be a shot across the bows of one or more individuals, or it could be a final outburst of frustration by reformers in the face of spirited opposition. Whatever it is, it doesn’t bode well for change.

Change is the last thing China’s leadership wants before the end of 2017 and the 19th Party Congress, which marks the halfway stage for President Xi’s decade in government. At that time, the president will want to fill top-level government vacancies with his own supporters. His case will not be advanced if the economy falls on harder times. So, tough as it is to decipher the outlook, it seems as though the status quo will prevail, and China may have a couple of years before it deals with its looming financial instability, which will usher in a protracted period of low growth. Such is the aftermath of excessive debt creation, as we know.