Analysis – Part of the Chinese economic miracle was a mirage. The reality check is next

Written by Joe Cash

BEIJING (Reuters) – Chinese President Xi Jinping’s first major reform plans a decade ago were the most daring, envisioning a transition to a Western-style free market economy driven by services and consumption by 2020.

The 60-Point Agenda was intended to reform an outdated growth model better suited to LDCs – however, most of these reforms have gone nowhere, leaving the economy largely dependent on outdated policies that only add to the debt pile China’s massive industrial overcapacity.

The failure to restructure the world’s second-largest economy has raised critical questions about what comes next for China.

While many analysts see the most likely outcome as a slow drift into a Japan-style recession, there is also the possibility of a more severe crisis.

“Things always fail slowly until they break suddenly,” said William Hirst, professor of Chinese development at the University of Cambridge.

“There is a significant risk in the short term of a financial crisis or some other degree of economic crisis that would have very large social and political costs for the Chinese government. Ultimately, there will be reckoning.”

China emerged from its Maoist planned economy in the 1980s as a largely rural society, in dire need of factories and infrastructure.

Economists say that by the time the global financial crisis hit in 2008-2009, China had already met most of its investment needs commensurate with its level of development.

Since then, the economy has quadrupled in nominal terms while total debt has expanded ninefold. In order to keep growth high, in the first decade of the twenty-first century, China doubled its investment in infrastructure and real estate, at the expense of household consumption.

This has kept consumer demand weaker as a share of GDP than in most other countries and concentrated job creation in the construction and manufacturing sectors, professions increasingly rejected by young university graduates.

The policy focus has also swelled China’s real estate sector to a quarter of economic activity and made local governments so dependent on debt that many are now struggling to recapitalize.

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The pandemic, demographic contraction, and geopolitical tensions have all exacerbated these problems to the point that the economy has struggled to recover this year even as China reopens.

“We are in a moment where we are seeing some structural shifts, but we should have expected them to happen,” said Max Zenglin, chief economist at Merex Institute for China Studies.

“We are just beginning to face reality. We are in an area that has not yet been tested.”

The end of China’s economic boom is likely to hurt commodity exporters and dampen export inflation around the world. At home, it will threaten the living standards of the millions of unemployed graduates and many whose wealth is tied to real estate, posing risks to social stability.

Crisis vs. Recession

Beyond short-term solutions, which are likely to perpetuate debt-based investment, economists see three options for China.

The first is a quick and painful crisis that writes off debt, curbs industrial overcapacity, and deflates the real estate bubble. Another way is a decades-long process by which China will gradually reduce these excesses at the expense of growth. The third is to shift to a consumer-led model with structural reforms that cause some pain in the short term but help it re-emerge faster and stronger.

The crisis could unfold if the huge property market collapses in an out-of-control fashion, dragging the financial sector with it.

Another high point of tension is local government debt, estimated by the International Monetary Fund at $9 trillion. China promised in July to come up with a “basket of measures” to address municipal debt risks, without providing details.

Logan Wright, partner at Rhodium Group, says Beijing will have to decide which part of this debt to bail out, because the amount is too large to provide full guarantees of repayment, which the market now considers implicit.

“There will be a crisis in China when the government’s credibility falters,” he added.

“When funding is suddenly cut off from remaining investments that appear to be exposed to market risks, it is a huge moment of uncertainty in Chinese financial markets.”

But given the state’s control of many developers and banks and a limited capital account that limits flows to assets abroad, this is a low-risk scenario, many economists say.

Alicia Garcia Herrero, chief economist for Asia-Pacific at Natixis, expects there will be plenty of buyers if Beijing consolidates its debt given the limited investment alternatives.

“I’m more in the slow growing camp,” she said. “The more debt accumulated in favor of non-productive projects, the lower the return on assets, especially public investment, and this really means that China is unable to achieve growth.”

But averting the crisis by extending the adjustment period carries particular risks for stability, as youth unemployment rates exceed 21% and about 70% of household wealth is invested in real estate.

“One of China’s biggest success stories, building a strong middle class, has also become its greatest weakness,” said Zhenglin of Merex. “If you look at it from a younger person’s perspective, you now run the risk of being the first post-reform generation whose economic well-being may hit a wall. If the message is to tighten your belts and roll up your sleeves, this is going to be kind of a hard sell.”

reforms this time?

A third path, an active shift to a new paradigm, is considered very unlikely, based on what happened to Xi’s 60-point programme.

Analysts say such plans have barely been mentioned since 2015 when fear of capital outflows sent stocks and the yuan down and generated an official aversion to potentially disruptive reforms.

Since then, China has backed away from liberalizing financial markets significantly, while plans to rein in state giants and provide universal social welfare have not materialised.

“Now is the time when there is a possibility to change the train to a new model, and I think there is a desire to do that,” Hirst said.

“But at the same time there is a great fear of political and social risks in the short term, especially triggering an economic crisis.”

(Reporting by Liangpeng Gao and Kevin Yao; Illustrations by Kripa Jayaram; Editing by Marius Zaharia and Sam Holmes)