Chinese economic miracle: from mirage to face reality

The first big reform plans of the Chinese president Xi Jinpinga decade ago, were also the boldest: they envisioned a transition to a Western-style free market economy driven by services and consumption by 2020.

The 60-point agenda was intended to fix an outdated growth model more suitable for less developed countries; Yet most of those reforms have gone nowhere, leaving the economy largely dependent on older policies that have only added to massive debt and excess industrial capacity.

The failure to restructure the world’s second largest economy has raised serious questions about the future of China.

Many analysts see a slow drift towards Japanese-style stagnation as more likely, but there is also the prospect of a more serious crisis.

“Things always fail slowly until they suddenly break“, said william hurstChong Hua Professor of Chinese Development at the University of Cambridge.

“There is a significant near-term risk of a financial or other degree of economic crisis that would entail very appreciable social and political costs for the Chinese government. In the end there will have to be a reckoning”.

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

When the global financial crisis hit in 2008-09, it had already covered most of its investment needs for its level of development, according to economists.

Since then, the economy has quadrupled in nominal terms, while global debt has increased ninefold. To maintain high growth in the 2010s, China doubled 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 has concentrated job creation in the construction and manufacturing sectors, careers increasingly shunned by young college graduates.

The policy has also inflated China’s real estate sector to a quarter of economic activity and made local governments so reliant on debt that many now find it difficult to refinance.

The pandemic, demographic decline and geopolitical tension have aggravated problems to the point that the economy has struggled to recover this year, even with the release from lockdown.

“We are in a moment where there are some structural changes, but we should have seen them comingsaid Max Zenglein, chief economist at MERICS, an institute for China studies.

“We are beginning to face reality. We are in unknown territory”.

The end of China’s economic boom will likely hurt commodity exporters and export disinflation around the world. At home, it will threaten the standard of living for millions of unemployed college graduates and many whose wealth is tied up in property, posing risks to social stability.

crisis vs. stagnation

In addition to short-term solutions, which would likely only perpetuate debt-fueled investment, economists see three options for China.

One is a quick and painful crisis that cancels the debt, curbs excess industrial capacity, and deflates the housing bubble. Another is a decades-long process in which China gradually reduce these excesses at the expense of growth.

The third is to switch to a consumer-led model with structural reforms that cause pain in the short term, but would help you come back faster and stronger.

A crisis could break out if the huge housing market crashes out of control, taking the financial sector with it.

The other point of great tension is the debt of local governments, estimated by the International Monetary Fund at 9 trillion dollars. China promised in July to present a “package” to face the risks of municipal debt, without detailing them.

Logan Wrightpartner of Rhodium Groupsays that Beijing has to decide how much of that debt to bail out, as the amount is too large to offer full repayment guarantees, which the market currently sees as implicit.

“The crisis will occur in China when the credibility of the government falters“, it states. “When all other investments that appear to be subject to market risk are suddenly cut off from funding, it will be a time of enormous uncertainty in Chinese financial markets.”.

But given state control of many developers and banks and a tight capital account that limits outflows to assets abroad, it’s a low-risk scenario, many economists say.

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

“I am more in favor of slow growth“, it states. “The more debt that accumulates for projects that are not productive, the lower the return on assets, especially public investment, will be, and that really means that China cannot grow out of it.”.

Avoiding a long crisis in the adjustment period has its own risks for stability, with youth unemployment exceeding 21% and around 70% of household wealth invested in property.

“One of China’s greatest successes, building a strong middle class, is also becoming its greatest vulnerability.”said Zenglein, of MERICS.

“If you look at it from the perspective of a young person, you risk being the first post-reform generation whose financial well-being could hit a wall. If the message is to buckle down and roll up your sleeves, it’s going to be a hard sell.”.

reforms again

The third track, actively moving to a new model, is considered highly unlikely based on what happened with Xi’s 60-point program.

The plans have barely been mentioned since 2015, when a capital outflow scare sent stocks and the yuan tumbling and engendered official aversion to potentially disruptive reforms, analysts say.

China has since backtracked on major financial market liberalization, while plans to rein in state giants and introduce universal social benefits never materialized.

“Right now there is a possibility that the train will change direction towards a new model, and I think there is a desire to do sosays Hurst.

“But at the same time there is great fear of short-term political and social risk, especially of causing an economic crisis.”.

Source: Reuters