By Joe Cash
BEIJING (Portal) – Chinese President Xi Jinping’s first major reform plans a decade ago were also his boldest, envisioning a transition to a Western-style free market economy based on services and consumption by 2020.
The 60-point agenda was intended to repair an outdated growth model that is better suited to less developed countries. But most of these reforms have gone nowhere, leaving the economy largely reliant on older measures that have only added to China’s massive debt pile and 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 a slow drift toward Japan-like stagnation as the most likely outcome, there is also the prospect of an even more serious crisis.
“Things always fail slowly until they suddenly break,” said William Hurst, Chong Hua Professor of Chinese Development at the University of Cambridge.
“In the short term, there is a significant risk of a financial crisis or an economic crisis of a different magnitude, which would entail very significant social and political costs for the Chinese government. At some point there will have to be a reckoning.”
China emerged from its Maoist planned economy in the 1980s as a largely rural society in desperate need of factories and infrastructure.
When the global financial crisis broke out in 2008/2009, the country had already met most of its investment needs for its level of development, economists say.
Since then, the economy has quadrupled in nominal terms, while total debt has increased ninefold. To keep growth high, China doubled its infrastructure and real estate investments in the 2010s at the expense of household consumption.
This left consumer demand relative to GDP weaker than in most other countries and job creation concentrated in the construction and industrial sectors, occupations increasingly rejected by young college graduates.
The political focus has also ballooned China’s real estate sector to a quarter of economic activity and made local governments so dependent on debt that many now struggle to refinance.
The story goes on
The pandemic, a demographic downturn and geopolitical tensions have all exacerbated these problems to such an extent that the economy has struggled to recover this year despite China’s reopening.
“We are in a moment where we are seeing some structural changes, but we should have seen these coming,” said Max Zenglein, chief economist at MERICS, a China studies institute.
“We are just beginning to face reality. We are in untested territory.”
The end of China’s economic boom will likely hurt commodity exporters and lead to export disinflation around the world. Domestically, it will threaten the living standards of millions of unemployed graduates and many whose wealth is tied up in real estate, posing risks to social stability.
CRISIS VS. STAGNATION
Aside from short-term solutions that would likely only sustain debt-financed investment, economists see three options for China.
One is a quick, painful crisis that writes off debt, curbs excess industrial capacity and bursts the housing bubble. Another reason is a decades-long process in which China is gradually reducing these excesses at the expense of growth. The third step is to shift to a consumer-focused model with structural reforms that, while causing short-term problems, will help the country get back on its feet faster and stronger.
A crisis could occur if the huge real estate market collapses uncontrollably, taking the financial sector with it.
The other stress point is local government debt, estimated by the International Monetary Fund at $9 trillion. China promised in July to present a “catalog of measures” to address local debt risks, without providing further details.
Logan Wright, partner at Rhodium Group, says Beijing will have to decide what part of that debt it will save because the amount is too large to offer full guarantees of repayment, which the market currently sees as implicit.
“There will be a crisis in China if the government’s credibility falters,” he said.
“If funding suddenly stops for the remaining investments that appear to be subject to market risk, it will be a major moment of uncertainty in China’s financial markets.”
But with government control over many developers and banks and a tight capital account that limits outflows to assets abroad, many economists say it is a low-risk scenario.
Alicia Garcia Herrero, chief Asia-Pacific economist at Natixis, believes there would be plenty of buyers if Beijing were to consolidate its debt given limited investment alternatives.
“I’m more in the slow growth camp,” she said. “The more debt that is accumulated on projects that are not productive, the lower the return on investment, especially in public investments, and that really means that China cannot grow out of it.”
However, avoiding a crisis by extending the adjustment period carries its own stability risks, as youth unemployment is over 21% and around 70% of household assets are invested in real estate.
“One of China’s greatest success stories, building a strong middle class, is also becoming its greatest vulnerability,” said MERICS’ Zenglein. “If you look at it from a younger person’s perspective, you are now at risk of being the first post-reform generation whose economic well-being hits the wall. If the message is “tighten your belt and roll up your sleeves,” then “so be it” is going to be a pretty hard sell.
REFORMS THIS TIME?
The third option, the active transition to a new model, is considered very unlikely given the development of Xi’s 60-point program.
Those plans have been barely mentioned since 2015, when fears of capital outflows roiled stock prices and the yuan and sparked official reluctance to potentially disruptive reforms, analysts say.
Since then, China has backed away from comprehensive financial liberalization, while plans to rein in state-owned behemoths and introduce universal social welfare never fully materialized.
“Right now there is a possibility that the train will change direction to a new model, and I think there is interest in that,” Hurst said.
“But at the same time there is great fear of the short-term political and social risk, especially of triggering an economic crisis.”
(Additional reporting by Liangping Gao and Kevin Yao; Graphics by Kripa Jayaram; Editing by Marius Zaharia and Sam Holmes)