Author: Max Tomlin

The Year of the Rooster was pivotal in terms of China’s continued economic development. After a prolonged period of slowing growth, China’s vast economy expanded by an impressive 6.7 percent in 2017 – its first increase since 2010 (see Fig 1). The results, published in January, exceeded the expectations of most, including that of the IMF, which had forecast a more-than-respectable growth rate of 6.5 percent.

The success of the last year is a positive sign for China’s ability to shift its gargantuan manufacturing-driven economy to one that is services-led

Recovery of the global economic landscape played a crucial role, with export revenue rallying as international demand continued to climb. China’s real estate sector, meanwhile, rebounded, thus acting as another important driver for growth. But what makes the rate particularly impressive is its occurrence in spite of measures taken by Beijing – including necessary curbs on lending and manufacturing – which had threatened to stifle expansion prospects. As efforts for both continue, many again expect growth to be impacted in 2018.

That being said, what is most noteworthy about the success of last year is the positive sign it heralds for China’s ability to shift its gargantuan manufacturing-driven economy to one that is services and consumption-led; a feat that few nations have managed successfully. Beijing is all too aware of the importance of the transition. Now, after six years of slowed growth, the state is pushing forward with greater momentum, implementing essential reforms and promoting growth that is based upon quality, sustainability and efficiency – factors that now trump speed and size in their importance.

At full capacity
For decades, China had focused on the aggressive expansion of its manufacturing capabilities and output. The country subsequently became known as ‘the world’s factory’, exporting cheaply made goods and components across the planet at a fraction of the price buyers paid elsewhere. This strategy essentially enabled China to achieve double-digit GDP growth for close to three decades – a feat that is nothing short of spectacular for a nation of its size.

From the very beginning, however, the strategy was a double-edged sword, being simply unsustainable. “The world cannot continue to absorb more imports from China at the previous growth rates,” commented author and economics professor Ann Lee. And so today, one of the biggest problems facing the Chinese economy is overcapacity.

“China is structurally overinvested – in many cases acutely so: in manufacturing capacity in many sectors, and in both infrastructure and real estate capacity in some regions – bridges to nowhere, ghost cities, among others,” said David Hoffman, Senior Vice-President and Managing Director of the Conference Board China Centre. As Hoffman explained, such scenarios generate low, and sometimes even negative, productivity growth. “This is the fundamental problem,” he continued. “Overinvestment is dragging on productivity growth, and unproductive investment yields debt build-up. If the investments eventually prove to be unviable commercially, this then turns into bad debt.”

Consumption-driven growth, on the other hand, is more sustainable because capacity adjusts to demand from the bottom up, as opposed to dictating a false sense of output requirements from the top down. Through the former, the rate of investment and manufacturing capacity stays in tune with demand, thereby remaining steady, but appropriate. Following such a route is of paramount importance for China, now more so than ever before; after years of producing at overcapacity, an overreliance on government funding and ballooning debt have reached dire levels.

Treading a greener path
China’s strategy of heavy manufacturing is not only unsustainable economically speaking: it has also had a dramatic and unfortunate impact on the environment. For years, smog-filled skies have been the everyday norm for the citizens of metropolises such as Beijing, Shanghai and Guangdong. As stated by Lee: “China can’t take on more pollution from manufacturing.” It has taken a long time for the government to heed the warnings of environmental organisations, but 2017 was a significant shift in this respect.

Stringent anti-pollution policies were introduced to 28 cities last year, which included reining in production at heavy industry factories. Specifically, the urban areas across the north of the country had to reduce steel capacity by half and aluminium capacity by around a third over the most polluting period of the year (the months between November and March). The demand for steel also took a hit as places like Zhengzhou suspended the construction of roads, buildings and water facilities to fight pollution. Meanwhile, illegal or outdated steel mines, coal mines and aluminium smelters are in the process of being closed down.

China’s strategy of heavy manufacturing is not only unsustainable economically, it has also had a dramatic and unfortunate impact on the environment

Last year, consumers were also asked to switch from coal to natural gas for their electricity needs, though this had to be abandoned temporarily due to improper heating. Ultimately, however, the winter saw a sharp improvement in the quality of air in Beijing – undoubtedly a major milestone for the capital and the country as a whole, which can now set forth with a new outlook of optimism for the change that can be achieved through collective support.

Another way in which industrial overcapacity can be overcome is through China’s One Belt, One Road initiative, a state-led strategy to promote economic cooperation and connectivity with and between Eurasian nations. “All excess steel, cement, etc is being used to build infrastructure with countries such as Pakistan, Sri Lanka and Russia,” Lee told World Finance. This, however, could be another double-edged sword, according to Bart van Ark, Executive Vice-President, Chief Economist and Chief Strategy Officer at the Conference Board: “Yes, it’s a way to keep investing, but will that make China more productive, and therefore put it on a more solid growth path?”

The role of the state
The issue surrounding productivity is closely linked to China’s drawn-out overreliance on state-owned enterprises (SOEs). “SOEs are the primary agents of the government’s investment-led growth ‘addiction’,” Hoffman explained. These organisations are given credit by the state, with which they can make investments, regardless of whether they are risky or commercially viable. Hoffman continued: “After all, investment – even if it involves digging a hole and filling it up again – creates GDP growth. If the investment is unproductive, however, it only creates a one-off GDP boost. It is suspected that more and more of China’s ever-increasing investment is of this one-off nature. Because SOEs don’t have balance sheet accountability, in that they’re backed by the state and can’t go bankrupt, there is an intrinsic moral hazard in SOEs leading China’s investment drive. The only way for money-losing SOEs to survive is to continue borrowing, to continue investing, to continue building capacity. New borrowing then evergreens the old loans, and new loans are taken for more investing, and so forth.”

As hazardous as they can be to sustainable growth, SOEs do have a positive role to play in China’s transition, in that they enable the state to maintain a level of control. Indeed, the process of manoeuvring such a vast shift would be more difficult in a solely private-sector-driven environment. “SOEs are the most effective vehicle the Chinese Government has to impact on the economy,” van Ark noted. “There is a lot of awareness that SOEs are molochs [giants] that tend to be relatively inefficient. The government is trying to take significant measures in order to force mergers to make them more efficient going forward – so that is all really good stuff that is happening there.”

As van Ark explained, productivity is fundamentally born from free market processes; in such an environment, inefficient firms are simply unable to survive and so give way to more efficient firms that are able to grow, all the while becoming more productive. Although this is happening to an extent in China’s private sector, it has not yet transpired in the state-owned sector. Consequently, SOEs continue to crowd out opportunity for the private sector, which is where productivity growth is most likely to result. “Ultimately, the question is whether the state-led transition that the government is now undertaking will be the best way to make this transition – or whether it will be suboptimal and therefore keep China addicted to putting in more and more resources in order to keep the system going,” van Ark said.

The debt dragon
While the issues surrounding SOEs remain uncertain at present, one challenge that China seems to be tackling with fervour is its reduction in risky lending which, thanks to the introduction of more robust financial policies, was one of its biggest achievements of 2017. This pillar of Beijing’s economic strategy is crucial, as China’s debt has ballooned in recent years in not just one but multiple areas, ranging from local government loans to corporate and household debt to non-performing loans. Accumulatively, China’s debt is now equivalent to 234 percent of the country’s total output, according to the IMF. Growth, the organisation purports, must now take second place to improving the financial system.

Hoffman explained why this is so important: “Debt servicing costs drag on corporate performance, impacting the abilities of firms to invest in expansion, innovation and people. In parallel, non-performing debt constrains the amount of bank lending and government financing that can flow to maximally productive and beneficial purposes in the economy and society. Risky debt – where ultimate ownership of the debt and its liabilities are unknown – can have catastrophic consequences on healthy market players, hence wiping out positive economic activity.”

Despite the impact that a regulatory overhaul is expected to have on GDP growth, China is making arduous efforts to this end

Despite the impact that a regulatory overhaul is expected to have on GDP growth, China is making arduous efforts to this end. At the tail end of last year, for example, Beijing targeted the cheap capital that has flooded the market of late, thanks to the onslaught of online microlenders. Circumventing traditional lenders, borrowers could instead obtain funding for practically anything with just a few clicks – from a financial injection to their start-up to a personal loan for a new car. It perhaps comes as little surprise then that, according to the central bank, the business was responsible for a whopping RMB 1.49trn ($224.7bn) in outstanding short-term consumer loans within the first nine months of 2017, almost double the amount for the whole of 2016. News about aggressive loan collection agents also began to spread, as did the harmful nature of short-term, unsecured cash advances. And so last November, the People’s Bank of China (PBOC) issued its strictest restrictions yet. In effect, the central bank and its regional branches can no longer license new microlenders. Their offline counterparts, meanwhile, cannot operate outside their registered locations.

Tighter mortgage rules and a clampdown on speculation within the property market are other areas that are also being targeted. While China’s economy has experienced a boost thanks to the housing market’s two-year boom, fears of a bursting bubble have surfaced. Despite measures to curb speculative purchases, which began in late 2016, prices have continued to climb, albeit at a slower rate. Subsequently, in November, regulators announced further measures, including mechanisms to prevent funds from being channelled illegally into the market, as well as ensuring a more balanced capital allocation between real estate and other industries.
Through an announcement televised on state-owned China Central Television, the PBOC, the Ministry of Housing and Urban-Rural Development, and the Ministry of Land and Resources also instructed provinces to maintain their tightening measures, as lax regulation could lead to fluctuations in the market and financial risks. Another step due this year is the improvement of land market management, in a bid to prevent high prices pushing up property prices.

Transitioning to services
Alongside reforms to SOEs and the financial sector must come an overhaul of China’s services sector if its transition to a consumption-led economy is to be a success. At present, the development of traditional service sectors such as healthcare and public education has been slow given the entrenchment of the state, which has resulted in issues such as excessive red tape, bloated budgets and bureaucratic inefficiency. Focusing instead on newer, more nimble industries like e-commerce, technology and private education would give more space for growth generation.

This focus is already seeing results. In 2016, the services sector grew to be worth RMB 38.4trn ($5.6trn), which is equal to just over 50 percent of GDP, an increase from 42 percent around 12 years ago. Beijing’s goal is to increase the rate to between 70 and 80 percent of GDP – the average for advanced economies. The US, UK and France, for example, derive around 80 percent of their GDP from services, while Japan and Germany are at around 70 percent (see Fig 2).

To this end, in February 2017, Beijing revealed plans to set up a RMB 30bn ($4.7bn) fund to encourage high-value-added service exports. The state is contributing some 16.7 percent of the value of the fund, with non-government investors providing the rest. Such a boost is expected to have a dramatic impact on the sector, in addition to bolstering the number of jobs within. According to the Central Intelligence Agency, there are already more than 300 million people working in services, in areas ranging from hotels and restaurants to shops and real estate. But there is much more room for growth, and this is key for the population. Crucially, higher employment in the services sector correlates with higher wages, which will not only improve quality of life and reduce poverty levels but also lead to higher consumption, which in turn will further prop up the economy.

Van Ark explained: “When an economy gets more advanced and gets richer, it is normal for it to become more service-driven. You have a rising middle class, who are consuming far more services than they would have done previously, so you need to see that transition from a manufacturing and investment-led economy to a services-consumption driven economy. So in a way, what I would say is that this kind of transition is healthy – it is exactly what China needs.”

Pathway to the future
Certainly, there are numerous challenges yet to be overcome for China to push its economy to the next phase in its development. “We mustn’t forget that China is in the midst of a momentous economic transition; one that will require deep structural adjustments if it is to put the Chinese economy back on a sustainable path,” Hoffman told World Finance. “These adjustments lay before us, as they have largely been forestalled by elevated levels of credit expansion and fixed asset investment these last several years. Contrary to today’s prevailing thinking, a soft landing has not been achieved, even despite the stabilisation and slight uptick that occurred in 2017. Looking forward, it’s hard to see how many of these adjustments won’t be disruptive, if not painful, for markets.”

As described by Hoffman, it will indeed be painful at times, and the rest of the world will undoubtedly be impacted at some level or another, but given that China is now the world’s second-largest economy and an integral player in the global system, attaining sustainable growth is crucial for all. Furthermore, as economic development dictates, its transition to a consumption-led economy is the only way that quality growth in the long term can be achieved. Ultimately, this shift is absolutely necessary for China’s economy, as well as for its 1.4 billion-strong population. Yes, China’s transition is a monumental task – but given the capabilities of those in charge, together with their commitment to achieving quality growth across the long term, if any nation can make it happen, it’s the one in question.