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The contradiction at the heart of China’s growth strategy  

First published, 14/03/2015

This is a longer version of the article published in the Financial Times on 12/03/2015

China set a new lower growth target of ‘about 7 percent’ at this year’s annual session of the National People’s Congress. It was a signal that, while the double-digit growth years may be over, Beijing remains confident that the world’s biggest economy will continue to sustain healthy and high rates of expansion. The truth is that outcomes will more likely be determined by an important contradiction in economic development strategy than any official pronouncements.

According to a government report, presented by Premier Li Keqiang, China needs to find the ‘right balance between managing debt and maintaining steady growth’. The urgency of managing debt derives from the rapid doubling in total non-financial debt over the last decade to about 250 percent of GDP. Most resides with companies and local governments. On first glance, this balancing task seems sensible enough. In reality, though, there is a fundamental inconsistency between the two objectives.

The high credit intensity of China’s GDP – roughly 4 yuan of new credit is associated now with 1 yuan of GDP – means that 7 percent growth (nearly 8% in money terms) requires an increase in credit of close to 18 trillion yuan. At this rate the stock of debt outstanding will continue to expand at nearly twice the rate of money GDP, so that the debt to GDP ratio would double again by 2022. In view of the overhang of real estate and other investment, excess capacity in many industries, and the resulting build-up in deflationary pressures, high credit expansion threatens both financial and economic stability. 

Management of debt, on the other hand, requires a clamp down on credit creation, and a willingness, hitherto absent, to tolerate defaults and restructuring among the main those accounting for the bulk of the build-up in debt. These include shadow financial system lenders, property developers, local government finance vehicles, and the property-focused activities of state-owned enterprises. To wean the economy away from credit, though, would knock at least a couple of percentage points off GDP growth. This need not be disastrous but there is no political appetite for it because high rates of growth and job creation are a vital part of the social contract.

Reconciling these objectives, according to the official and widely shared narrative, can be done via deep economic reforms. As is well known, the government has articulated a wide array of economic reforms deemed important to changing China’s growth model. Some that focus on better governance, innovation, the environment, social welfare and greater use of market mechanisms could all improve economic performance in the long-run if successfully implemented, and political feasible.

More urgently, and relevant from a macroeconomic standpoint, other reforms such as financial liberalisation, local government, and state-owned enterprise (SOE) reforms are more relevant. But they are also more problematic because financial and local government reforms are adding to credit creation at a time when the government should be trying to constrain it. SOE reform, moreover, could be adding to growth but isn’t consistent with more assertive economic rebalancing because it is being driven by politics, not the the drive for greater efficiencies and productivity.

Financial liberalisation is less contentious politically. Rules on deposit rates have been eased to some extent, new financial products and firms have evolved to intermediate savings, and a vibrant shadow finance sector, including trust, finance and securities companies, has grown up alongside the state banking system. These developments, however, have also fostered a surge in new term lending of often doubtful quality, funded by short maturity and high yielding deposits. This is the antithesis of taming credit expansion.

Capital account liberalisation, meanwhile, is proceeding very slowly and selectively,  which is probably just as well. Measures such as the Shanghai-Hong Kong Stock Connect scheme linking the two stock exchanges, tend to be more favourable for foreign investors who want to move capital into China than the other way round. Outward liberalisation is viewed still with suspicion. Nevertheless, the easing of inward regulations also hinders the task of curbing credit creation.

After encouraging local governments to borrow heavily in the wake of the financial crisis, Beijing is trying to stop local government finance vehicles, which sprung up as the main borrowing agents, from incurring new debts. But instead of establishing a legal framework to define local government economic functions and curb and focus their spending, the central government is now encouraging them to raise money through a newly evolving municipal bond market. The main purpose at the moment is to refinance expensive debt raised though shadow finance intermediaries for cheaper, more transparent debt in fixed income markets. There is no great appetite, however, to rein in the spending and functions of local governments, or ultimately to prevent them from using new funding sources to supplement other revenues.

Hopes for more extensive SOE reform were raised when it was announced that state enterprises would become a sharper focus for the anti-corruption campaign that has become the hallmark of the President Xi Jinping’s presidency. Earlier initiatives had included executive compensation, ‘blended ownership’ proposals, and increased dividend pay-outs to the government, and a new proposal announced in early March proposed mergers to create synergies and national champions. The target of the anti-corruption campaign, however, is to reinforce Party influence in the iron triangle of party, state, and business, not to establish growth oriented outcomes, such as those that could flow from limiting the role of the state, introducing new institutional governance and the rule of law, and reducing financial and other privileges.

For now, the government will continue to rely on traditional public investment measures, an easing in property restrictions, and lower interest rates and bank reserve requirements to counter weaknesses in the property, investment and export sectors, and offset the rise in real interest rates occasioned by rising deflationary pressures. But the choice to manage debt and maintain 7 percent growth is no choice at all. The two goals are in contention. In an ideal world, the government would resolve to manage debt down, by restraining the financial sector and local governments, accept lower growth and its consequences, and simultaneously accelerate reforms to build a new growth model. In the real world, politics are kicking the proverbial can down a shortening road.