The Major Paradox at the Heart of the Chinese Economy

China Old Economy vs New

The day-to-day data coming out of China are sometimes reminiscent of the classic Zen riddle about listening to the sound of one hand clapping. They’re puzzling, even a little baffling.

The world’s second-biggest economy is decelerating. The government reported Wednesday that first-quarter gross domestic product grew 7 percent, the slowest pace since the 2009 global recession. The International Monetary Fund, meanwhile, sees Chinese expansion slowing even further to 6.8 percent this year and 6.3 percent in 2016. India is now the rock-star emerging market, tipped to grow 7.5 percent this year.

At the same time, the scent of fast money hovers over Shanghai, Shenzhen and Hong Kong, where stock markets are enjoying explosive rallies. The Shanghai Composite Index is up 94 percent over the last 12 months and some $4 trillion has been added to the total market value -- now $7.3 trillion -- of companies listed on domestic exchanges over the past year.

Step back from conflicting daily headline numbers, and a different economic reality emerges. China is the midst of an ambitious, and risky, rebalancing act -- away from its old growth model of credit-fueled, investment-led and export-powered growth that astounded the world with 10 percent annual average GDP gains from 1980 to 2012.

Long Game

The long game is to transform China’s $10.4 trillion economy into a more sustainable one, featuring a vibrant service sector and a more diversified finance industry that doesn’t rely so heavily on state-owned banks to allocate capital. It will be a messy process and will result in sub-par growth, at least by Chinese standards.

“China’s economy is in a very critical period of restructuring,” said Zhang Bin, a senior fellow at the Chinese Academy of Social Sciences in Beijing. And there will be economic pain as the government pushes through overdue structural reforms. “Even if GDP growth is lower, it isn’t a bad thing. We have talked about it for many years without progress, but now it is really making progress.”

It’s too early to know whether such tough-love optimism is fully justified. However, there’s evidence that President Xi Jinping’s team is making headway.

While China’s lousy industrial data -- worse than any of the 40 analysts surveyed by Bloomberg News anticipated -- received the most attention from Wednesday’s releases, buried in the numbers was an important milestone for China. The services sector for the first time accounted for more than half, at 51.6 percent, of GDP in the first quarter. Consumption growth was also solid.

Potential Pick-Up

“The latest GDP report underscores offsets coming from China’s services-led transformation -- a key underpinning of consumer demand,” said Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia. “I suspect the economy is close to bottoming and could well begin to pick up over the balance of this year.”

Chinese officialdom has little choice but to tap on the brakes of the old-line economy. Years of politically driven investment with diminishing returns led to too much debt and industrial overcapacity, as well as ghost towns with unfinished hotels and unoccupied residential towers.

Bad debt piled up at a faster pace at China’s big state banks in the fourth quarter. Meanwhile, the country’s total debt -- government, corporate and household -- rose to about $28 trillion by mid-2014, according to an estimate by McKinsey & Co., or about 282 percent of GDP.

De-leveraging Challenge

Xi and Premier Li Keqiang are trying to defuse that debt bomb, rein in banks and local governments and promote the nation’s stock markets as a primary way for innovative and smaller companies to raise capital.

Both leaders say they’ve mapped out more than 300 reforms that over time will reduce state intervention in the economy. Among the initiatives is scaling back energy-price controls that favor manufacturers. The changes are also designed to improve the social safety net and encourage market-driven deposit rates to get Chinese families saving less and spending more.

Few countries with the scale of China’s credit boom have escaped unscathed without experiencing some sort of banking crisis. Research by Michael Pettis, a finance professor at the Guanghua School of Management at Peking University, shows that “every investment-led growth miracle in the last 100 years has broken down.”

Investment Wind-down

Avoiding that fate requires a high-wire balancing act for the government. It needs to wind down the torrent of investment -- 49 percent of China’s GDP from 2010 to 2014 -- without cratering the economy and worsening the situation for indebted local governments or the bad-debt burden of Chinese banks.

“Our goal is to keep China’s economic operation within the proper range,” Premier Li said in a March 31 interview with the Financial Times that was published Wednesday. Achieving the 7 percent target this year “won’t be easy” and requires “vision, perseverance and courage,” Li said, as cited by the newspaper.

Selling slower growth now for greater prosperity later isn’t an easy political sell, even in a one-party state. Xi faces entrenched interests that favor the status quo, such as state-owned nonfinancial enterprises that have $16 trillion in assets and local governments that have benefited from big public works projects and thriving real-estate markets.

Asia’s largest economy is “running out of steam” and risks a “day of reckoning” if leaders don’t adopt a new model for municipal finances, former U.S. Treasury Secretary Henry Paulson said in an interview Tuesday in New York.

There’s also the risk of a disorderly de-leveraging in the banking sector and the jobs-intensive property market. Any crisis there could take growth rates well below the government’s target of about 7 percent. China is already home to income-inequality levels on par with Nigeria and Mexico.

Throw higher unemployment into the mix and the risk of social unrest rises.

The Temptation

The temptation to blink and rev up the economy with debt-fueled investment is also tough to resist. In January, people with knowledge of the matter said the government approved plans to accelerate 300 infrastructure projects valued at 7 trillion yuan ($1.1 trillion) in 2015. The nation’s central bank, meanwhile, has cut interest rates twice, to lower the cost of corporate borrowing.

Such tactical fall-backs won’t matter in the long run if China can truly reform its financial sector so it gets better at allocating capital. Too much credit risk has been concentrated in China’s powerful state-owned banks. Bank lending last year accounted for 62 percent of China’s total social financing, the broadest measure of credit, according to research by Macquarie Group analysts.

There has been some progress: Most interest rates, except for the benchmark deposit rate, have been liberalized. Officials have begun the biggest shake-up of state-run companies since the 1990s. China has been widening the channels for onshore and offshore yuan markets and weighing whether to relax rules for Chinese companies to sell bonds and stocks in overseas markets.

Connecting Investors

A big catalyst for the stock market boom this year has been the creation of a new cross-border investment channel called the Shanghai-Hong Kong Stock Connect that allows investors in Hong Kong and China to trade a specified range of listed stocks in each other’s market.

Right now, Chinese stocks are a big momentum trade, fueled by excess liquidity and bets that authorities will do more to stoke growth, said Wang Tao, chief China economist at UBS Group AG in Hong Kong. In China, “the stock market never correlates with the economy,” she says.

Whether Chinese stocks are overvalued may be a secondary concern for policy makers who view promotion of the stock markets as a key way to diversify credit allocation away from banks. “Most enterprises raising capital through the stock market are real-economy enterprises, and this helps the real economy to develop,” said People’s Bank of China Governor Zhou Xiaochuan at a press conference on March 12.

Credible Effort

That’s the plan at least. Just how smoothly China’s grand economic transition goes is difficult to say. Helen Qiao, chief greater China economist at Morgan Stanley, gives Xi points for making a serious and credible effort to alter the economic landscape.

Xi has been touting a “new normal” for growth as the government looks to manage the slowdown. “It shows they are not too worried about short-term volatility in growth,” said Qiao. “Rebalancing is working.”

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