2. China is transforming and rebalancing to move away from an export-based economy to a more consumption-based one. This transition is not without challenges, and policy actions could determine whether a downward trend in China's economic growth since the global financial crisis leads to a hard landing, Japan-style stagnation
3. China Dream is taking shape as a concrete plan of action, centered on China’s One Belt, One Road (OBOR) plan supported by a new set of China-centric financial institutions—the Asian Infrastructure Investment Bank (AIIB), the New (BRICS) Development Bank, and the Silk Road Fund.
3. Do the figures reflect economic restructuring? Services now count for more than half of the economy, high-tech manufacturing is expanding rapidly, and the issuance of new credit is slowing. But despite these efforts, productivity is still flagging.
OBSTACLES
1. A consumer-led growth strategy is tougher to pull off than originally thought. The consumption share of GDP has risen just 2.5 percentage points since 2010—far short of the boost to personal incomes that might be expected from the 7.5-percentage-point increase in the share of services and a 7.3-percentage-point increase in the high-wage urban share of its population over the same period.
2. Growth has fallen considerably since, coming in at 6.7 percent for all of 2016. China’s growth now is achieved through mobilizing more money and labor, not improvements in human capital or technology. It now takes three times as much capital to generate a single unit of economic growth as it did in 2008. The result is an explosion of debt that now accounts for at least 280 percent of GDP, and could break through the 300 percent mark by year’s end.
3. As a producer-focused economy, China has long been the greatest beneficiary of globalisation—both in terms of export-led growth and poverty reduction stemming from the absorption of surplus labor. However that approach has now been stymied by China’s mounting internal imbalances, a post-crisis slowdown in global trade, and an increase in China-focused protectionism.
ROOT CAUSES
1. In 2013, Chinese President Xi Jinping promised that the market would play a decisive role in the allocation of resources. However government bureaucrats have increased their role in the economy via industrial policy and mercantilism, and factory closures and production cuts are now the purview of policymakers rather than business people.
2. Under the Made in China 2025 plan and other similar initiatives, billions, if not trillions, are being thrown at strategic industries from semiconductors to artificial intelligence
i. Almost two dozen Chinese provinces are investing simultaneously in fabrication facilities to pump out memory chips.
ii. Companies and research institutes are filing worthless patents in record numbers because they receive a fee from bureaucrats
iii. State-backed credit is still flowing freely to high-priority projects around the country, which is why the economy grew at 6.9 percent in the first quarter of 2017 despite tepid private-sector enthusiasm.
3. The Trump administration threw away the best tool to incentivize China to change when it abandoned the Trans-Pacific Partnership, an agreement that would have lowered barriers for trade in goods, agriculture, and services, and would have created entirely new rules to govern the behavior of state-owned enterprises, e-commerce, investment, and government procurement.
CHINA VS JAPAN
1. The current state of China’s economy has prompted many comparisons to Japan in the late 1980s. In Japan, the 1980s were followed by the “lost decades,” with a sharp downturn in GDP growth, a deflationary spiral, and an asset price bubble burst. Japan ended up with many evergreen loans, zombie companies, and zombie banks.
2. The two economies share some similarities, including their financial imbalances, savings and investment dynamics, and a general structural downward trend. Both countries enjoyed three decades of fast economic growth with rising financial and structural risks buried behind the glorious scene.
3. Compared with Japan in the late 1980s, China has more policy leeway and buffers to deal with a potential economic or financial crisis, as well as more growth potential for long-term development, given the low urbanization rate and capital stock level.
STRATEGIES
1. Shrink the size of the old economy by reducing capacity in heavy industrial sectors dominated by lethargic state-owned enterprises, including steel and aluminum.
2.Expand the new economy by supporting high value-added services and advanced technologies.
3. Reform local government fiscal systems while tightening regulation of new financial instruments such as wealth management products.
4. Balance between the pace and quality of growth:
i. The first is short-term in nature. There is an above-50% chance that China will be able to avoid a hard landing or systematic financial crisis, even though the market may suffer from a confidence crisis in the ability of Chinese authorities to maintain balance given domestic headwinds and unfavorable external condition
ii. The second is in the medium term to long term. Despite ongoing policy debates, expect an above-50% probability that the government will successfully push for structural reforms in a timely manner.
iii. A supportive macro policy cushion and, hence, a stable growth environment could buy China time to implement painful structural reforms. However, if maintained for too long, these policy cushions could weaken the incentive for reforms and sow the seeds of future volatility.
5. The Chinese government has a deep pocket for monetary, fiscal, and regulatory tools to cushion the slowdown or protect itself from a potential policy mistake. The government accepts that the growth will need to slow down, but at a gradual pace. If the deceleration is gradual, the government will not intervene and instead will focus on reforms and financial stability; but when the pace is rapid and creates market panic, the government will fight against the trend to stabilize the growth. This will allow the government to engineer a smooth deleveraging process and soft landing. The macro policy cushions include:
i. FX reserve cushion: China has $3 trillion FX reserves, which can cover imports for two years, and the debt ratio of FX reserves to short-term external debt is low
ii. Monetary policy cushion: The central bank balance sheet remains solid, and the reserve requirement ratio is much higher than the average level prior to the Global Financial Crisis.
iii. Fiscal policy cushion: Although a 2008-style stimulus package is unlikely, the central government’s budget deficit is low as a percentage of GDP and allows room for increased fiscal spending, particularly in the infrastructure sector.
iv. Others: The Chinese government is implementing reforms to reduce tax and fee burdens for corporations. Policy restrictions on the property market could be reduced again, should the housing sector slow more than expected. The government can manage capital account restrictions temporarily to avoid capital flight and sharp depreciation on the renminbi.
FOUR SCENARIOS FOR CHINA'S MEDIUM-TERM GROWTH OUTLOOK
1. four potential scenarios exist for the future of China’s economy. These scenarios will be shaped by two main domestic forces: structural reform progress and macro policy cushions
i. Under this scenario, China uses policy tools to engineer a soft landing, while unleashing long-term growth potential by implementing timely, effective structural reforms.
ii. GDP growth gradually decreases to about 4% then rebounds to about 5% as productivity and capital stock growth gradually rise after the reforms.
3. Hard landing (Limited policy cushion and capital flight; structural reforms implemented)
i. In this scenario, an economic hard landing and sharp deleveraging are triggered when the macro policy cushion is insufficient. Social instability could rise. However, the crisis provides the government strong incentive to conduct aggressive structural reforms and thereby revive the longterm growth potential.
ii. China experiences a very low growth rate or even an outright recession, followed by a long-term economic rebound. GDP growth rate rebounds to 5% with stronger investment and productivity growth after most bad debts and inefficient economic models are reshuffled
iii. The growth rebound in this scenario is unlikely to be as strong this time, because the global environment is less supportive
4. Japan-style stagnation ( No effective structural reform; government cushions economy)
i. Under this scenario, the government is overly protective and delays necessary structural reforms. The economy is stuck in a “Japan-style” stagnation, though at a much lower wealth level.
ii. The continued increase in credit expansion and the implicit government guarantee help with near-term stability but also allow many loss-making companies to survive. Such a slow-burn scenario makes China lose long-term competitiveness and fail to escape the “middle-income trap” with stagnant GDP and productivity growth, while capital investment continues to decelerate because of the gloomy long-term prospect. GDP growth is likely to gradually drop to about 2%–3% by 2025
5. Emerging-market style instability (No effective structural reform; limited policy cushion; permanent low growth)
i. In this scenario, the government fails to engineer a soft landing, while structural reforms are too painful because of pressure from vested interest groups. Economic and social instability persists in the medium term.
ii. GDP growth falls sharply, to the low single digits or even negative. In the long term, China loses its shine, and GDP growth decreases to 2%–3% by 2025, with falling productivity growth and lower capital investment. GDP growth under the four scenarios.
