Written by Joe Cash
BEIJING (Reuters) – Chinese President Xi Jinping’s first major reform plans a decade ago were his boldest, envisioning a transition to a Western-style free-market economy driven by services and consumption by 2020.
The 60-point agenda was meant to reform an outdated growth model more favorable to less developed countries – however, most of these reforms went nowhere, leaving the economy largely dependent on outdated policies that only increased the debt pile. China’s enormous industrial surplus capacity.
The failure to restructure the world’s second-largest economy has raised critical questions about what comes next for China.
While many analysts see the most likely outcome as a slow drift into a Japan-style recession, there is also the possibility of a more severe crisis.
“Things always fail slowly until they suddenly break,” said William Hirst, professor of Chinese development at the University of Cambridge.
“There is a significant short-term risk of a financial crisis or other degree of economic crisis that would impose very significant social and political costs on the Chinese government. Ultimately, there will 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.
Economists say that by the time the global financial crisis hit in 2008-2009, China had already met most of its investment needs commensurate with its level of development.
Since then, the economy has quadrupled in nominal terms while total debt has expanded nine-fold. In order to keep growth high, in the 2000s China doubled its investments in infrastructure and real estate, at the expense of household consumption.
This has kept consumer demand weaker as a share of GDP than in most other countries and concentrated job creation in the construction and industrial sectors, professions that young university graduates are increasingly rejecting.
The policy focus has also swollen China’s real estate sector to a quarter of economic activity and left local governments so dependent on debt that many are now struggling to refinance it.
The pandemic, demographic downturn and geopolitical tensions have exacerbated all of these problems to the point that the economy has found it difficult to recover this year even as China reopens.
“We are in a moment where we are seeing some structural shifts, but we should have seen them coming,” said Max Zenglin, chief economist at the Merics Institute for China Studies.
“We are just beginning to face reality. We are in untested territory.”
The end of China’s economic boom is likely to hurt commodity exporters and dampen export inflation around the world. At home, this will threaten the living standards of millions of unemployed graduates and many whose wealth is tied to real estate, posing risks to social stability.
Crisis versus recession
Beyond short-term solutions, which are likely to perpetuate debt-based investment, economists see three options for China.
The first is a rapid and painful crisis that leads to debt write-offs, the suppression of excess industrial capacity, and the deflation of the real estate bubble. Another way is a decades-long process through which China works to gradually reduce these excesses at the expense of growth. The third is to shift to a consumer-led model with structural reforms that cause some pain in the short term but help it emerge again faster and stronger.
The crisis could unfold if the massive real estate market collapses out of control, dragging the financial sector with it.
Another acute point of tension is local government debt, which the International Monetary Fund estimates at $9 trillion. China promised in July to come up with a “basket of measures” to address municipal debt risks, without providing details.
Logan Wright, partner at Rhodium Group, says Beijing must decide which part of this debt to bail out, because the amount is too large to provide full guarantees of repayment, which the market currently takes to be implicit.
He added: “There will be a crisis in China when the government’s credibility falters.”
“When financing is suddenly cut off from remaining investments that appear to be exposed to market risk, it is a major moment of uncertainty in Chinese financial markets.”
But given state control of many developers and banks and a limited capital account that limits flows to assets abroad, this is a low-risk scenario, many economists say.
Alicia Garcia Herrero, chief economist for Asia-Pacific at Natixis, expects there will be plenty of buyers if Beijing consolidates its debt given the limited investment options.
“I’m more in the slow growth camp,” she said. “The more debt is accumulated in favor of unproductive projects, the lower the return on assets, especially public investment, and this really means that China is unable to achieve growth.”
But avoiding the crisis by extending the adjustment period carries particular risks to stability, as youth unemployment rates exceed 21% and about 70% of household wealth is invested in real estate.
“One of China’s biggest success stories, building a strong middle class, has also become its biggest weakness,” Merix’s Zenglin said. “If you look at it from a younger person’s perspective, you’re now at risk of being the first of the post-reform generation whose economic well-being might hit a wall. If the message is tighten your belts and roll up your sleeves, that’s going to be a bit of a hard sell.”
Fixes this time?
The third path, an active shift to a new model, is considered extremely unlikely, based on what happened to Xi’s 60-point program.
Analysts say the plans have barely been mentioned since 2015 when fear of capital outflows sent stocks and the yuan tumbling and generated official aversion to potentially damaging reforms.
Since then, China has backed away from liberalizing financial markets significantly, while plans to rein in state giants and introduce universal social welfare have not materialized.
“Now is the time when there is the possibility of changing the train to a new model, and I think there is a desire to do that,” Hirst said.
“But at the same time there is great fear of political and social risks in the short term, especially provoking an economic crisis.”
(Reporting by Liangping Zhao and Kevin Yao; Graphics by Kripa Jayaram; Editing by Marius Zaharia and Sam Holmes)
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