Speaking to IMF News, James Daniel, IMF Mission Chief for China, said that the authorities have made impressive, though uneven, progress on reforms, but noted that the country’s reliance on credit growth, in particular, clouds the country’s outlook. Without reforms, growth would stay high in the near term, but would likely weaken even more in the medium term and with a higher likelihood of a sharp slowdown.
IMF News: The IMF just released its annual assessment of the Chinese economy. What can you tell us about the IMF’s view of China’s growth outlook?
Daniel: We have a positive view of China’s growth outlook as China continues to mobilize its very considerable resources and catches up with higher-income economies. We project growth to decline moderately from 6.6 percent in 2016 to about 6 percent in 2018 and a bit further thereafter. This assumes a continued shift from investment to consumption and from industry to services. Many countries could only dream of achieving growth rates that China has and is likely to achieve, which also reflects positively on the reforms that Chinese policymakers have undertaken.
That said, we see growth declining in the medium term, especially if reforms fall short. A more “pro-active” reform scenario with faster progress on enacting structural reforms would boost medium-term growth (to about 6 ½ percent) but at the cost of weaker short-term growth, as highly-indebted firms are restructured. There is also a downside risk of a “no-reform” scenario with limited reform progress and continued reliance on unsustainable policy stimulus. Under this scenario, growth would stay high in the near term, but would weaken even more in the medium term and with a higher likelihood of a sharp slowdown.
IMF News: China aims to transition to a sustainable growth path. Is the rebalancing progressing. What is the impact so far?
Daniel: Rebalancing is a phrase often used about China but it means different things to different people. In our report, we define four dimensions of rebalancing and where progress has been uneven:
-
External rebalancing has progressed well—the current account surplus has come down a lot and net exports are not driving growth.
-
Domestic rebalancing has three components: moving from investment to consumption, from industry to services, and reducing reliance on credit. China has made strong progress on switching to services, reasonable progress on switching to consumption but, critically, little progress on reducing credit reliance.
-
Environmental rebalancing has been mixed. The energy intensity of growth has declined, but air pollution remains very high.
-
Income distributional rebalancing has also been mixed. The share of national income going to labor has increased, but income inequality remains very high with fiscal policy doing little to reduce it.
IMF News: How about the pace of reforms?
Daniel: Overall, the pace of reform has been strong. Reforms have advanced impressively across a wide domain. Indeed, just keeping up with the myriad of reforms on an almost daily basis is a challenge for us. Over the last 12 months, the authorities have undertaken key reforms, including: (1) making the monetary framework more modern and market based, including a more flexible exchange rate regime (2) improving the fiscal structure, for example, extending the VAT to all services and a new budget law to improve local government financial transparency, and (3) encouraging urbanization, for example by improving rural land rights, making pensions more portable, and developing new urban registration systems so migrants can gradually qualify for basic social welfare and residency benefits.
However, progress has also been uneven. It was slower on some key areas, such as strengthening corporate governance, preventing weak state-owned firms from borrowing more, tackling excessive corporate debt, and opening up state-dominated service sectors. As a result, this worsens resource allocation, weakens longer-term growth prospects and raises vulnerabilities.
IMF News: What are the main risks to the short and medium-term for China?
The short-term risks are low probability and relate more to a potential loss of investor confidence, renewed capital outflow pressures, disorderly corporate defaults, and a sharp fall in asset prices, which could be amplified by the increasingly large, interconnected and opaque financial system. For the medium-term, the main risk is slow progress on reform and continued reliance on policy stimulus and credit to achieve growth targets. While this would support near-term growth, medium-term growth prospects would fall as productivity weakens, and risks rise, as credit and debt keep building up.
Let’s not forget that there are upside risks too. In the near-term, the recent stimulus measures may have a longer-lasting impact but, more importantly, faster progress on structural reform and curbing credit growth would significantly lift medium-term growth prospects and reduce downside risks.
IMF News: Going forward, what are the policy actions needed to ensure China reduces its vulnerabilities?
Daniel: A priority is to slow credit growth. This can only be done by tackling its root causes: the pursuit of unsustainably high growth targets, soft budget constraints on state-owned enterprises and local governments, the web of implicit and explicit government guarantees, and excessive risk taking in parts of the financial sector. This in turn requires a comprehensive strategy and decisive measures to address the corporate debt problem, switching from public investment to fiscal measures that support consumption, boosting bank buffers and reining-in risks in the financial system, continuing to make the exchange rate more flexible and strengthening transparency, both in communications and data.
IMF News: Tackling the corporate debt problem seems key . Practically, how should the authorities go about it?
Daniel: Yes it is a priority. China’s corporate debt is still manageable, but at approximately 145% of GDP, it is high by any measure. Moreover, the country’s nonfinancial state-owned enterprises account for around half of bank credit but only produce about a fifth of industrial output. So first and foremost, a high-level decision is needed to stop financing weak firms and accept the likely lower near-term growth. Such a decision would pave the way for other measures. The authorities will need a strategy to deal with these weak firms, especially state-owned enterprises. How to go about this? A triage between the viable, which should be restructured, and the nonviable, which should be liquidated, is essential. Doing this triage will crystalize losses, for example on bank loans, which will need to be recognized—something the regulatory authorities should encourage.
Once these losses are recognized, they need to be allocated—to banks, to firms, investors and, if necessary, backstopped by the central government. These viable but weak firms then need to be restructured, which likely requires a market-based, out-of-court, process and would be helped by a strong market for distressed debt.
Finally, and equally important, the social costs, such as layoffs, will need to be addressed, for example, with targeted assistance through earmarked budgetary funds.
