Hard landing, soft landing, no landing, overheating. Pundits’ views on China’s economy bounce around—often rapidly—between these descriptions.
Just two short months ago, the dominant concern was about a sharp slowdown, below this year’s official growth target of 7½ percent. Now, these fears have retreated, pushed aside by talk of renewed momentum.
Our sense, here at the International Monetary Fund, has always been that economic growth will slightly surpass this year’s official target. But we have also cautioned that China’s economic challenges are growing, and that accelerating reform is critical for containing risks and achieving a smooth transition to sustainable growth.
The upcoming Third Plenum provides an opportunity for the new leadership to provide guidance on how they plan to meet these challenges.
The challenges ahead
After three decades of unprecedented expansion, during which nearly 500 million people have been raised out of poverty, China’s growth model is under stress. Pressure points are beginning to develop in the financial sector and in local government finances. This, against a backdrop of an aging population. These strains arise from a development strategy heavily reliant on capital accumulation and the relocation of surplus labor from the countryside to urban factories.
China’s stock of credit is among the highest in the world and growing fast, particularly in the non-bank segment. In the past four years alone, the stock of credit as a share of GDP has risen at breathtaking speed from around 140 percent to 200 percent.
Elsewhere, rapid credit growth of this kind has often been accompanied by widespread mispricing of risk and a buildup of asset quality problems. And while the emergence of non-bank intermediaries marks a shift toward more market-based intermediation, these institutions also pose risks by mobilizing short-term deposits to lend for longer maturities without the same capital buffers, provisioning, or regulatory rules that banks adhere to.
On the other side of this rapid credit expansion is the large buildup in debt, including at the level of local governments. Infrastructure spending by local governments has often been used as a counter-cyclical tool to stabilize activity in the face of shocks––even more so since the global financial crisis.
Since local governments are generally constrained in how they raised revenue, and are not permitted to borrow directly from the markets, they have tended to channel infrastructure funding through off-budget financing vehicles. Augmenting the reported public debt numbers to include this additional infrastructure-related borrowing, our sense is that the general government debt is around 45 percent of GDP (twice the official number). This is still manageable, but it does suggest less fiscal space to deal with unanticipated events than the reported headline number indicates.
The inter-related risks in the financial sector and local government finances reflect deeper vulnerabilities along the current growth path, which remains heavily dependent on capital accumulation. Capacity continues to be built well ahead of final consumer demand and returns to capital are diminishing. And demographic trends suggest surplus labor will be exhausted by around 2020, so it will become more difficult to offset diminishing returns by relocating surplus labor from the countryside to factories.
Put together, the growth model which has delivered spectacular results for China in recent decades looks increasingly unsustainable.
What’s to be done?
Shifting to a sustainable growth path––one that uses resources more efficiently, is more inclusive, and more consumer-based––requires actions on several fronts: financial sector and fiscal reforms, as well as structural measures.
Further financial reforms are essential to contain the buildup of risks, enhance the efficiency of investment, and boost household capital income. The main dimensions of reform are deposit rate liberalization; the elimination of perceived widespread implicit guarantees on financial products and intermediaries through the introduction of deposit insurance, and a formal resolution framework for failing institutions; and gradually moving away from administrative guidance on credit allocation to adopting a policy rate as the main operating target for monetary policy.
Fiscal reforms, including giving local governments authority over their own revenue sources more in line with their expenditure mandates; shifting the tax burden toward progressive and efficient forms of taxation; and channeling dividend payments from state-owned enterprises to the budget; all these measures will complement financial sector reforms in addressing the vulnerabilities in local government finances, reducing excess investment, and boosting household consumption.
The third broad area––structural measures––will reinforce the impact of financial and fiscal reforms and enable a shift toward a growth model less reliant on capital accumulation and more dependent on the efficient use of resources (‘total factor productivity’ growth). The measures include leveling the playing field within and across sectors through deregulation and easing barriers to entry (particularly in services); raising resource prices to rationalize investment and protect the environment; and reforming the hukou (household registration) system to improve labor market mobility and achieve a more efficient matching of workers to vacancies.
Eyes on the Third Plenum
Implementing these significant measures is a tall order and involves tough choices, including possibly accepting slower growth as the economy adjusts to the new path. But starting now will allow China to sustain its convergence to the level of higher income economies and deliver the benefits of growth to an ever-wider cross section of its population in a way that’s environmentally sustainable and sound. But delay reforms and the challenges grow larger, raising the probability of stalled convergence.
China’s leadership recognizes the challenges and has already indicated their reform objectives. The priority now is to lay out and then, critically, implement concrete reform plans to manage the transition to a new growth path.
It doesn’t matter whether the cat is black or white, Deng Xiaoping famously said, so long as it catches mice. Expectations are high for a similar sense of far-sighted pragmatism at the Third Plenum to shape the course of China’s economy over the next decade and beyond.
