Author: Huang Yiping

Posted on : Caixin Global, January 5th, 2017

Official and unofficial economic data confirms that the Chinese economy stabilized in mid-2016. But there is disagreement about the country’s growth outlook moving forward.

Three important forces are likely to shape economic trends in 2017: Developments in the property market, infrastructure spending, and manufacturing investment. These forces are also the sources of much uncertainty about the future direction of China’s economic policy.

The country’s gross domestic product growth reached a steady 6.7% over three consecutive quarters in 2016, fueling renewed speculation about the reliability of official data. The consensus was that economic activity was bottoming out. Big data analysis and grassroots investigations came to the same conclusion. But activity in many sectors started to pick up during mid-2016.

First, the property market started to turn around at the end of 2015, contributing to the overall stability of the economy. Property investment grew modestly from a negative figure to around 5%. The signs of a boom in the property market resulted in a stronger demand for electronics, furniture, building materials and automobiles.

Infrastructure spending also served as a stabilizing force, with local government spending picking up again through various forms of investment funds.

Finally, activity in emerging sectors of the economy has strengthened. This was evident in both the higher sales figures for materials, energy and internet products as well as upgrades of traditional products such as household appliances and large machinery.

What remains unclear is whether this floor on growth is sustainable. During China’s National Day holiday, many local governments announced policy measures to cool down home sales. In November, the property market in some cities had started contracting. While it is difficult to assess how this reversal will affect growth in 2017, the positive effects of the property sector are likely to peter out.

The political cycle suggests that infrastructure spending will continue, at least through 2017, as the country prepares for the 19th National Party Congress in October. This could further worsen local governments’ balance sheets and overall investment efficiency.

Manufacturing investment is also a source of continuing uncertainty and has been extremely weak for the past few years. In mid-2016, manufacturing investment started to pick up again. Two theories explain the latest improvement: either property-related increases led to higher demand for manufacturing goods, or investor sentiment steadied as 55 months of producer price index deflation came to an end.

Most probably, the downward pressure on growth will continue in 2017 unless the government steps up its macroeconomic stimulus policy. There is an ongoing debate about whether the current growth slowdown, which started in 2011, is cyclical or structural. While this discussion is useful for understanding the persistence of China’s slowdown, it misses the point about the need to upgrade industries that are contributing to this slowdown.

For several decades, Chinese economic growth was powered by exports and investment, while consumption remained relatively weak. Behind those two growth engines was a rapidly expanding manufacturing industry — labor-intensive manufacturing at one end, which produced exports, and heavy industry at the other end, which produced investment goods. These two sectors were the backbone of the “world’s factory” and the “China miracle.”

Changing Times

Labor-intensive manufacturing has rapidly lost its competitive edge as wages and other costs have risen. Heavy industries are suffering from massive overcapacity problems. The pillar industries that once supported China’s growth can no longer carry their own weight. The country needs to build a new set of industries either focused on high-end manufacturing or the services sector.

To some extent, this trend reflects a typical middle-income-trap story. Most of the old industries, built on a low-cost advantage, are no longer commercially viable as costs have risen alongside income. The challenge that China faces today is not just to recognize cyclical or structural slowdowns, but to understand the nature of the battle between new and old industries. The most important policy objective is to facilitate an industrial upgrade by creating and developing new industries and encouraging old ones to exit.

China is faced with an extremely difficult set of policy choices in 2017. This is partly because of external uncertainties — a result of an unclear global economic outlook, and a new U.S. administration headed by President-elect Donald Trump. But the domestic policy options are also narrowing as the country faces the so-called risky trinity — declining productivity, rising leverage ratios, and a narrowing of the space for policy flexibility.

There are two key areas to watch closely: the growth target and growth policy. Authorities should lower the annual growth target. The government committed itself to achieving 6.5% growth during the 13th Five-Year Plan, which runs through 2020, but this does not necessarily mean that it must hit this target every year or every quarter. A growth target that is too high will neglect structural reform. It is now extremely difficult for both monetary and fiscal policies to support growth. Instead, China needs to lower the near-term growth target, allowing economic restructuring to occur for sustainable growth in the long run.

State-owned-enterprise (SOE) reform is crucial. Industrial upgrading is happening across the country except where overcapacity is overwhelming. But there are a large number of “zombie firms,” and government controls are tight and comprehensive. In these areas, the private sector is not dynamic, innovation is weak, and young people are leaving.

The challenge for China right now is not how to support the creation of new industries, but how to facilitate the smooth exit of old industries. And this comes back to the question of SOE reform — will the government have the courage to allow these inefficient and unprofitable zombie SOEs to go bankrupt?

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