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Time to get wise on China's trajectory

China's economic growth can only be sustained with painful reforms

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The world gained amply from China's fast economic growth, and the impact will likely be tumultuous when it falters.   © Reuters

That China is reaching the end of its current phase of development is a recognized fact but there is disagreement about whether the transition will be smooth by way of a soft landing for the economy, or disruptive in the scenario of a hard landing. Ultimately, China's trajectory will be a function of four inter-related issues.

First, China's economic model of growth is driven by debt-fueled investment. A high portion of that is in property and is unsustainable, a fact acknowledged by Chinese authorities.

But the scale of the required shift to greater consumption is large, given that roughly half of all economic activity in China has been driven by investment in recent years. It requires difficult decisions such as increasing household income, reducing savings and extending the rudimentary welfare system, which at around 6% of gross domestic product is well below the average of 25% in the Organization for Economic Cooperation and Development. The rebalance will, therefore, be slow and result in lower growth at least in the short term, compounding challenges China already faces.

Second, China's financial resources to manage the transition may be over-estimated. Foreign exchange reserves of around $3 trillion may not be as large as they appear when measured against the minimum required by the International Monetary Fund, once adjustments are made for illiquid assets, such as infrastructure investments including those in the Belt and Road initiative.

The budget deficit may be close to 10% of GDP, when off-balance sheet items are included. China's government debt, around 55-60% of GDP, is lower than that of many developed nations. But if all obligations such as contingent liabilities are included, then it is perhaps as high as 90% of GDP, limiting China's fiscal flexibility.

Third, policy choices are increasingly difficult. Rebalancing the economy will lower growth and result in job losses. But not rebalancing from investment to consumption will also result in slower growth and job losses.

Conundrums and dilemmas

Increasing wages to boost consumption decreases competitiveness. But not increasing wages necessitates reliance on investment with the concomitant risk of more mal-investment and exacerbating over-capacity in many industries. Increasing real rates of interest to properly compensate savers or encouraging higher levels of spending will help the rebalancing toward consumption but will create problems for the financial sector. Tackling underperforming state-owned enterprises will result in bad debt and job losses, but not dealing with the sector will lead to capital being tied up in unproductive, zombie industries.

Recognizing and writing off bad loans in the banking and shadow-banking sectors would potentially set off a financial crisis. But not addressing the asset quality issues may also result in a calamity. Devaluing the yuan would lead to accelerated capital flight and complaints from trading partners, like the U.S. But supporting the yuan reduces China's export competitiveness. Dealing with environmental issues would lead to millions of job losses, but not dealing with the problem may lead to rising health costs and ultimately to millions of premature deaths.

Fourth, the Chinese social compact requires high rates of economic growth and improvement in living standards to maintain the Chinese Communist Party's legitimacy and monopoly over political power. Today, slower economic growth has affected real income and employment. Many new workforce entrants find it increasingly difficult to find jobs consistent with their education, training and aspirations.

Popular dissatisfaction represents a potential threat to the CCP's authority, undermining the willingness to implement necessary reforms, especially when they would have short-term costs. It makes the party reluctant to reduce its power and control over crucial economic levers, such as the SOEs and the banking sector.

Balancing these factors means that China will undertake reactive tactical reforms to deal with emerging problems, rather than meaningful strategic changes to the country's economic structure. A prolonged Japan-like period of stagnation or a crash like that which signaled the end of the bubble economy is a high risk.

Cognitive dissonance means that Western investors want to believe that China will change. But the country's history shows that conservatism persistently triumphs over reform. China will continue its present economic model until it fails or the existing structure reaches breaking point.

The fallout will be significant. China is the world's second-largest economy and contributes around one third of global growth. It is also a significant buyer of commodities and a major source of foreign investment globally. Global reflation of asset prices is driven in part by the significant increase in Chinese net credit creation. Just as the world shared in China's feast, the famine will be felt worldwide.

Satyajit Das is a former banker. His latest book is "A Banquet of Consequences," published in the U.S. and India as "The Age of Stagnation." He is also author of "Extreme Money," and "Traders, Guns & Money."

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