In 2005, Hunan Valin Steel Tube and Wire, a Chinese state-owned steelmaker a few hours' drive from Changsha, sold a large minority stake in itself to the Luxembourg-based steel group ArcelorMittal in an attempt to become too important to be closed by the government, or merged into a bigger local entity.
When I visited Hunan Valin shortly after the deal was announced, the skies over the shabby plant were the sort of yellow grey that residents and visitors have long associated with Chinese mainland pollution. Its chimneys spewed brown smoke into the atmosphere, and its equipment looked ancient compared to the facilities at Baosteel, a world-class Chinese steelmaker in Shanghai.
By 2016, Hunan Valin was China's 10th largest steel company by production volume. But it remained deeply inefficient and value destructive. In July, the company announced a change in its principal business from steelmaking to finance and environmental management. In August, ArcelorMittal sold its shareholding to Shenzhen Qianhai Eagle Fund, a Chinese fund management company.
There was one part of the operation, however, which was superb. The dining hall attached to Hunan Valin's guesthouse served up wonderful cuisine, including delicately spiced fresh tofu, mushrooms and vegetables. If the government had closed the steel mill in 2005 and kept the guesthouse and its kitchen open, it would have been less value destructive, and might have been highly profitable.
What the government should have done 10 years ago to Hunan Valin is what it must now find the courage to do all over China. It must take out inefficient pollution-producing capacity from heavy industrial sectors such as cement, coal, shipbuilding and steel, and nurture the service sector to generate quality economic growth and jobs.
But that sort of reform requires a change in China's model of capital allocation -- away from support of state-owned enterprises and toward lending to private enterprises and encouraging innovation -- that would affect the entire Chinese system, including the ideological basis for the legitimacy of the ruling communist party. Whether the government can achieve such a transformation will determine the future of China, and whether its economy will prosper over coming months and years or continue to slow, risking social stability in the process.
Unsurprisingly the signals are mixed. Consumption contributed 71% of economic growth for the first nine months of 2016, "the highest since 2001, while the rotation from traditional to new sectors continued on track," according to JPMorgan in Hong Kong. The bank's economists added: "The government will aim to achieve a fine balance between stable growth, economic restructuring and financial stability in 2017. Stability is the keyword for 2017 -- economic, social and financial."
Beijing is also making cautious progress in reducing capacity, especially in coal. One indication of its progress is that deflation in wholesale prices ended in the third quarter of 2016 after 54 months. That is good news -- for China and its companies, if not for western consumers -- because inflation reduces the interest burden of existing debt, helping corporate profits to recover and reducing the rate of growth of banks' problem loans.
However, financial risk of all kinds is on the rise. The People's Bank of China, the central bank, faces hard decisions, all of which involve difficult trade-offs. Total outstanding credit has increased from 239% of gross domestic product at the end of 2015 to an estimated 250% today and a likely 300% (based on present trends) within three years, according to figures from JPMorgan. In part, this is because the efficacy of lending and investment has come down. The economic growth that a single dollar of credit produced a few years ago now requires four dollars, suggesting extensive capital misallocation.
Exactly where all the money goes remains opaque because much of the growth in lending has come from sources other than banks. But so-called shadow banks are intertwined with the official banking system; if there are problems in the shadows, they will be quickly transmitted to the official sector.
Credit risk is also becoming more of an issue. A few years ago, when the subject of insurance against defaults was first raised, the market failed to develop because it was one-sided: There were no defaults. That is no longer the case -- there have been at least 28 corporate defaults in 2016, according to data from Bloomberg, up from seven in the previous year.
Moreover, China's capital markets are no longer sealed against influences from beyond its borders. As the U.S. raises its interest rates, the gap between the yields on U.S. and Chinese government bonds has narrowed -- from 2 percentage points in 2014 to 60 basis points -- increasing the comparative attractiveness of the U.S. to investors and making capital outflows a continuing worry for the central bank. (A basis point is one hundredth of a percentage point.)
Fears of leverage and capital outflows have led the central bank to focus less on financing growth and more on tightening monetary conditions to maintain stability in the currency and asset markets. That is a shift "from stimulating growth towards restructuring, deleveraging and risk control," as the Institute of International Finance put it in a report in mid-December.
In other words, 2017 will likely prove even more challenging than 2016.