China's markets took a tumble after a front page article on May 9 in the People's Daily, the official Communist Party mouthpiece, questioned the sustainability of the economy's recent credit-fueled growth and highlighted potential risks, in particular the rapid accumulation of debt. The unidentified "authoritative source" cited in the article warned that high leverage could lead to a systemic financial crisis, a deep recession or the evaporation of household savings and wealth.
The source urged local governments to push for painful but necessary structural reforms and embrace more supply-side policies, which in China is usually a reference to measures to eliminate excess production capacity and allow the closure of "zombie" companies kept alive by state support. The article concluded that China's economic trajectory is set to be "L-shaped," rather than "U-shaped" or, ideally, "V-shaped."
Many of the concerns raised in the article are well warranted. China's growth in the first quarter was built on extended borrowing by companies and local governments. The nominal gross domestic product growth rate was 7.2% in the first quarter whereas total social financing, a broad gauge of credit growth in the economy, accelerated to 13.1% year-on-year in the same period.
As a consequence, China's aggregate debt level exceeded 250% of GDP at the end of March compared to less than 150% in 2008. Although the credit build up has helped to boost growth in the short term, the resultant accumulation will eventually weigh on economic momentum and increase financial vulnerabilities in the long run. In this respect, the market has similar worries about the strong side effects of policy stimulus.
On the positive side, the article in the People's Daily helps dispel uncertainties surrounding the government's policy stance by reemphasizing the authorities' commitment to supply-side policies. It particularly sends a clear signal to local governments to stay on track with structural reforms rather than divert their attention to stimulating demand.
The article however overlooked the key question of how to balance meeting growth targets and pushing for structural reforms. During the National People's Congress session in March, officials set the average annual growth target at 6.5% for the next five years, with a range of 6.5%-7% for this year.
These growth targets are exerting substantial pressure on local governments and limit their policy choice. Supply-side reforms would likely dampen economic activity in the short run, making local governments' preference for undertaking demand-stimulus measures a rational reaction to mounting pressure to meet growth targets.
If the authorities want to effectively accelerate structural reforms, they must show a greater tolerance for slowing growth. This could mean providing a wider GDP target range for the next few years rather than setting a floor of 6.5%.
The central government should also provide more financial and policy support so that local governments have an incentive to push through structural reforms. Otherwise local governments may oscillate between demand stimulus and supply-side policies, leading to more market confusion. In this respect, the central government might consider running a wider budget deficit to provide funds to deal with layoffs caused by the shutdown of zombie companies. Already the central government in March pledged to expand a program to refinance local government debt to lower interest costs.
It is important to recognize that the real culprit that is increasing financial vulnerability is the lack of structural reforms, not such easing initiatives. If the authorities can withdraw the implicit guarantees enjoyed by state-owned enterprises and establish a level playing field for different types of companies, money will automatically flow to the most productive sectors and optimize resource allocation.
Theoretically, such a process will not necessarily raise overall leverage in the economy since aggregate output will increase in tandem with debt. Unfortunately, state enterprise reform has thus far lagged significantly behind schedule. In this regard, the inertia of local governments has been partly caused by the central government's own sluggishness; as with past reform efforts, the central government should boldly set a good example in pushing through changes first.
On balance, the authorities should increase their tolerance for slower growth in the short term in exchange for the brighter growth outlook that reforms can bring in the long run. They also need to take the lead in reforms in key areas, such as state enterprises. The resulting growth trajectory might then be a deep-V shape rather than L-shaped.
Xia Le is chief economist for Asia at BBVA Research. He is also a research fellow with the International Monetary Institute at Renmin University of China.