At the National People’s Congress meeting in early March, the Chinese Government set its annual growth target at 6.5 per cent, a couple of notches lower than the actual performance of 6.7 per cent in 2016. In the first half of this year growth in gross domestic product (GDP) reached a better-than-expected 6.9 per cent. But the analysts remain divided over China’s medium term economic outlook.

The debate about China’s growth slowdown since 2010 continues to rage. Some think that the drop in China’s growth rate is cyclical. Others believe that trend growth has shifted down a gear. Neither assessment pays sufficient attention to the structural shifts that the growth slowdown is making necessary.

The most important structural shift in China is that many of the industries — the labour-intensive manufacturing and resource-based heavy industries — that supported strong economic growth over the past few decades have lost their competitiveness. Exports and investment were the main drivers of Chinese growth, while consumption was relatively weak. New industries, such as services are not yet strong enough to provide the same momentum.

Can the ‘new economy’ offset the slowdown of declining industries and continue to sustain a relatively high rate of Chinese growth? Success in this transition will depend upon lifting technology and productivity in the new growth sectors in the economy.

Significant barriers stand in the way. At the Central Economic Working Conference in December 2016, the National People’s Congress in March 2017 and the Politburo meeting in April 2017, Chinese leaders warned about rising financial system risks.

In the past couple of years a range of financial market risks have emerged: in equity and bond markets, the explosion of shadow banking, in property markets, in digital finance and in foreign exchange markets. The Shanghai A-share Index rose from about 2,000 in May 2014 to 4,500 in May 2015, before collapsing below 3,000 in May 2016. The ratio of commercial bank non-performing loans has jumped by 75 per cent over the past two years. The property market has also gone through three cycles since 2009, of growing amplitude. There are also risks of capital flight and currency depreciation. The prevalence of these risks across the financial sector is a signal of systemic problems.

China remains the only major emerging market economy that has not experienced a serious financial crisis, protected by continued rapid economic growth and government guarantees.

It will be increasingly difficult for China to maintain that no-crisis record. China’s current macroeconomic conditions look more and more like what the Bank for International Settlements calls the ‘risky trinity’: rising leverage ratios, declining productivity and shrinking policy flexibility. These trends might make the government less able to contain financial risks than in the past.

The growth slowdown and structural shifts have led to a significant deterioration of corporate balance sheets and produced large numbers of zombie firms that that are stopped from dying and continue to waste resources. Zombie firms are at the heart of China’s current economic problems: they impede industrial upgrading, lower financial efficiency and increase financial risk.

How can the government maintain its no-crisis record?

Since July 2016, President Xi Jinping has advocated pushing ‘supply-side reform’. Although it’s not always clear what this is supposed to mean, supply-side reform implies prioritizing measures to lift productivity rather than measures to pump up demand. The objectives of supply-side reform are to help achieve growth sustainability and maintain financial stability. On the former, the key is promotion of industrial upgrading — letting go of old industries and developing new ones. On the latter, the key is to get financial risks under control — by eliminating old risks and containing new ones.

The most important government priorities are letting market discipline have its way and improving financial regulation.

The trickiest issue is how to deal with zombie firms. Some zombie firms, which enjoy underlying competitiveness but suffer from temporary market setbacks, need measures such as issuing shares to management, encouraging mixed ownership, forcing mergers and acquisitions and debt–equity swaps may solve the problem. But for others, bankruptcy is the only option.

The framework of financial regulation needs to be revamped to preserve financial stability. Regulators are not really independent, so their primary responsibility for financial stability is often compromised by other policy considerations. Regulators also lack an effective coordination mechanism because of fragmentation of authority, which often leads to regulatory overlap or regulatory vacuum. Macro prudential regulation remains immature and needs significant improvement to contain systemic financial risks.

Despite uncertainty about recovery in property markets and manufacturing investment, there are two important reasons for optimism despite all China’s economic problems.

The growth outlook has brightened somewhat in the industrial economies, especially the United States, Japan and the European Union, and that could lead to increased demand for China’s exports. And as Chinese leaders emphasize the importance of stability ahead of the Party Congress this coming November, local governments are strongly motivated to support growth. The Chinese economy will likely achieve its 6.5 per cent growth target in 2017, even if some of the downside risks materialize. But in the medium term meeting growth targets won’t suffice; getting tough on structural reform will be the only way to cut through in resolving China’s mounting economic woes.

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