HONG KONG – With China's economic slowdown more apparent than ever, its
prospects of avoiding a hard landing are weakening. Whether policymakers succeed
will depend on whether they can navigate the challenges stemming from an
increasingly divided dual-track economy.
The latest year-on-year data, from January, highlight the danger. The consumer price
index dropped to 0.8%; the producer price index fell by 4.3%; exports contracted by
3.3%; imports were down by 19.9%; and growth of broad money (M2) slowed by
1.4%.
Moreover, the renminbi has come under downward pressure, owing partly to
economic recovery in the United States, which has fueled capital outflows. Given
huge declines in industrial profit growth (from 12.2% in 2013 to 3.3% last year) and in
local-government revenues from land sales (which fell by 37% in 2014), there is
considerable anxiety that today's deflationary cycle could trigger corporate and local-
government debt crises.
China hopes to secure its long-term economic development by shifting from a state-
directed to a market-led economy. But the process has created significant
discrepancies in economic performance, with state-owned enterprises (SOEs)
performing significantly worse than their private-sector counterparts, despite having
better access to credit. And there is a widening disparity between real-estate prices in
China's thriving first- and second-tier cities and its lagging third- and fourth-tier cities
(though higher household incomes in the former make housing there more affordable).
The authorities' task now is to determine how to support continued growth on the
better performing track (the private sector and the first- and second-tier cities), while
eliminating overcapacity and boosting productivity on the weaker track (SOEs and
third- and fourth-tier cities). To succeed, they must address the fallout of the previous
approach, which, by providing more money and preferential policies to the lagging
track, ended up fueling overcapacity and unsustainable local debts.
In other words, China must confront the sunk costs of bad local-planning decisions.
Instead of continuing to hope that bureaucratic intervention can repair flawed
projects, officials should take a market-based approach, allowing losses to be
allocated through the bankruptcy process, thereby enabling all stakeholders to move
on to more productive activities.
The Chinese economy's dual-track structure also presents unique challenges for
macro-financial management. As the fast-growing sectors absorb an increasing
amount of resources, a shift toward more market-oriented interest rates is needed to
ensure efficient allocation. Meanwhile, the slow-growing sectors risk falling into a
“balance-sheet recession," with highly indebted SOEs and local governments
becoming so focused on paying down their debts that they stop investing in needed
infrastructure, even when interest rates fall. As a result, conventional monetary and
macro-prudential policies are caught between competing demands for credit, with one
track needing to support productive growth and the other attempting to buy time for
restructuring.
The People's Bank of China (PBOC) has attempted to confront this dilemma by
differentiating reserve requirements according to sector or type of financial institution.
The results have not been encouraging.
For example, when the PBOC cut its benchmark interest rate last November, in order
to help reduce private-sector borrowing costs, it triggered a speculative stock-market
boom. Following January's disappointing macroeconomic data, the PBOC acted
again, by lowering the reserve ratio for banks by 50 basis points, with additional cuts
for banks focused on small and medium-size enterprises (50 basis points) and for the
Agricultural Development Bank of China (400 basis points). Despite these efforts,
neither track seems satisfied that their credit demands are being met.
Efforts to address these structural challenges are being frustrated not just by
institutional barriers, but also by entrenched official corruption. The problem is that
anti-corruption measures, despite enjoying broad public support, undermine
bureaucratic effectiveness in the short term – a significant issue in a critical reform
year, especially given slowing growth.
Institutional reforms aimed at combating corruption, reducing overcapacity, and
dealing with unsustainable local debts will generate long-term dividends and
sustainable payoffs. But short-term stimulus measures, such as tax cuts and higher
fiscal deficits, will be needed to minimize growth disruptions. This would mean
reversing the recent decline in the government budget deficit, which narrowed to
1.8% last year, from 2% of GDP in 2013.
The transition from a dual-track economy to a market-based economy will not be
easy. The Chinese economy is clearly in urgent need of repair. But the news is not all
bad: a substantial portion of the economy continues to expand, underpinning much
higher overall growth rates than in most other economies. Moreover, despite some
concerns about capital outflows, China's consolidated net foreign-asset position,
which stands at $1.7 trillion (17.6% of GDP), remains sufficient to sustain China
through this tough transition.
China's leaders recognize the long-term imperative of serious institutional reform,
even as concerns about slowing growth heighten the temptation to embrace short-
term fixes. The authorities are taking strong action to curb pollution, improve energy
efficiency, implement pension reform, and expand access to health care and low-cost
housing.
More immediately, China's leadership is committed to excising the cancer of
corruption. The key, as with any critical surgery, is to ensure that the necessary life-
support systems are in place. In China's case, that means maintaining adequate
liquidity.
In the end, sustainable development will require that China's two economic tracks
merge. With the right approach, relatively stable and rapid growth can be maintained
throughout the reform process. Avoiding a hard landing would be good not only for
China; it would ensure much-needed growth and stability for the global economy.
A version of this article appeared in Project Syndicate, 26 February 2015
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