Why China's Economic Problems May Be Worse Than We Think

China's authoritarian leaders must enact deep reforms, not just stimulus. It is not clear if they are willing to do that.

Chinese president Xi Jinping is leaving behind a struggling economy as he visits the United States this week. That is worrying leaders of other countries that do business with China, including the United States, and is sure to be a topic of discussion when Xi meets with President Barack Obama on Thursday.  

China’s trading partners have good cause for concern: Whether China will emerge from its current challenges stronger, hobble along or enter a free fall is largely up to China’s authoritarian leaders. They must enact deep economic reforms that will increase competition, transparency and rational allocation of resources if China is not only to revive its growth, but also to do so sustainably. And it is not at all clear that Xi or the country’s other decision-makers are willing to make those changes. 

The Chinese economy is not in recession, but its growth has slowed considerably in the past two years, and shown especially troubling signs in recent months. China’s economy is on track to grow 7 percent in 2015, according to official Chinese government estimates. Most Western analysts believe that the real rate will be slightly lower. (Some observers argue that it will be much lower, dropping to 4.5 percent or less.) 

An expansion rate of 7 percent is much higher than the growth typically enjoyed by developed nations. The U.S. economy, for example, has been growing at around 2 percent since 2010. But China has depended on consistent, near double-digit growth to lift 500 million people out of poverty since 1978 -- and it still has at least 100 million people living in poverty.

And since China is the world’s second-largest economy, after the United States, even modest declines can have a significant negative impact on economies across the world. China’s slowdown has had the gravest consequences for countries like Brazil, Argentina, Chile, Canada and Australia that relied heavily on China’s demand for their commodities.

The U.S. has not been immune to these trends. Concerns about China’s downward trajectory and its impact on emerging markets like Brazil prompted a sell-off on the U.S. stock market in August. The Federal Reserve cited concerns about China fallout in its decision not to raise interest rates last Thursday. 

The immediate cause of China’s deceleration is the normal business cycle. China’s economy is not growing as rapidly because foreign demand for its exports has slowed down. The country’s manufacturing sector hit a three-year low in August. 

To some degree, a slowdown of this kind is inevitable as China hits a point of diminishing return that many maturing economies face. “China has become a very large economy,” said Nicholas Hope, a China specialist and director of the Stanford Center for International Development. “It is hard to keep growing at 10 percent.”

Workers produce electronic products in Dongguan, Guangdong province of China. Chinese manufacturing has been performing
Workers produce electronic products in Dongguan, Guangdong province of China. Chinese manufacturing has been performing poorly of late.

A common analysis of the deeper causes of China’s economic troubles is that it's in the midst of a painful transition from an investment and industrial export-driven economy to a service and domestic consumption-driven economy. If it could make up for its industrial losses with a commensurate increase in the high-value service sector and domestic demand for its goods and services, it would be on a solid path for the future. 

While that is indeed the transition China must make, it is really only one manifestation of China’s need to become a less state-controlled, more competitive economy. Services generally make up a larger share of GDP than manufacturing in advanced economies, because as wages and living standards rise in these countries, industrial production becomes less competitive. Wealthier, more educated citizens become better poised to provide professional services.

In a relatively liberal economy, capital would force such a transition naturally, rewarding competitive businesses with investment and withdrawing from others. 

But the Chinese government’s intervention has distorted market forces to the long-term detriment of its economy. Since 2008 in particular, China’s central and provincial governments have inflated China’s manufacturing and construction sectors far above their market value, investing or backing investments in factories, roads and housing that rarely reflected real market demand for goods and services -- or in the case of infrastructure, a genuine public need. 

Rather than market forces, these investments are often motivated by patronage or political considerations. Normally a bank would only lend to a viable business, Hope said, but “China gets around that constraint by having powerful local officials request a bank loan for a local enterprise.”

New residential buildings in Chongqing, China. China has experienced a construction boom in recent years that many observers
New residential buildings in Chongqing, China. China has experienced a construction boom in recent years that many observers believe is outstripped demand for homes.

As a result, China’s economy is weighed down by a vast oversupply of manufacturing, construction and real estate infrastructure. 

“They have already built too many bridges to nowhere and they have an overhang of real estate debt,” said Diane Swonk, chief economist of Mesirow Financial.

When the economy began cooling in 2014, the government fostered a stock market bubble to offset corporate losses, encouraging China's new middle class to invest their savings in stocks. But that bubble too has since burst, erasing trillions of dollars in wealth.

Inefficient state-owned enterprises also dominate industries like telecommunications and petrochemicals that would otherwise be more competitive, creating a drag on economic growth. 

The Chinese government appeared to recognize the need to liberalize its economy when the Central Committee of the Communist Party of China met for its third annual plenum in November 2013. 

But few of the recommendations that emerged from the plenum have been implemented. The government and private banks alike continue to finance projects that do not fill a clear need. Not many state-owned enterprises have been privatized or streamlined. And to make matters worse, there is a dearth of reliable information about those companies’ and banks’ finances.

“Banks are slowly developing a backbone,” Hope said. “As the economy slowed down though, I was disappointed they were continuing to fund projects that were not worth it.”

Plainclothes policemen guard in front of Tiananmen Gate outside the Great Hall of the People where the Communist Party's 205-
Plainclothes policemen guard in front of Tiananmen Gate outside the Great Hall of the People where the Communist Party's 205-member Central Committee gathered for its third annual plenum on Nov. 12, 2013, in Beijing.China's leaders pledged major reforms to liberalize the Chinese economy at the meeting, but they have yet to put many of them into practice.

Hope believes there is disagreement within Communist party leadership as to whether to liberalize the economy more, or preserve state-owned enterprises and a government-driven financial system.

He is nonetheless confident that the Chinese government has enough tools at its disposal to reinvigorate the economy in the short term by boosting demand. The Chinese government has already cut interest rates several times in a short period, even as it depletes its sizable foreign currency reserves to prevent the value of the yuan from dropping too much. China has also spent $236 billion purchasing stocks over the summer to keep prices high.

If the situation gets worse, Hope notes, the government can engage in fiscal stimulus through public spending projects to boost domestic demand for China’s goods. 

But if China only stimulates demand the way it has in the past -- by funding bogus infrastructure and housing projects -- without liberalizing its economy, it risks laying the groundwork for yet another bubble. A series of fiscal stimulus measures designed to offset a decline in foreign demand after the 2008 financial crisis contributed to the bubbles afflicting China today.

“You have the problem of the urgent being the enemy of the important,” Hope said. “I’d rather see them forgo some growth and focus on important reforms.”

CORRECTION: A photo caption in an earlier version of this story misidentified the Tiananmen Gate.