This study is first and foremost an assessment of the existing situation. Numerous reports have been written regarding the imbalances in the Chinese economy. Here, our aim is to offer a broad overview of the majority of the interlinked issues involved – economic, financial, social, political and geopolitical. From this analysis, we have set out the most widely accepted proposals. We are perfectly aware that the majority of them stem from the liberal approach currently favoured by most economists and multilateral organisations. We have also attempted to set out the reasons behind the political decisions made by the authorities and highlight the dilemmas they face.
The recommendations made in this report may appear liberal in nature. Although they are backed by reasoning, we cannot deny that they do partially reflect some of the themes of the Washington Consensus. It is understood that China will do everything it can to avoid remaining boxed into a liberal Western model, with the support of an ever-increasing list of BRICS partners (Argentina, for example, will probably join this club). China questions the instructions of the IMF and liberal economists (Joseph Stiglitz, who is very sceptical regarding the Washington Consensus, is one of the few Western economists to command respect in China). And yet, the IMF acknowledges the errors in the Washington Consensus and the virtues of the Chinese model for the early stages of development. Consequently, the recommendations in this report do not dispute what has been achieved through this “highly regulated and administered” Chinese approach. Its objective is rather to set out a road map for the next stage, for the transition from an emerging economy to a developed economy, seeking to become a coherent and stable part of the mechanisms of international finance. Lastly, it offers some solutions for situations when the degree of imbalance means that state interventionism is no longer sufficient. As financiers say, you can’t fight the tide. The legendary American investor Warren Buffet joked that “Only when the tide goes out do you discover who’s been swimming naked” (meaning those whose investments are insufficiently diversified and vulnerable to risks). Diversification in political and economic approaches can only ever be a good thing.
Balancing the sources of growth
China’s unprecedented successes – 9% annual GDP growth since 1978, 800 million people lifted out of poverty, the world’s highest GDP in real terms and second highest in nominal terms – are the result of economic governance that has been acknowledged by analysts and financial strategists. And yet, over the last ten years, behind these positive results have developed major imbalances which the government’s interventionist approach will have to tackle.
If it is to overhaul the country’s economic structure and achieve more balanced and inclusive growth, the Chinese government has numerous challenges ahead of it. It is against this backdrop that this report intends, after setting out the current state of Chinese growth and in particular its imbalances, to provide a broad overview of the interlinked issues involved and to develop avenues through which China could achieve a positive outcome. Chinese imbalances impact the world as a whole, not only through trade and the knock-on effect on global growth, but also because of the way the jolts – or worse – it experiences affect global finance.
What financing problems is China experiencing?
Firstly, its total debt is unusually high for a middle-income country. It currently stands at over 300% of GDP (against an average of 192% for emerging markets). But beyond its level, it is the composition of the debt that raises questions. Corporate-sector debt is particularly worrying as it equates to more than 160% of GDP. These record levels of debt go hand in hand with a spectacular increase in the value of defaults (failure to repay) on debt instruments. The Chinese government is working to bring the necessary stabilisation to the market. Similarly, bank debt remains high, at almost 180% of GDP (compared to an average of 70% across other emerging markets). The government’s lack of transparency regarding the conditions and the sharing of any losses, and the fragmentation of the banking system as a whole, are a concern for the IMF and the rating agencies.
Secondly, the property sector, a pillar of the Chinese economy (30% of GDP) continues to deteriorate. The concern is that the country relies on it as an economic stimulus, because of its numerous knock-on effects. China has 50 ghost towns and 64 million empty apartments, and the property giant Evergrande is facing potential bankruptcy. The absence of any clear reaction from the Chinese government on Evergrande demonstrates the authorities’ uneasiness regarding the sector, which appears to underpin the financial and social fabric of China. Property investments are popular with Chinese households as a way to optimise their pension capital, leading to overinvestment in the sector and apartments purchased as financial investments left standing empty. Consequently, were the financial bubble to deflate too rapidly, the pension system would be pushed off balance, forcing households to save even more and spend even less. All in all, the side effects of a crisis originating in the property sector may lead to a lasting lack of overall demand, causing the economy to suffer embedded unemployment and a permanent fall in output.
Thirdly, capital flight is a worrying trend. Although Chinese household savings are constantly increasing (around 42% of GDP in 2021) and will soon account for half of global household savings, the Chinese growth model remains paradoxically dependent on foreign capital. In fact, Chinese investors are increasingly seeking to buy foreign assets. This capital flight, which has reached a very high level since 2014, has been a factor in reducing household savings and consequently the country’s official reserves. Between 2010 and 2020, China’s foreign exchange reserves fell from 20% of GDP to 10%. The Chinese authorities consider the influx of foreign capital as a solution to the pressures caused by capital outflows, which avoids excessive reliance on the sale of accumulated foreign exchange reserves. But this capital flight is becoming increasingly structural, and foreign capital inflows increasingly volatile.
What are the economic policy recommendations to get the country out of its economic and financial rut?
On the basis of this study, the following elements have been identified as priorities:
- Break free from the middle-income country trap.
- Escape the debt trap.
- Keep the growth of credit under control.
- Stabilise the ever-expanding shadow banking system.
- Cut the dead wood from the property sector.
- Deal with the environmental issues that cost the Chinese economy several billion dollars every year (desertification, sandstorms, etc.).
- Limit fraud and corruption. This important topic has already been tackled but consolidation is needed now that the current government looks set to stay in power, with Xi Jinping potentially president for life.
1. Break free from the middle-income country trap
Although China has reached an advanced stage of development, the country’s economy still relies mainly on manufacturing, property and raw materials, with too little focus on high-value-added service sectors such as financial services and insurance. A pivot towards these new growth drivers would enable China to break free from the middle-income country trap (World Bank). This is however a difficult thing to achieve, because the primary and secondary sectors are managed by the state through a regulatory framework, with economic financing set centrally by the Politburo of the Chinese Communist Party (CCP), which tends to focus on the sectors historically most apt to provide jobs and growth, in particular manufacturing, energy and property.
Recommendation: (already expressed by the government, but to be tackled as a priority) separate the private and public sectors more distinctly to encourage the development of services (which are often organised in a more “liberal” manner than industry), give more prominence to innovative SMEs, overhaul finance (put an end to the “pawnshop” approach) and subject non-bank financial institutions to stricter regulation.
At the present time, it appears necessary for China to refocus and rebalance its growth model, which is currently slowing due to structural constraints, in particular a fall in population growth, lower returns on investment and stalling productivity.
2. Stimulate domestic consumption
To this end, the key means of stabilising growth and making it self-perpetuating regardless of production costs and the population’s standard of living would seem to be stimulating domestic consumption. This also involves a major challenge: the proportion of domestic consumption within wealth created in the country is very low, at around 40% to 50% of GDP depending on the sources consulted. This lack of demand is mainly explained by the population’s propensity to save and by low wages. China’s gross savings rate is very high at 45% of GDP, mainly due to an ageing population and doubts about pension system sustainability.
Recommendation: domestic consumption should be boosted in a progressive and sequential manner, in tandem with a reduction in investment to avoid causing even higher levels of debt.
3. Escape the debt trap
Consumption remains less significant than investment within the components of Chinese GDP. Investment does not dominate in the same way in developed countries.
Recommendation: implement an efficient solution to the corporate debt issue: classify receivables, recognise losses, share the burden, strengthen the legal framework around insolvency, facilitate the transition out of unemployment and active policies to combat it, widen unemployment benefit coverage, facilitate market entry and improve local government financing.
4. Use foreign capital to finance debt
One of the solutions envisaged by the Chinese government is to develop the bond market further, by widening the investor base currently mainly made up of domestic institutional investors to include international investors. It thereby hopes to keep the lid on interest rates despite the overall level of debt, as incoming bond investments will serve to support official reserves. To attract this international investor base, it will be necessary to improve the transparency, liquidity and above all taxation of renminbi-denominated bonds. China has made major progress in many of these areas, but is still struggling with certain transparency issues, unconditional free movement of capital and interest rate liberalisation. Of course, one of the consequences of internationalisation will be deeper integration with global markets, meaning that shocks will be transmitted more easily between China and the rest of the world (in both directions).
Recommendation: Chinese financial markets need to encourage more international portfolio investments. This must be achieved through:
– Independent legal institutions.
– Clarification of creditor rights.
– Standardisation and transparency of financial and non-financial (sustainability) reporting standards.
– Prudent regulation of financial market players.
– More cautious and gradual classification of the risks linked to financial assets.
– Active market makers to ensure sufficient liquidity.
– Clear requirements as regards information.
– Independent rating agencies (the Dagong agency’s methodology remains bewildering and lacks transparency).
– A progressive liberalisation of Chinese interest rates.
– A withdrawal of the Chinese government from credit allocation interventions.
– A need to maintain, or even restrict, currency inflows and outflows, due in particular to the ongoing exchange rate volatility.
5. Tackle population decline
At the same time, China is facing a significant decline in its population. In 2022, the population of China fell by 850,000. It has already been overtaken by India as the world’s most populous country, and numbers could reduce very quickly, to drop below the one billion threshold by 2060. The fertility rate has been falling since the 1970s and is now at a very worrying level of around 1.16 children per woman in 2021. The causes are the very high cost of education and childcare, and social pressure regarding extracurricular activities. A drop in the population of this magnitude will have at least a triple impact on the Chinese economy: 1) colossal government spending, to encourage couples to have more children (subsidies for education, preferential mortgage rates, tax relief, equal parental leave for both parents and construction of childcare centres), 2) lower production capacity, leading to a mechanical fall in exports and therefore a fall in the foreign currency income which is necessary to counterbalance the structural capital outflows and capital flight, and 3) an inability to fund the social pension systems due to the ratio of retired people to the working-age population, compounded by low diversification in the financial system and savings bogged down in sectors of the economy suffering payment defaults (property, etc.).
Recommendation: tackle the crucial demographic issue. Measures need to be taken to counter the excessive cost of education and housing, which are a result of extremely strong urban pressure and a property sector which remains too inaccessible. China must continue its multidimensional pro-birth policy by making massive use of financial subsidies (raise allowances, subsidise extracurricular activities, extend maternity leave and add paternity leave) and media strategies to rebuild the positive image of large families, including in urban settings. The internal migration that is sometimes mooted remains a purely political question.
6. Increase the Potential for Growth
The fall in the Chinese working population (down 1.5% in 2021), lower growth in productivity gains and weaker potential for economic growth (that does not generate imbalances, inflation-stoking overheating or debt) at around 2% to 2.5% have reduced the country’s economic attractiveness for numerous multinationals. To boost its potential for growth slightly, China needs to modernise and optimise its use of resources and at the same time upgrade its production processes by developing automation and tapping into synergies to achieve economies of scope and network effects.
Recommendation: China should therefore:
– Accelerate the dissemination of advanced technologies and existing innovations.
– Encourage entrepreneurship and start-ups.
– Invest in human capital and make support for innovation and entrepreneurial spirit more targeted.
– Optimise the management structure of businesses.
– Put in place antitrust legislation to cover groups in dominant positions.
– Reinforce competition in markets for products and factors of production and ensure fair competition for all investors.
– Eliminate zombie companies that no longer have the funds to invest, train staff, innovate, etc.
7. Tackle the country’s economic and social challenges
Chinese people are irritated or concerned by slowing growth, the numerous wealth inequalities within the country and concerns regarding the pension system, the perceived inadequacy of public services and the relatively high level of public-sector corruption. Signs of social opposition mushroomed during 2021 and 2022, in particular in opposition to the government’s Zero Covid policy, since abandoned.
Recommendation: to respond to the population’s social concerns, China could:
– Continue to explore supplementary pension systems.
– Make the healthcare system, and in particular treatment for young children, more financially accessible.
8. Ensure the country’s economic model is sustainable as it becomes more integrated into global financial markets
Over the last few years, China has put the accent on the fact that it shares a land mass with both Asia and Europe, with the New Silk Road project which involved over 40 countries and included overland as well as maritime trade corridors. In parallel, China organised a sort of “non-Western front” when it founded the Shanghai Cooperation Organization in 2001. It is therefore ploughing considerable sums into all-in-one turnkey infrastructure projects including financing, design, accelerated implementation, engineering, staff training, operation-ready infrastructure, on-time delivery, etc. This model is very attractive for numerous poor and developing countries because no other country or international organisation is capable of providing comparable services. Through this, China has become the planet’s leading creditor, ahead of the FMI, the World Bank and the Paris Club. And yet, slowing domestic Chinese growth suggests that this external investment will slow, and a rigorous or even severe collection programme will be put in place to recover money due from debtor countries.
Alongside these financial claims on developing countries, China is simultaneously becoming financially dependent on FDI (foreign direct investment) from the West, despite the diplomatic tensions between Beijing and for example the US and Australia.
Recommendation: it is now more important than ever for China to reinforce its economic fundamentals to ensure the stable circulation of international capital and encourage growth which will lead to balanced economic development.
