Divided

In the first half of the year, China’s economy sustained steady growth. The nominal growth rate, which does not take price changes into account, had been creeping up for several quarters in a row. This is thanks partly to the domestic supply-side structural reform, and also to improvements in the world economy. 　

However, deep problems in China’s economy linger, and have become evident in very different ways across many facets of the economic operation, showing increasing divergences within the economy. 　

Prices as measured by the consumer price index and producer price index have rebounded fast since 2016. As a result, nominal GDP growth accelerated. It reached 8 percent in the fourth quarter of 2016, and 11.8 percent in the first quarter of 2017, the fastest since the first half of 2012. By contrast, price-weighted real GDP did not grow as fast as the nominal rate. It hovered at 6.7 percent during the last three quarters of 2016, and went up slightly to 6.9 percent in the first quarter of 2017. It means the nominal price increase has not been fully turned into real GDP growth. 　

Historically, a price hike is a precursor to real GDP growth. This is because price hikes typically generate more revenue for companies and strengthen their financial position. Investment and consumption are then boosted, and the two demands stimulate production output – the real GDP. However, in this current cycle, real production output may lag farther behind the nominal output. When such a gap peaks, the upward growth trajectory begins to go down. This is why the nominal GDP increase being much faster than the real GDP growth may indicate the end of this round of economic rebound. 　

Meanwhile, external demand is getting stronger as a driving force for growth. The global economy, particularly that of the US, is recovering, and growth prospects have improved. In the first half of 2017, China’s exports grew faster than widely expected, which boosted domestic industrial production. In the first quarter of 2017, the driving force of the US and European economies was shifting to investment from consumption. The strong investment there bodes well for China, the world’s largest exporter of capital goods which are used for production. Chinese exporters of mechanical and electronic products will benefit from this.  　

This may not last long. China has nearly completed its quest of winning orders from other suppliers on the developed market. Now China’s share of the developed market is no longer expanding as fast as before. New opportunities from tapping emerging markets cannot make up for the loss of momentum in developed markets for China. The long-term trend is that China’s export growth will slow. The contribution of exports to China’s growth will be much more limited than it was between 2003 and 2008 [when China, as a new WTO member, enjoyed fast rising exports to developed markets whose demand was driven by strong economic growth]. 　

Investment in infrastructure and real estate will be restrained to some extent by existing policy. It is not certain how much the private investment sector will recover, but it is not very likely that it will be strong enough in the short term to make up for China’s shrinking infrastructure and real estate investment. Fixed asset investment as a whole is under pressure. In terms of consumption, the constant slowdown of residents’ income does not support strong consumption growth. 　

Our conclusion is that China’s economy reached another rock bottom between the end of 2016 and early 2017. It has stabilized there despite some fluctuation. The GDP growth for the whole year of 2017 is forecast to be about 6.7 percent, with inflation, measured by the consumer price index, at two percent. 　

The biggest issue to be addressed in China’s economy is structural dilemmas. The policy has tightened. This could make it even more likely for risks built up during the economic downturn to be unleashed. New problems are emerging during the period when conventional engines are weakened and new ones are gaining ground. As a result, additional earnings brought about by higher prices can hardly generate as much investment and consumption as expected, and long-term productivity declines. 　

There are several underlying factors that have caused the problems. The first and largest one is the high debt ratio. Chinese enterprises have accumulated massive debts to drive their business expansion. Once the monetary policy is tightened, much of the additional revenue earned from price hikes has to be spent on debt repayment which has become more expensive. Investment is not an option. This is exactly the case in China at present. 　

Secondly, the “virtual economy” has been siphoning off too much money in recent years. A huge amount of capital is moving within the financial sector and sloshing around the stock, bond and real estate markets. Successive asset bubbles have been created. The situation is particularly severe in the real estate sector. While real estate investors have got more bank credit, investors in the real economy have got less. In addition, households have to consume less when they have borrowed a lot to buy housing. 　

Thirdly, investment by central State-owned enterprises is quasi-fiscal spending in nature. It has crowded out local private investment. In the more developed eastern areas, central SOEs’ investment has attracted local private investment. The opposite happened in the less market-oriented western areas. This seems also to be the case in smaller places which are at much lower administrative levels themselves than the central SOEs in their midst. 　

Fourthly, the old model of reform does not work any more. Local governments were empowered to try reforms to compete for GDP progress. This cannot be applied to the “new normal” which focuses more on the quality than speed of growth. 　

Fifth, the potential for foreign trade expansion has been shrinking, which in turn has restricted the progress of technological development. By integrating into the world market, China has gained access to new technologies and management expertise which contributed a great deal to improving China’s productivity and narrowing the technology gap between China and advanced economies. However, it will be more difficult for China to expand on the world market as it has already become a major trader. This decreased the potential of technological progress. 　

Finally, declining productivity has pushed corporate costs higher. China’s manufacturing enterprises still lag behind major developed countries in terms of labor productivity. Given that labor shortages and labor cost increases have intensified, Chinese producers face the risk of losing their existing advantages and market share. 　

In this context, the tasks set by the central government – removing overcapacity, reducing excessive inventory, decreasing debt ratios, lowering corporate costs and strengthening any weak points – is the prescription for tackling urgent supply-side problems. 　

China’s long-term reform must be based on “one key and two pillars.” The key is to reshape the relations between the government and the market. The old relations resonated with the old growth model which was driven by investment in labor and capital. New relations must facilitate innovation, the new growth dynamics. 　

One pillar is to adjust the relations between the central and local governments, particularly in terms of the fiscal system. The other pillar is the ownership reform of SOEs which encourages private investors to hold stakes in SOEs. 　

These reforms are expected to fix the blocked channels in the economy and improve productivity. Success of the reforms in the context of the “new normal” depends on the following conditions. 　

Firstly, a GDP race should not be used as an incentive for local governments. In the “new normal,” the quality of growth is regarded as more important than its speed. Quality is assessed by various indicators other than speed alone. In the pursuit of speed as the only standard, local governments would compromise other development goals, such as the environment, as they did in the past few decades. 　

Secondly, the central government has to lead this round of reform. As quality-oriented growth involves many more goals, the priorities of these goals will vary nationwide, and have to be decided by policy-makers at the top level, taking into consideration of the national overall development goal. 　

Thirdly, stricter scrutiny has to be put on local governments’ implementation of reform policies set by the central government. 　

Fourthly, the Central Leading Group for Deepening Overall Reform of the CPC Central Committee needs to play a bigger role in coordinating jobs between different ministries and between different places, if one or multiple ministries are responsible for a particular reform task. This coordination can be a part of the routine operation of the Group. 　

In the short term, proper fiscal and financial policies are necessary to provide time and space for the new round of reform. Better fiscal policy can be designed to boost growth. High debt ratios, the biggest problem choking the economy, must be reduced. However, if regulators rush to compete to wield their sticks on the market during the process of deleveraging, there is a risk of triggering a systematic financial crisis. This has to be avoided by coordination at the higher level. 　

When drafting monetary policies in this period, more attention has to be paid to changes in market interest rates. In fact, the process of making market interest rates the benchmark rates can be accelerated.　
　
The author is professor and researcher at the National Academy of Development and Strategy of Renmin University of China