China’s Balancing Act

Fortunately, demographic changes are about to make it easier to rebalance the economy and boost employment enough to avoid social tension. The Chinese working-age population is now slowly shrinking. More dramatically, the number of 15-30-year-olds from 2015 to 2025. The rural workforce is still above 300 million, implying that large numbers could still migrate to urban areas. But as the rural workforce ages, the pace of migration will slow.

As a result, China’s labor market will tighten more rapidly than many expect. Rising real wages will support the shift to a more consumption-driven economy, and declining worries about unemployment will reduce reliance on credit-fueled construction to soak up labor supply.

But the huge debts created by the credit boom remain a major problem. No other economy has ever experienced such a boom and avoided a financial crisis or major growth setback. Optimists often stress two ways in which China is different. First, many debts involve different arms of the Chinese state – owed, say, by state-owned enterprises (SOEs) and local governments to state-owned banks.

Second, China’s central government has – only 22% of GDP at the end of 2013 – and thus significant fiscal firepower. With the financial sector facing a large volume of non-performing loans, the government could repeat what it did in the late 1990s, absorbing bad debt and recapitalizing banks, rather than allowing defaults and bank failures to shock the economy into recession.

But, though China enjoys more room for maneuver than other countries facing similar credit booms, the risks remain serious. The bad-loan problem may be most severe among SOEs, but slightly more than half of new business loans since 2010 have been to the private sector, which plays in the troubled property market. And when property booms head south, efforts by companies and households to deleverage can undermine growth – even if banks are not allowed to fail. A balance-sheet recession does not require a financial crisis.

The more China achieves its stated objective of a decisive role for the market, the less the China is different argument applies. Interest-rate liberalization would increase borrowing costs for many over-indebted borrowers. A no-bailout rule for shadow banking entities would produce losses that hit confidence. The more the capital account is opened, the more China’s huge debts will be held by banks and other institutional investors around the world.

In an economy with inherited debts equal to 250% of GDP, simply tightening credit supply and imposing market discipline could be a recipe for disaster. Instead, China should use direct fiscal stimulus to offset the deflationary effect of declining credit growth and deleveraging. And it should clean up its banks’ balance sheets through debt write-downs and recapitalization before undertaking full financial liberalization.

China undoubtedly needs to rebalance its economy and introduce more market discipline in its financial system. Demography will give a helping hand with the former challenge. But without careful policy design and sequencing, there could be major setbacks along the way.

Adair Turner, former Chairman of the United Kingdom’s Financial Services Authority, is a member of the UK’s Financial Policy Committee and the House of Lords.

Copyright: Project Syndicate, 2014.