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  • Writer's pictureSteve Coker, CFP

China at Crossroads


As most of the press focuses on the US economic growth, fueled by Trump’s expansionary policies and tax reductions, it is important to remember that, although critically important, the US is still only a part of the global economic story. In fact, even with the higher US growth outlook, the United States only represents about 10% of projected global growth. It is emerging markets that represent a full 40% of global growth, with China specifically generating 30% of expected growth in the world.

It is with this as a backdrop that we take a moment to reflect on what is happening in China. As we have written in the past, China’s controlled economy presents policymakers with a bit of conundrum. While the ultimate goal of Chinese policymakers is to reform the debt-fueled, investment-driven economy, Chinese officials also must avoid downturns that could result in social instability. As a result, the Chinese business cycle can be seen as a balance between policy maker’s long-term reform goals and short-term economic and social stability.

Because of the control that the state has on the economy, policy actions are critically important to any China growth outlook. Unlike the US, which has a consumption, consumer-driven economy. China’s economy is largely investment-driven and fueled largely by government debt. You can think of the comparison this way: the US economy is driven by how much consumers spend on cars, computers, and cell phones, whereas the Chinese economy is driven by how much the government loans out to build airports, apartments, and factories. Chinese officials control the level of investment by setting quotas for loans, primarily made to state-owned enterprises and local governments for the execution of these investment projects.

The problem is that loans made by the Central Government to state-owned enterprises (‘SOE’) or local governments are ripe for abuse and inefficiency. Since 2007 total non-financial debt-to-GDP has risen from 145% in 2007 to 255% by 2016. The rapid rise in debt was the result of China encouraging state-owned enterprises to initiate large-scale investment projects to prop up the economy coming out of the 2008 crisis. As a result, state-owned enterprises took on large amounts of debt to develop projects that have questionable benefit. It is estimated that a full 30% of state-owned enterprises operate at a loss and therefore loan losses are rising.

Therefore, it appears that China is at a bit of a crossroads. China’s growth has been fueled by massive debt accumulation and is not sustainable at the historical pace. Already China’s growth has slowed from the 7% - 12% pace of the last 30 years to a 6% growth rate and is projected to go lower. When China first entered the World Trade Organization, its cheap labor and pro-business regulation allowed it to quickly emerge as the “world’s factory,” and exports became a primary part of the country’s growth. However, since the Global Financial Crisis, annualized export growth fell from 27% to 4% as China’s labor costs rose, and competitiveness waned.

Meanwhile, China’s central government still has massive amounts of reserves that it can use to help smooth the transition while reforms take place. If policymakers are able to balance the near-term pain of reform and the long-term benefit of reform, China may be able to navigate a smooth rebalancing with the needed reform. While a smooth landing is the most likely path, we are entering a period of heightened risk for China. If policymakers are too slow to reform then China risks a period of Japanese style stagflation caused by inefficient allocation of capital. If policymakers are too quick to reform they could cause a hard landing and economic crisis.

McVey, Henry. “Asia Pivot Required” KKR Global Perspectives. March 2017. http://www.kkr.com/global-perspectives/publications/asia-pivot-required

Wang, Qian; Wu, Jessica; Odenwalder, Zoe. “Navigating the transition: China’s future at a crossroads”. March 2017. https://institutional.vanguard.com/iam/pdf/ISGCHI.pdf?cbdForceDomain=true

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