By Wang Yiming et al. ^①

Research Report Vol.19 No.6, 2017

I. China’s Economy at High Risk in the New Round of Economic Transformation

With the shift from high rate of growth to high quality of growth, China’s economy is now at a critical stage of changing growth model, improving economic structure and replacing old engines of growth with new ones. Profound changes have taken place in the pace, structure and drivers of economic development, ushering in a new round of economic transformation that surpasses previous ones in both scope and depth.

1. Main characteristics of the new round of economic transformation China has entered the new round of economic transformation against the backdrop of global economic slowdown, staggering growth in external demand, domestic overcapacity, high leverage ratios and major structural imbalances since the 2008 financial crisis. Therefore, this round of economic transformation is more complicated and arduous than ever before.

The new round of economic transformation is essentially a transitional period of economic development characterized by the shifts from high rate of growth tohigh quality of growth, from mid-to-late phases of industrialization to post-industrialization period, and from a middle-income economy to a high-income one. During this transitional period, the original growth model, economic structure and growth engines will be shaken up, periodic issues and structural issues will be interwoven, situational changes and institutional reform will influence each other, domestic conflicts and external impacts will interact with each other, and destocking pressures and incremental risks will be inextricably intertwined, posting serious challenges to economic transformation. China has seen growing risks in recent years, such as the money shortage in 2013, drastic fluctuations in the stock and exchange rate markets in 2015, surge of housing prices in 2016, and wide volatility in the bond market since the fourth quarter of 2016. This suggests that China has entered a stage prone to economic and financial risks.

Internationally, Japan, the Four Asian Tigers, Latin American countries, and the former Soviet Union and Eastern European countries either experienced serious economic crises or fell into the “middle-income trap” in the process of economic transformation. Some of them were even beset by social upheavals and regression. Only a few countries managed to cope with the risks and join the ranks of modernized countries.

Now and in the near future, China will remain at the critical stage of shifting to high quality of growth. Like in other economies, this period will see high risks as well as opportunities. To effectively prevent and deal with all kinds of risks and turn risks into opportunities is not only key to the success of economic transformation but also determines whether China can attain the goal of building a moderately prosperous society in all aspects and embark on the new journey of building a great socialist modern country in all aspects.

2. Factors associated with risks

It takes time for risks to form, accumulate and release. The evolution of risks depends on changes to the external environment and internal conditions as well, subject to the influence of both periodic factors and fundamental, structural and institutional factors. The main factors that influence the emergence of risks currently are as follows.

(1) The deceleration of economic growth brings to the fore the potential risks. Risks are often covered and hedged when the economy is growing at a high rate. As China’s growth rate dropped by nearly 40% to 6.7% in 2016 from 10.6% in 2010, the growth rate of corporate profits and fiscal revenue also saw a considerable decrease, and the risks of local government debt, heavily indebted state-owned enterprises, the real estate sector and the financial sector have gradually come to the surface. According to estimates in the research on economic and social development environment and strategies for 2030 by the Chinese Economists 50 Forum team, China’s economic growth rate will continue to decelerate for years to come, from lightly over 6.5% in recent years to the range of 5% to 6% between 2020 and 2030. The projected slowdown of economic growth will increase the pressure to address risks.

(2) Major structural imbalances give rise to risks. The period of economic transformation generally means that an economy is at the end of the long economic and technological cycle, when the space of achieving economies of scale relying on mature technology contracts significantly, the real economy suffers from serious overcapacity and structural imbalances, industrial profit margins decrease sharply, and a large amount of capital swarms from the real economy into financial and capital markets in pursuit of yields, leading to excessive prosperity of the financial sector and real estate bubbles. Currently, China’s major structural imbalances are mainly reflected in the demand-supply imbalance of the real economy, imbalance between the financial sector and the real economy, and imbalance between the real estate sector and the real economy. Such structural imbalances not only aggravate the accumulation of potential risks but also amplify the relevance and complexity of economic and financial risks.

(3) Lower investment efficiency leads to an increase in debt ratios. In the process of economic transformation, the heavy chemical industry in which investment used to grow rapidly is now grappling with overcapacity and a sharp reduction in investment efficiency. In 2015, the incremental capital-output ratio (ICOR) in China was 6.7:1, meaning that an increase of RMB1 in GDP requires an investment of RMB6.7, nearly 60% higher than that in 2010. With the decrease in investment efficiency, the expansion of investment and debt is inevitable in order to keep the growth rate above 6.5%. From 2010 to 2015, the total debt of the non-financial sector saw an average annual growth rate of 16.6%, about six percentage points faster than the growth of nominal GDP over the same period. The hikes in debt and leverage ratios, which even exceed threshold levels, will be definitely manifested in the release of various risks.

(4) The pro-cyclical market environment aggravates the accumulation of risks. During an economic boom, market participants, optimistic about future growth and revenue, tend to overestimate their debt tolerance, so the credit of the entire economy expands rapidly, creating a feedback loop of rising asset prices, expanding labilities and enlarging asset size. However, once the growth momentum of the real economy fades away, a cycle of falling asset prices, expanding debts and insolvency or liquidity draining will appear, and the stretched debt relationship will break apart in areas of weakness, causing all kinds of economic and financial risks. Meanwhile, the investment impulsion of local governments and the flawed constraint mechanism of financial institutions, the rapid expansion of debt from local government financing vehicles, and economic growth driven by debt expansion will also aggravate the pro-cyclical effect.

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