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2016 for China’s economy could look like 1991 in Japan, but with far worse consequences

09 February 2016

By Sebastian Heilmann

China’s overdue structural reforms, rapidly increasing debt, growing industrial overcapacities combine to produce declining growth in spite of monetary and fiscal stimulus efforts. This current situation displays many analogies with Japan’s economic turbulence in the early 1990s, but carries a much graver risk of social and political destabilisation.

China’s overdue structural reforms, rapidly increasing debt, growing industrial overcapacities combine to produce declining growth in spite of monetary and fiscal stimulus efforts. This current situation displays many analogies with Japan’s economic turbulence in the early 1990s, but carries a much graver risk of social and political destabilisation.

Uncertainty is creeping into projections of China’s future contribution to global demand and growth. To date, Chinese output, investment, exports and prices are not collapsing, but a growing number of signs indicate the potential of an impending economic crisis.

The continuing decline of producer prices is a result of vast excess capacity in many sectors of China’s industry, and the policy responses to this misalignment have been inconsistent. Crucial reforms of state enterprises or of central-local fiscal relations are stalled, and there are growing doubts about the party leadership’s determination and ability to implement its plans for economic restructuring and deregulation.

Compared to previous periods of economic stress, the Chinese government is now much less effective in steering business, investor and consumer behaviour through loan and investment instruments. The current expansion of services and consumption will not be able to compensate for shrinking industrial employment. Stagnant industrial wages and (still largely hidden) unemployment will have delayed negative effects on consumption growth and service sector investment. This situation is compounded by the fact that Chinese consumers are not as well off as it may seem because their savings are diverted by a state-guided financial system to support shrinking government-linked industries.

China’s reserves can prevent a hard landing

The most dangerous scenario for China would be for growth to plunge in 2016 and 2017 without anything to cushion a hard landing. The likelihood of this worst-case scenario seems low – it would only occur if destabilising domestic and global economic events coincided with severe internal and international political tensions. In the absence of such extreme circumstances, China’s government still has enough currency reserves and other financial and fiscal means to prevent short-term economic contraction.

The most likely scenario for China’s economy is similar to the situation that produced shrinking growth rates and rapid debt build-up in Japan beginning in the early 1990s. Japan’s government and central bank sponsored stimulus and stabilisation packages failed because of deferred structural adaptation, growing industrial overcapacities and shaky consumer confidence. The same factors are now threatening China’s legendary growth. But a long period of protracted economic decline or stagnation would be even more dangerous in China since it would increase the risk of social and political destabilisation.

Declining growth would create social and political tension

China’s economically ambitious and agile middle and upper classes have a tacit agreement with their government: in exchange for political obedience the Communist Party guarantees economic prosperity and internal stability. Declining income growth and the prospect of stagnation would severely aggravate social and political tensions and likely result in a progressive loss of political support and systemic disruption.

The Chinese government is acutely aware of this threat to its own legitimacy and will therefore attempt to use economic policy to maintain Communist Party control. Renewed stimulus packages would clearly be the most effective tool to prevent social tensions in old industries (coal, steel, ship building etc.) and in economically depressed regions (Shanxi, Liaoning etc.) from spiralling out of control. Such time-buying measures can mitigate the situation in the short term, but they would lead to a further postponement of painful reforms.

A protracted economic slump in China would also curb international diplomatic and funding initiatives recently launched by the Chinese government. The profitability of foreign investments made by state banks or state enterprises and the government’s capital injections into the Asian Infrastructure Investment Bank (AIIB) or the “Silk Road” initiative (“One Belt, One Road”) will become subject to scrutiny and curtailment in the context of an internal downturn.

Even with China’s impressive resources, the potential costs of buffering a declining or stagnating economy would create financial bottlenecks, and China’s costly geopolitical ambitions promoted with great fanfare and a thick chequebook would likely peter out. This would greatly reduce China’s ability to shape its external economic environment to create opportunities for struggling domestic industries - starting a vicious cycle in which stagnant growth at home cannot be offset by economic gains abroad.

 

A longer version of this article was first published in the Berlin Policy Journal in November 2015.

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The  Mercator Institute for China Studies (MERICS)is a Stiftung Mercatorinitiative. Established in 2013, MERICS is a Berlin-based institute for contemporary and practical research into China.

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