China has pulled hundreds of millions of people from poverty, supercharged its economy and burnished the pride of a nation that stood weak and isolated only decades ago.
But swelling levels of debt, bloated state companies and an overall aversion to market forces are swamping the world’s second-largest economy, threatening to derail China’s ascent to the ranks of rich countries.
As Beijing battles another bout of stock-market turmoil—and global markets shudder in response—the risks of doing nothing about these deep-seated problems are rising, economists said. Without a change in course, they said, China faces a period of low growth, crimped worker productivity and stagnating household wealth. It’s a condition known as “the middle-income trap.”
“The era of easy growth is over,” said Victor Shih, professor at the University of California-San Diego. “It’s increasingly about difficult choices.”
Some economists don’t rule out an abrupt drop in growth, a hard landing that would see bad debts soar, consumer confidence tank, the Chinese yuan plunge, unemployment spiral and growth crater.
Chinese stock markets recovered Friday after a tumultuous week. But the WSJ’s Andrew Peaple explains why few expect the relative calm to last. Photo: EPA
More likely is that Beijing will continue to prop up growth, steering more capital to money-losing companies, unneeded infrastructure and debt servicing, depriving the economy of productive investment and leading to the sort of protracted malaise seen in Japan in recent decades. But China is less prosperous than Japan.
An anemic China would weaken global growth at a time of low demand and prolong the downturn for big commodity producers like Brazil that have been dependent on the Asian economic giant.
“They don’t want to take the pain,” said Alicia Garcia Herrero, economist with investment bank Natixis SA. “But the longer they wait, the more difficult it becomes.”
Chinese leaders are aware of the risks. On Tuesday, Premier Li Keqiang called for a greater focus on innovation to spur new sources of economic growth and to revitalize traditional sectors, according to the Xinhua News Agency.
A far-reaching economic blueprint laid out in 2013 after President Xi Jinping came to power vowed to let markets take a “decisive” role and build out a legal framework to restructure the economy and benefit consumers and small businesses, rather than industry.
Progress to date, economists said, has been disappointing. Political objectives stand in the way. Mr. Xi has committed the government to meeting a goal of doubling income per person between 2010 and 2020, the eve of the 100th anniversary of the ruling Communist Party. That means, in Mr. Xi’s eyes, that growth must reach 6.5% annually.
With global demand slipping and fewer Chinese entering the workforce, Beijing will need to resort to stimulus spending to get there, analysts said, delaying the reckoning with restructuring.
“It’s very costly and inefficient to reach these growth targets,” Mr. Shih said. “The political leaders want all these good outcomes, growth, some degree of reform and a high degree of stability,” without recognizing the tough trade-offs these entail, he said.
One such trade-off is that between pollution and growth. By letting steel and other heavy industries in northern Hebei province ramp up to meet their year-end production targets last year, the government left the capital bathed in toxic pollution, angering the city’s residents, according to Mr. Shih. If Beijing shutters them, growth will fall, leading to more unemployment, which is another potential source of unrest.
Among the most nettlesome issues is what to do about the state companies that dominate heavy industry and strategic sectors of the economy and wield great political influence.
Some state firms remain in business despite massive debt, several years of loss-making operations and a weak business model—Chinese officials have dubbed them “zombie” companies. Earlier this month, during a visit to the northern industrial city of Taiyuan, Mr. Li railed at the drag of “zombie” companies, according to a government account. He said they should be denied loans to reduce excess supply in the steel and coal industries.
State companies suck up 80% of the country’s bank loans, while delivering a return that’s a third below that of private Chinese firms and half that of foreign companies, according to estimates by Spanish financial institution Banco Bilbao Vizcaya Argentaria SA.
Reducing the footprint of these state behemoths, let alone getting rid of them, poses a huge challenge. Société Générale CIB calculates that a 20% reduction in excess capacity among state companies in the most distressed sectors of iron and coal could lead to 1 trillion yuan ($151.7 billion) in bad loans—equivalent to 2% of the nation’s bank loans—and 1.7 million laid-off workers, or 0.3% of the urban workforce.
Labor protests have already increased in a slowing economy as the number of demonstrations hit a record in December, according to a Hong Kong-based monitoring group, and the government has in the past chosen to boost growth to keep employment high and forestall the risk of social unrest.
Getting a handle on the mounting pile of debt is becoming a critical task in the eyes of some economists. While debt levels are manageable by global standards, their rate of increase has set off alarm bells. Fitch Ratings estimates that China’s total debt was equivalent to 242% of its gross domestic product by the end of 2014, up from 217% a year earlier.
Servicing that debt now costs households and companies some 20% of GDP, according to the Bank for International Settlements. That level, said research firm Gavekal Dragonomics, puts China on a par with Korea and higher than the U.S., Japan and the U.K.
Rising debt also threatens to crowd out the innovators and entrepreneurs that China is counting on to reboot growth.
China stands to reap a huge dividend if it weeds out the economy’s many inefficiencies and vast amount of misallocated capital, said Eswar Prasad, economics professor at Cornell University and former China head for the International Monetary Fund.
“My view is that reforms and rebalancing are compatible with high growth,” he said. “Of course, high growth built on a shaky foundation of rapid credit expansion without reforms and rebalancing would be undesirable and risky.”