Deciphering China's economic future

By Benjamin Cavender

Last week China's State Council released its 2018 work report which highlights the government's plans for China's economy in 2018 and key themes that it expects to address.  The key takeaways from the report are as follows.  China has set its economic growth target for 2018 at 6.5%, similar to last year's growth target, but below last year's stated growth.  In the work report Premier Li Keqiang also pointed to several other top line goals for the year including reducing the government's budget deficit from around 3% last year to 2.6% this year.  The government also has plans to cut taxes and increase military spending by around 8%.  This suggests that overall government spending will need to be lower this year and it indicates that we are likely to see a significant pullback in investment into large scale infrastructure projects that were previously used to boost top-line growth.  This is a good thing.

Photo taken on March 17,2015 shows people working at Zhongguancun Innovation Street in the Haidian District of Beijing, capital of China.[Photo: Xinhua]

Over the past 20 years the government has successfully managed to drive GDP growth in China through investment in road, rail, and airport projects but returns on every yuan invested are now diminishing as most needed projects have already been developed and further projects have less and less real impact on productivity.  Realizing this, the government is instead focused on the idea of slower, but 'high quality' growth, and the phrase is now being used repeatedly by high-level officials to describe China's future approach to economic development.  So, what does 'high quality' growth look like, and what are the challenges that China's economy currently faces that could make high-quality growth difficult to achieve?

Looking at the prospects for China's economy this year, overall the country is in a good place.  The country is effectively operating at full employment, sentiment by small business owners, and by sales managers at larger companies is optimistic, and China is increasingly being seen as an inclusive trade partner and as a champion of free trade.  Something that would not have been the case even 5 years ago.  On the other hand, the economy continues to face some stiff challenges this year including ballooning government debt, major concerns over the environment, a host of inefficient industries that need to be reformed, and the potential for a looming trade war with the US.

To combat these problems the government will need to take some key steps to ensure that 'high quality' growth is achievable.  First, the government is planning to create 11 million new urban jobs this year.  This is important as the overall population continues to migrate to cities more white-collar jobs will be needed.  This job creation is likely to come in the form of investment into services focused jobs, as well as jobs targeted at the green economy, and through tax breaks to small businesses.  Second, the government is looking at reducing risk in the financial services sector.  2016 and 2017 saw unsustainable amounts of M&A taken on by Chinese firms investing overseas.  Many of these deals made very little strategic sense and to make the acquisitions happen,  companies like Anbang and HNA had to take on seriously scary levels of debt.  

The government does not like this as it creates the potential for a chain reaction of failed companies and lost money if just one or two deals end up being written down.  In response the government took control of Anbang Insurance and has sent a message to national level banks that they need to be more careful about how they are lending funds.  This may slow economic growth in the near-term, but it helps to mitigate the chances of a severe slowdown if too many deals go wrong, and banks are destabilized.  It is important that the government continues to treat these issues seriously as China’s total debt is well over 200% of GDP.  While most of it is domestically owned such high debt levels are dangerous.

We are also expected to see continuing efforts to streamline underperforming manufacturing industries.  China drastically reduced steel and coal output in 2017 and is set to do the same in 2018 with a target of reducing steel production by 30 million tons and coal by 150 million tons.  The key to this reduction will be to think about how to reemploy effected workers, and how to ensure energy security (China actually ran short on natural gas last winter when shifting away from use of coal).  On the whole these changes represent the right kind of efforts needed to continue modernizing China's economy.

Finally, if the government wants to leave China's economy in a significantly stronger place at the end of 2018 it needs to invest further in supporting innovation and in protecting intellectual property.  For China to continue to grow the wealth of the average citizen it needs to shift from a focus on manufacturing and cheap exports towards strong domestic consumption and becoming a leader in design and development of new products.  With support for electric vehicle development and opening manufacturing, telecom and other sectors to international investment the government is also taking steps to at least open the door to this happening.

(Benjamin Cavender is director of China Market Research Group)