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Photo: Bloomberg
Photo: Bloomberg

Slowing growth: Lessons from China

In China, weakening fundamentals in corporate balance sheets are translating into rising bank vulnerabilities

The G-20 summit in Hangzhou in early September will have an assessment of why global growth has become weaker and more fragile than expected—and what can be done to build a more sustained recovery from the financial crises—among its main objectives. This has major implications for India, which continues to grow close to its potential and remains the fastest growing major country.

Let’s begin by looking at the evidence which most international institutions have been slow to recognize. For some time, emerging markets were projected to lead the global recovery. However, this has not happened; global growth expectations have been steadily revised downward since 2011, and the fragility has spread to emerging markets. Global growth in 2016 is now projected at just over 3%—below the outcome in 2014—and the differences are wider for emerging market countries. China—today the largest country in purchasing power parity terms—has become the main subject of the growth uncertainties.

The repeated downward revisions to growth have reflected growth fundamentals, namely the capacity to grow sustainably, rather than cyclical factors. Both advanced and emerging market countries have experienced successive declines in potential output and growth rate since then, with the leading cause being lower efficiency of resource use, or total factor productivity (TFP) growth. The latest projections of potential output growth for both sets of countries for 2015-20 are well below those made during the pre-crisis period (2003-08), and for 2010-14.

Let’s look more specifically at China’s growth outlook and uncertainties, and its lessons for other emerging markets, including India. Growth in China has long been driven by high and rising (credit-financed) investment rates, especially since the global financial crisis. As China’s investment rate reached historic highs—close to 50%—capital efficiency steadily fell, with total factor productivity significantly declining and reducing its contribution to overall growth. Yes, China still needs much more infrastructure investment per capita, but its rising investment was concentrated in less productive sectors such as real estate, and implemented by state owned enterprises (SOEs) that built excessive capacity in upstream sectors, such as coal, cement and steel.

China’s latest five-year plan is rightly trying to change that, boosting consumption and expanding the service sector’s contribution to growth. Moderate progress is being made in this direction. Already, consumption is contributing more to growth in China than investment. However, to reverse the trend of falling productivity, and nurture investment and innovation in globally surging service sectors, the legacies of credit- and investment-led growth—which limit more efficient resource allocation—need to be urgently addressed. These include, especially, the interlinked problems of heavily leveraged financial and corporate sectors, from the rapid rise in (mainly domestic) corporate debt of SOEs and real estate related firms, close to 150% of GDP. In particular, in China, we are seeing weakening fundamentals in corporate balance sheets that are translating into rising bank vulnerabilities.

These domestic imbalances mirror the fault lines in other emerging market countries that have also experienced rapid rises in credit growth, corporate and bank debt, and consequent declines in TFP and potential growth. India’s stress tests of corporate and banking vulnerabilities confirm the risks from its high corporate leverage and the potential need to recapitalize state-owned banks. Other emerging markets have also built up their debt as they turned to capital and financing to drive domestic spending and deliver higher headline growth, with reduced productivity. It is important for the G-20 to recognize that these fault lines have also resulted from the external spillovers from the unconventional monetary policies of many countries, especially in the advanced countries. Thus, many emerging markets are vulnerable to potential global shocks, such as from commodity prices, foreign currency, interest rates and capital flows. These need to be resisted by implementing restructuring plans that deal comprehensively with both creditors and debtors.

The need for such restructuring plans to act across multiple fronts undoubtedly faces political resistance, especially because of the likelihood of slowing growth in the transition. In many emerging market countries, the test is to harden budget constraints, remove implicit guarantees to state-owned banks and enterprises that distort the pricing of capital, and improve resource allocation to higher productivity sectors. In China, the government is developing a reform plan for the state-owned enterprises, has announced capacity reduction targets in the coal and steel sectors, and is working on a strategy that includes debt equity conversions to address the problems of excessive corporate debt and vulnerable bank loans. And India has elevated the priority of dealing with stressed loans on banks’ balance sheets. Such solutions have successful international experience and could be an important driver of needed reforms provided they build new corporate and bank governance safeguards.

These challenges facing China and many emerging markets are compelling, but they have the buffers to undertake reforms without social dislocations. Most importantly, these reforms need to bolster potential growth through productivity gains by encouraging the more efficient allocation of resources and building a more competitive economic environment. The coming summit should be used to build consensus across advanced countries and emerging markets on consistent structural reforms that would reverse the productivity declines being experienced in both sets of countries, and restore potential growth.

Anoop Singh is adjunct professor, Georgetown University, and former director, Asia-Pacific Department, International Monetary Fund.

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