Bloomberg.- As China’s top leaders tallied the cost of another year of debt-fueled growth at a December meeting, the imperative for stability as a leadership reshuffle loomed later this year prompted an unexpected conclusion.
The price was too high, the leaders agreed, according to a person familiar with the situation. The buildup of debt used to fuel smokestack industries from steel to cement had helped win the short-term battle for growth, but the triumph itself undermined the foundations of long-term expansion, the leaders decided, according to the person, who asked not to be named because the meeting was private.
What followed was an order to central and local government officials that if they are forced to choose this year, stability must be the priority while everything else, including the growth target and economic reform, is secondary, said another four people familiar with the situation.
Other concerns aired at the meeting that contributed to the policy shift were the short-term risk of a confrontation with the U.S. under President-elect Donald Trump over trade or Taiwan, and longer-term challenges including how to spur the innovation needed to prevent economic stagnation as well as cleaning up toxic air that enrages and poisons citizens, said the person. Left unsaid was that economic growth underpins the legitimacy of Communist Party rule.
«China’s reaching the point where it has to pick its poison and giving up a half percentage point of growth would be far less politically damaging than instability in the bond or currency markets,» said David Loevinger, a former China specialist at the U.S. Treasury and now an analyst at fund manager TCW Group Inc. in Los Angeles. «Looking past the Party Congress later in the year, President Xi Jinping may realize that unlike his predecessor, Hu Jintao, he can’t kick the can to his successor, even more so if he plans on extending his term» beyond 2022.
As many as five out of seven members of the nation’s top leadership committee are expected to be replaced at a twice-a-decade Communist Party Congress later this year, a gathering that traditionally spurs a greater emphasis on maintaining stability.
As recently as a year ago a depreciating yuan and surging capital outflows from China roiled global markets as anxiety over a chain-reaction of competitive devaluations spooked investors. That followed a roller coaster 2015 that featured a shock yuan devaluation, a record plunge in foreign exchange reserves and a stock market rout that at one stage wiped out $5 trillion in market value. While policy makers quickly countered those anxieties, they highlighted the risk of China triggering global financial market shocks.
At the December meeting, officials expressed alarm over the nation’s rapid accumulation of total debt, with some present noting that other nations have experienced crises after allowing debt to climb to about 300 percent of gross domestic product, the person said. China’s credit boom may have pushed overall debt at the end of 2016 to 265 percent of GDP, according to Bloomberg Intelligence. Also aired at the meeting was the risk that China falls into the so-called Thucydides trap, a theory attributed to the eponymous Greek philosopher that says a rising power will clash with an established force.
So menacing is the array of economic and political challenges confronting the nation that some leaders at the meeting said there’s no prospect for yuan appreciation against the dollar until at least 2020, said the person.
«Tapping the brakes may help avoid the economy skidding off the road,» said Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc in Hong Kong. «While this may involve giving up on the cherished goal of achieving middle income status by 2020, missing the target by a couple of years is a small price to pay compared to the consequence of financial systemic stress should credit continue to expand at a rapid pace.»
Leaders reached an understanding at the meeting to be flexible over a previously sacrosanct target of doubling per capita gross domestic product by 2020 from 2010, and also a 6.5 percent growth target to 2020, the person said.
They agreed it would be acceptable if the goal to double per capita GDP by 2020 — first conceived by former leader Deng Xiaoping and endorsed by all three presidents since — slipped by two or even three years, the person said.
The hope is that this shift smooths a path for China to climb from a middle-income to high-income economy. The feat of avoiding the so-called middle-income trap has been achieved by only five economies — Japan, South Korea, Taiwan, Hong Kong and Singapore — while maintaining relatively high rates of growth, according to Nobel laureate Michael Spence, a professor at New York University’s Stern School of Business.
Some analysts doubt whether the government has the resolve to follow through on the shift to de-emphasize the importance of growth. Back in November 2013 the nation’s so-called third plenum vowed a series of sweeping policy changes to restructure the economy that were hailed by some analysts as the broadest reform pledges since at least the 1990s. Despite that, economic reform has since been subordinated to domestic political goals, according to Andrew Batson, head of research at Gavekal Dragonomics in Beijing.
«I’d be cautious in claiming this as the nail in the coffin for the growth target,» said Andrew Polk, Beijing-based head of China research at Medley Global Advisors, which advises institutional investors. «There is a big difference between stepping back from an official growth target and abandoning growth-supporting policies altogether.»
Another danger is that the shift away from meeting growth targets at all costs confuses officials who implement economic policies at local levels, said Zhu Ning, author of «China’s Guaranteed Bubble» and deputy director of the National Institute of Financial Research at Tsinghua University in Beijing.
«What is going to happen after the shift is worth close attention,» he said. «It has not happened in the past two decades and it remains unclear whether party cadres know what to do if speed is no longer of paramount importance.»
China has the space to accommodate slower growth and six percent expansion annually is sufficient to maintain employment, the person said. Government studies show that if growth is maintained at 6.5 percent annually to 2020 the nation will face a labor shortage while problems, including excess industrial and housing capacity, will remain unsolved, the person said. Excess housing capacity will take six or even seven years to digest, he said.
«China’s growth is on a solid enough foundation that the leaders can now turn their attention to reining in financial risks,» said David Dollar, a senior fellow at the Brookings Institution in Washington and a former U.S. Treasury attache to Beijing. «This is a political year in which it will be difficult to follow through on key structural reforms such as letting zombie state enterprises go bankrupt or opening up more sectors to foreign trade and investment. Tolerating slower growth is accepting reality.»
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