China’s eye-catching economic performance in the first half of this year, with a growth rate of 6.9%, sparked a fierce debate on whether China’s economy has embarked on a new boom cycle. Proponents pointed to the upturn in commodities prices, industrial profits and export growth, claiming that the downward pressure on the economy has vanished.

 

By digging out the cause behind the rally of industrial indicators and looking into China’s growth engines, we think it is premature to draw such a rosy conclusion at this stage.

 

 

A closer examination on the increased industrial profits since last year showed that the improvements were not spread out evenly across sectors and various types of producers — specifically, upstream sectors such as coal, metallic metal, oil and gas mining and midstream manufacturers in heavy industry — wherein large state-owned enterprises preponderated, accounting for most of the rebound in profits. In the first quarter of this year, upstream sectors made a profit of 122.8 billion yuan ($18.71 billion), compared with a loss of 5.4 billion yuan over the same period last year. Midstream sectors saw a surge of 36% in profits as well, while downstream light manufacturers grew by only 2.9%.

 

The varying profitability made sense, for the substantial growth up till now stemmed from China’s “supply-side structural reform,” intended to cut capacity in heavy industry since early 2016. As steel mills and coal mines were shut, supply decreased and price soared. After years of financial deficits, manufacturers at upstream sectors finally had the chance to become profitable again. But this was not good news for downstream producers. Instead, they suffered from higher prices of raw materials, and their profits were squeezed as a result. The same was reflected by the divide between the upward producer price index and the unaffected consumer price index. In other words, the effect is more of a redistribution of profits than a meaningful growth of the whole industrial sector.

 

The unsustained growth of industrial profits, which originated from the capacity-cut decree, cast doubt on the prospect of investment. The picture of investment is even darker. Normally, more profits lead to more investment. This is true for most businesses under most circumstances, but not for steel and coal and other industries targeted as having overcapacity in China’s structural adjustment campaign. We did not find a positive correlation in these sectors between profitability and investment, partly because they experienced greater losses earlier. As profits increased, they were more likely to repair their balance sheets rather than rush to buy new equipment.

 

Even though corporate treasurers decide to invest in fixed assets as profits rise further, the credit environment may not be in their favor. China ranked the highest in the ratio of nonfinancial corporate borrowing to gross domestic product (GDP), surging from 99% to 170% since the global financial crisis. As the debt risks drew increasing attention, this year the financial regulatory authorities have strengthened supervision to prevent systematic financial risks. The interest rates rose significantly, resulting in higher costs of financing investment. And there is no sign of loosening monetary policy in the short run.

 

According to the newly released data, China’s investment growth in August dropped further. Industrial investment started to lose momentum in July and slowed for a second straight month in August, rising 3.9% and 3.8% respectively, in contrast to 4.6% in June. More essentially, China’s investment-led growth has run out of steam. The proportion of investment in GDP has plummeted from 86.5% in 2009 to around 41% in 2016. Since the global financial crisis, China’s investment has been mainly driven by a booming property market and infrastructure financed by local government debts. But their roles are also fading as the housing market showed signs of stabilizing and Beijing pledged to curb government debts. What matters more: None of these factors is unconventional, which cannot justify a new boom cycle.
 

 

What about the two other driving forces for China’s economic growth? Can foreign trade and domestic consumption support an optimistic picture in line with the market sentiment? The answer is far from positive.
 

Indeed, the contribution of net export to GDP growth in the first half of this year was 1 percentage point higher than the same period last year, leading the most to the better-than-unexpected growth. Meanwhile, external demand was cooling down, increasing 9.5 percentage points slower in August than in June. Fundamentally, global economic recovery that backdropped the rebound in net export is still weak after all. The Trump administration’s fiscal stimulus remains uncertain, and the U.S. economy is already close to its potential growth. Other economic giants such as Europe and Japan struggled to gain momentum. Therefore, there is limited space for a further boost in external demand.
 

Domestic consumption has been subject to a steadily declining growth rate since 2011. There was a transient upsurge of 15.9% in car sales in 2016 thanks to the favorable tax policies, whereas it dropped to minus 1.4% in the first four months of this year. Without considerable improvement in household income level or stimulating hot spots, domestic consumption is not expected to see a stronger growth.
 

That industrial output in August slowed down to the lowest rate of this year may dampen the excessive optimism. All in all, China will still find it difficult to maintain a high level of growth rate. Policy options are also limited. The traditional one is to adopt a “strong stimulus” approach; that is, to implement loose fiscal and monetary policies to prop up investment. This may create new problems as side effects, let alone the government now seems to place a high priority on deleveraging. Another option is to carry out the much-needed structural reform to release growth potential, which we believe is the key to usher China’s economy into a new boom cycle. In retrospect, China was placed on a sustained growth trajectory three times, each following profound institutional changes. The first was the rural land reform in the early 1980s; the second was the establishment of a market-oriented economic system in the early 1990s; and the third was the state-owned enterprise reform in the late 1990s and China’s formal accession to the World Trade Organization in the beginning of the 21st century.
 

 

The most important event in China this year will come soon. The National Congress of the Communist Party is expected to convene on Oct. 18. Will it herald a new round of reform in China? Only reform can unleash China’s growth potential. The reform package should include restructuring state-owned enterprises and opening the service sector to genuinely embracing private investment. Allowing private capital to engage in health care, education, communication, etc., is essential to improving social infrastructure and encouraging consumption. Plus, China should promote urbanization and environmental protection in a more market-oriented manner, advancing the transition to a more-sustainable, inclusive growth.
 

Is China on the cusp of a new boom cycle? Let’s wait and see what will happen after Oct. 18.

 

Ye Qianlin is a research associate at the RIMS.