China stumbles trying to merge two-track economy

There is no better metaphor for the economic challenge facing China than the futuristic architectural masterpiece designed to house the country's state television network, CCTV. A few months before the landmark building was to be completed in 2009, officials at the network conducted an unauthorised fireworks display, sparking a fire that consumed a smaller building in the complex, a wedge-shaped tower that Beijing's residents had nicknamed the 'Termite's Nest'.

The fire delayed the completion of the CCTV headquarters until 2012. The Termite's Nest remains unfinished and unoccupied; its structural integrity was destroyed in the fire, and it cannot be torn down for fear of undermining its bigger neighbour. The good part of the structure cannot shake off the burden of the bad. The two buildings recall China's increasingly two-tracked economy: a new track based on services and consumption burdened by an old, slower track made up of industries like steel and mining, which are inefficient and suffer from excess capacity. Straddling both tracks is the country's real estate market, which is characterised by massive overcapacity in mid-size and smaller cities and robust demand in large cities.

The problem is compounded by the Chinese leadership's insistence on sticking with high growth targets - 7 per cent at present - and the resulting reliance on credit to produce the requisite output. Because the credit system has been designed around implicit state guarantees, much of the financing is misallocated to the economy's less effi- cient, highly indebted sectors. As a result, the foundations of China's growth miracle are steadily being eroded by a debt overhang that shows few signs of receding. The government's loss of control over the economy has become increasingly evident. The meteoric rise and subsequent crash in the country's stock market has left investors badly rattled. But the real wake-up call has been the belated effort to sort out local government borrowing and misspending.

The National Audit Office's first attempt to estimate the size of local government debt uncovered a stock worth 26 per cent of GDP at the end of 2010. A second effort in mid-2013 revealed a further rise to 32 per cent of GDP. And the latest study by the Chinese Academy of Social Sciences shows that the debt jumped sharply, to 47.5 per cent of GDP, by the end of 2014. In November 2013, President Xi Jinping laid out a reform agenda that sought to increase the role of the market in China's economy. This, it was hoped, would solve the capital misallocation problem that seemed to be leading to an unsustainable rise in debt.

Local government debt became a major test case. In early 2015, the central government announced plans to convert the local governments' short-term, high-interest bank loans into long-term bonds. By increasing the maturity of the debt, the central government hoped to alleviate financing constraints on local governments and allow them to pursue financial stimulus.

When China's banks balked at accepting the low yields offered on the new bonds, the goal of increasing the market's role in the economy went out the window. The government forced banks to execute the debt swap. Unsurprisingly, banks suddenly became riskaverse. Local governments discovered that even with an improved liquidity position, banks were reluctant to extend new loans. Meanwhile a slump in the real estate market deprived local governments of their main revenue source: land sales. Thus ensued one of the more shocking developments in modern Chinese economic policymaking: the government's call for stimulus was simply ignored.

China appears to be falling into a trap that it assiduously sought to avoid. The country's debt problem looks set to worsen as the government neglects its reforms in favour of short-term growth objectives. The drag on the economy will increase as resources continue to be diverted toward keeping inefficient firms alive. Banks will become ever more riskaverse as they seek to hide bad debts and avoid write-downs. The government has sought to increase liquidity by dropping controls on the movement of capital. Doing so not only further undermines its control of the economy; it also creates the risk of a fullblown financial crisis that could engulf its neighbours and other emerging markets.