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Preparing for a Soft Landing

China's near-term vulnerabilities from a credit perspective, while numerous and seemingly dangerous on the surface, are in fact a bit exaggerated by most accounts. However, although danger is not imminent, it does not preclude a need for China's policymakers to ensure that the real economy is not also harmed by any sudden credit disruptions. So while credit from the stimulus was necessary to prevent an economic collapse in 2009, China now needs to correct the distortions that have manifested while also putting in place a third engine of growth.

In the short term, the Chinese government may have to bail out more LGFV companies and/or companies in the shadow banking sector should any of them be deemed too big to fail. Navigating China's economy in this period of transition will be fraught with challenges that may elicit the occa-sional headline in the media. No doubt Chinese policymakers will be tested should one of these pillars start to fall, and there will be plenty of winners and losers from both the public and private sectors should a full-scale cleanup take place. But since China has a strong balance sheet and a currently closed capital account, none of the scenarios arising from these problem areas will cause an outright collapse. Rather, a controlled "soft landing" will more likely materialize through aggressive use of fiscal and monetary policies should there be an absence of private capital and investment to take advantage of any dislocations.

Before diving into the policy options, one should note that a slowdown in China is inevitable and may be prolonged. Its transitions from an agrarian to an industrial manufacturing to a service economy have happened at breakneck speed for a country of any size, let alone the largest country in the world by population. So in comparison with past transitions, the current transition by China into an innovation economy that relies more heavily on research and high technology to power it into the twenty-first century may take much longer. This is because China will no longer simply play catch-up, but will have to start pushing against the unknown to make advances. It will also take longer because its leaders will now have the added challenge of managing not one, but two countries, since, economically and developmentally, the coastal areas will be distinctly first world in character while the western heartland of China will still lag behind as a third world nation.

Corporate bankruptcies, write-offs, NPLs, corporate restructurings, and consolidations could surge before leveling off to a more normal pace. To be sure, it will take some time to relocate laid-off workers and retrain them for new jobs when some of these businesses close. Many will not be reabsorbed and will rely on government assistance in the coming years as technological advances continue to replace humans. This will not be China-specific but a worldwide problem, though it does not necessarily presage a collapse.

Finally, China's shrinking labor force means that it can actually reduce its GDP growth rate quite substantially without it causing unemployment problems. The fact that wages have been increasing between 10 and 15% annually for over a decade means that China is experiencing a labor shortage. Like Japan, China can actually have decreasing growth rates while per capita incomes continue to rise. Thus, what some experts will call a "hard landing" for China will unlikely hurt the country as much as it will hurt all the other economies around the globe that depend on it for growth.

Consumption as Third Engine?

The Western consensus view for addressing China's slowdown is that it needs to shift to a more consumption-driven growth model and reduce its dependence on investment as its third engine of growth. Many people cite the extremely low share of consumption to GDP as indicative of repressed spending and believe that diverting the high share of infrastructure investment towards building stronger social safety nets will enhance consumer expenditure. There is some truth to that since many households often save for a rainy day when they cannot depend on social security or do not have access to universal healthcare.

However, a closer look at the numbers reveals that China's consumption growth has already been in double digits every year for more than a decade. Officially, China's consumption as a percentage of GDP was roughly 38% as of 2015, but double-digit sales growth rates have been recorded in many consumer sectors, ranging from movie ticket sales to fast-food outlets. Since retail sales have been growing at between 15 and 20% a year for decades while GDP numbers suggest lackluster growth in personal consumption, Chinese consumption figures might be drastically understated. In fact, Professor Wang Xiaolu of the China Reform Foundation reported in 2010 that unreported income was as high as 30% of China's GDP.16 In other words, per capita disposable income should have been 90% higher than official data. His findings seemed to be corroborated by an admission from China's Bureau of Statistics that its household consumption figures were based on an incomplete survey that does not take into account cash transactions and provision of social services through barter and other non-cash means. Other researchers have also concluded that many other consumption statistics have been underestimated. For example, businesses often do not issue receipts to avoid paying the high sales tax, leading to underreporting of household purchases that could be as high as 15 percentage points of GDP.

There is also the question of whether consumption growth is the chicken or the egg. According to Austrian economics, growth leads to consumption, but not vice versa. Thus, if this is true, China's economy will not consume itself into more growth because the Chinese citizens with money are already consuming as much as they are rationally able to. Rather, the problem lies in expanding the number of people who have money to consume in order to push the aggregate consumption numbers higher. To achieve this end, only another leg of growth can lead to higher consumption numbers. Of course, non-wage sources of income such as rents and dividends can also fuel more consumption, but these forms of income are more typical of wealthy economies with large numbers of retirees who consume but no longer work. There is no empirical evidence that aging populations with higher consumption spending as a percentage of GDP have led to higher growth in those economies; the opposite appears to be true, as evidenced in places such as Japan and parts of Europe. So instead of seeing China's consumption as being deficient, it is likely that consumption patterns are approaching a peak as its millennial generation has a higher income and a greater propensity to consume. This phenomenon may last another five to ten years and then moderate in the decades to come as the population ages and the economic growth matches that of the global economy. Of course, the government can alter consumption demand on the margin by provisioning more services to households, but all in all, consumption growth probably won't explode higher from these levels. Consumption, therefore, should not be seen as the sole third engine for Chinese growth.

Where, then, can China find the third engine to save its economy from falling apart?

China has announced in its 13th Five-Year Plan (2016-20) that it will focus on several reforms that will unleash more efficiencies. To be sure, China's leaders are uncertain which of their economic initiatives will ultimately succeed, and thus they will have to try multiple avenues simultaneously, whether it be supporting more entrepreneurship and innovation or leading with more political initiatives. It is also unclear whether the government can successfully implement their proposals, but at least they understand what needs to be done and have telegraphed their intentions without ambiguity.

Alternative policy choices could include reforming China's tax policies. While taxes have been kept to a minimum in order to encourage more economic growth, growth could also be stimulated by raising taxes on the margin to discourage certain behaviors. For instance, implementing a recurring property tax could end the distortions of over-construction and enable local governments to raise the necessary revenue to operate without having to borrow to meet their needs. A higher income tax on the super-wealthy could also help raise revenue to pay for clean technology implementation, which would be fitting since many of them were the beneficiaries of dirty manufacturing.

SOE Reform

One of the toughest reforms for the Chinese government to implement is to reform SOEs. Officials understand that the government needs to clear the distortions that come from government guarantees. With government guarantees, some SOEs don't have the incentives to operate more efficiently and lower leverage. But government officials walk a fine line between efficiency and social stability. Avoiding economic collapse is not just about maintaining economic efficiency, but also about ensuring the social fabric doesn't unravel too quickly. The calls to eliminate SOE participation in various commercial activities in order to clear the way for more productive private players to enter the market draw a false dichotomy. China can afford to let these less productive SOEs limp along while also opening up the space for more private companies in high-growth areas to come...