A hopeful tale for China's old and new economies

Optimism was in the air for the Chinese economy at the IIF-G20 conference in Shanghai late last month. The annual forum set the stage for leaders in the financial community to share their economic perspectives and voice their concerns prior to the G20 meeting. This year, in particular, at the height of global fears of its crash landing, the crowd was listening closely for insights on how China's economic transition would unfold.

The expectedly upbeat tone was supported by a belief in China's availability of policy tools and later affirmed by a new economic roadmap announced at the National People's Congress in the week that followed. The latest plan provides grounds for optimism as it includes more concrete measures for economic rebalancing coupled with an intensifying search for a new growth driver; though caution is still warranted in the short term against the backdrop of slow global growth.

What I found most encouraging is not the promise of reforms, but an admission of more realistic and slower growth prospects.

China's rapid expansion in the past decade was derived from an investment boom, in both the public and private sectors, largely funded by China's state-owned banks.

However, aggressive credit expansion is too often accompanied by resource misallocation, as in the case of China. Moreover, tightly controlled policies created imbalances such as distorted age and gender ratios in its population, rising income inequality, and over-reliance on certain parts of the economy. With global growth stuck in a low gear since the financial crisis in 2007, the trouble began to manifest itself. In particular, past growth policies split China's economy into two parallel universes -- the old investment-led manufacturing sector and the new consumption-based service sector.

China's old economy or the traditional manufacturing sector is currently ridden with debts and overcapacity. One of the root causes is the government's policy to prop up inefficient state-run companies. Many, especially those in the steel and coal industries, are now operating at a loss, turning into so-called "zombie companies". The name arises from the fact that these zombies would otherwise have been dead under usual market mechanisms, yet they live on only through life support from the government. Unlimited access to funding from state-owned banks distorted their incentives to invest, resulting in excess supply. Previously considered the core of China's growth, a large number of state-owned enterprises have now turned into a burden. Overcapacity in heavy industries also creates spillover effects in the global market, contributing to a plunge in commodity prices. Moreover, an influx of Chinese goods fans resentment in other nations and triggers a rise in trade protectionism.

On the other hand, the new consumption and service-based economy has been growing. There has been a rise in per capita consumption. China's imports are shifting away from manufacturing products toward consumer goods. There is also much more room for development for China's financial sector which is also undergoing large reforms. However, as the old economy has stalled, the new economy has to do most of the heavy lifting.

The short-term risk then remains whether the newer service engine can compensate for the declining manufacturing sector. According to official statistics, China's service sector continued to expand but at a slower pace, while the manufacturing sector contracted for the seventh consecutive month in February 2016. The most difficult task for policymakers is perhaps to manage between pushing the necessary reforms and still keeping a respectable pace of growth.

To make matters worse, China's two economies are not only divided by their economic activities, but also by regions. There is a stark contrast between the gloomy, polluted towns in the "Industrial Rustbelt" of northern China populated with steel mills and coal mines and the more lively, urban cities along the coast. An attempt to curb overcapacity in the old economy will bring about large-scale factory shutdowns and layoffs in cities like Liaoning, Shanxi and Hebei. Such a concentrated economic catastrophe could spark an uprising in a socially and politically sensitive environment in today's China. This fear was one of the factors why the reforms failed to materialise.

Yet, there are plenty of reasons to be hopeful about the future of the Chinese economy at least in the longer term. Despite previous unsuccessful attempts to deal with overcapacity, the new plan sets out to align incentives for local governments by making overcapacity and pollution reduction among their key performance indicators. It also includes measures to help the would-be unemployed look for new jobs. In doing so, the government set aside a $15 billion fund to relocate and re-train workers as well as provide an additional social safety net during the job search period. The challenges, however, remain in other aspects of social imbalances such as the ageing population. But at least the latest plan seems more promising than before.

On top of rebalancing its economy, the Chinese government is betting on innovations and technological forces to be the next growth drivers. It is pouring money into R&D and throwing generous support behind startup businesses. There are now 1,600 high-tech incubators in China along with 115 high-tech parks nationwide with over 500,000 firms registered. This is all the more reason to be hopeful about the Chinese economy in the long run.

For Thailand, China's transition will have strong and, more importantly, permanent repercussions on trade and financial markets given the ever-increasing interconnectedness of the global economy. In 2015, as much as 11% of all Thai exports went to China, making it the second largest trading partner for Thailand. Its role can only go up from now despite some short-term wobbles. China's experience provides lessons for countries that are struggling to escape the middle-income trap; to which, its answer is the shift toward a consumption and service economy.

Now that China's reform progress has become more pronounced, Thailand should take a forward-looking approach to form a long-term strategy before it is too late. At the top of the list, Thailand's export sector should shy away from manufacturing products with waning demand.

Thailand can also draw on China's case study in correcting for economic imbalances such as export dependency and labour redundancy in agriculture to ensure a turnaround in growth.

Sutapa Amornvivat, PhD, is Chief Economist and First Executive Vice President at Siam Commercial Bank. She has international work experience at the IMF, ING Group and Booz Allen Hamilton. She received a BA from Harvard and a PhD from MIT. Email: eic@scb.co.th | EIC Online: www.scbeic.com

About the author

Writer: Sutapa Amornvivat
Position: CEO of SCB ABACUS