China's investment-led growth model has served it extraordinarily well, setting it on course to become one of the world's advanced economies. Yet the strains associated with that approach have become evident.
Since 2015 the country's gross domestic product growth has dipped to 25-year lows, corporate debt has soared, foreign reserves have fallen by $800 billion and the stock market has dropped by nearly 40 per cent.
A long tail of poorly performing companies pulls down the average, although top-performing Chinese companies often have returns comparable with those of top US companies in their industries. More than 80 per cent of economic profit comes from financial services – a distorted economy. Speculation that China could be on track for a financial crisis has been on the rise.
The nation faces an important choice: whether to continue with its old model and raise the risk of a hard landing for the economy, or to shift gears.
A new approach, centred on productivity, could generate 36 trillion yuan ($5.6 trillion) of additional GDP by 2030, compared with continuing the investment-led path. Household income could rise by 33 trillion yuan.
China has the capacity to manage the decisive shift to a productivity-led model. Its government can pull fiscal and monetary levers, such as raising sovereign debt and securing additional financing on the basis of more than 100 trillion yuan in state-owned assets.
China has a vibrant private sector, earning three times the returns on assets of state-owned enterprises. There are now more than 116 million middle-class and affluent households – with annual disposable income of at least $21,000 per year – compared with just 2 million such households in 2000.
And the country is ripe for a productivity revolution. Labour productivity is 15 to 30 per cent of the average in countries that are part of the Organisation for Economic Co-operation and Development.
A new productivity-led model would enable China to create more sustainable jobs, reinforcing the rise of the consuming middle-class and accelerating progress towards being a fully fledged advanced economy.
Such a shift will require China to steer investment away from overbuilt industries to businesses that have the potential to raise productivity and create new jobs.
Weak competitors would need to be allowed to fail rather than drag down profitability in major sectors. Consumers would have more access to services and opportunities to participate in the economy.
Making this transition is imperative. The longer China continues to accumulate debt to support near-term goals for GDP growth, the greater the risks of a hard landing. McKinsey estimates that the non-performing-loan ratio in 2015 was already at about 7 per cent, well above the reported 1.7 per cent. If no visible progress is made to curb lending to poorly performing companies, and if the performance of Chinese companies overall continues to deteriorate, we estimate the non-performing-loan ratio could rise to 15 per cent by 2019.
This would trigger a substantial impairment of banks' capital and require replenishing equity by as much as 8.2 trillion yuan.
In other words, every year of delay could raise the potential cost by more than 2 trillion yuan. Although such an escalation would not lead to a systemic banking crisis, a liquidity crunch among corporate borrowers and waning confidence of investors and consumers during the recovery phase would have a significant negative impact on growth.
McKinsey's China's Choice report identifies five major opportunities to raise productivity by 2030:
- Unleashing more than 39 trillion yuan in consumption by serving middle-class consumers better.
- Enabling new business processes, products and services through digitisation.
- Moving up the value chain through innovation, especially in R&D-intensive sectors, where profits are only about one-third of those of global leaders.
- Improving business operations through lean techniques and higher energy efficiency, for instance, which could deliver a 15 to 30 per cent productivity boost.
- Strengthening competitiveness by deepening global connections, potentially raising productivity by another 10 to 15 per cent.
Capturing these opportunities requires sweeping change to institutions. China needs to open up more sectors to competition, enable corporate restructuring and further develop its capital markets. It needs to raise the skills of the labour force to fill its talent gap and to sustain labour mobility.
The government will need to manage conflicts among many stakeholders, as well as shift governance and incentives that rewarded a single-minded focus on rising GDP, even as it modernises its own processes.
This article ran first in Australian Financial Review.