Corporate debt is China’s biggest reform challenge

The best way to describe China’s economic quandary is also the simplest: It can strive for maximum growth now or later — but not both.
China’s government is well aware that promoting the growth of the world’s largest economy in the long term involves structural changes that will slow the economy in the short term. And its success in striking a balance has surprised many analysts. In several areas it has pressed ahead with ambitious reforms while letting growth moderate to a gentler pace (by Chinese standards) of less than 7 percent a year.
Even so, the dilemma remains, and resolving it is getting urgent.
The biggest threat to China’s rising prosperity is a continuing and largely uncontrolled expansion of credit. Making loans to failing enterprises is a long-term drag on the economy’s overall productivity. It discourages the entry of new and better-run suppliers. And it aggravates financial risk, especially because much of the the lending is extended through so-called shadow credit that isn’t properly measured or supervised.
The debt problem is bound up with the continuing role of state-owned enterprises. They are less efficient and less profitable than those in the private sector, and they rely more on credit, which they find easy to get because of implicit government guarantees. Evidence shows that losses and so-called “near defaults” are on the rise.
In their most recent appraisal of China’s economy, economists at the International Monetary Fund put the restructuring of weak state-owned enterprises high on the list of needed reforms. Chinese authorities have announced some initiatives in this area, such as reducing the size of state-owned steel and coal producers. But overall, the IMF says, progress has been slow.
The government continues to send mixed messages. On the one hand, it confirms the need to restructure “zombie” enterprises and encourage private ownership. On the other, it says that state-owned enterprises should be bigger and stronger so they can better serve “national strategies.”
What’s needed is a broader and more explicit strategy that focuses not only on state-owned enterprises but also the expansion of corporate debt.
Losses need to be recognized, and then shared by firms, creditors and the government. Implicit guarantees need to be curtailed.
Enterprises must be closed or restructured, with help for workers to find new jobs. Managing such a policy is an enormous challenge, and cannot be done all at once. It would make sense to press ahead faster in regions that are doing relatively well: That will make it easier to get workers into new jobs. At any rate, a more deliberate and less ad hoc approach has the best chance of succeeding.
China’s government is not averse to economic reform. It has moved to a more flexible exchange-rate system, promoted consumption and lessened the country’s reliance on exports. It has strengthened the fiscal system by making the value-added tax more comprehensive, made local-government budgets more transparent, and encouraged urban development. Reviewing these and other innovations, the head of the IMF team said that “just keeping up with the myriad of reforms on an almost daily basis is a challenge for us.”
Still, there is much left to do, and corporate debt is top of the list. The long-term health of the Chinese economy is a priority not just for the Chinese but, increasingly, for the world.