Is This the End of China's Economic Miracle?

A laborer works on piles of steel coils in Taiyuan, Shanxi province, Feb. 22, 2013. Jon Woo/Reuters

Ma Jijiang and his once poor family are the flesh and blood of China's modern economic miracle, living proof of how radically the country has been reshaped since the late Deng Xiaoping changed the world in 1978 by proclaiming that to get rich is glorious and launching China's experiment with market economics.

Ma grew up as the only son of peasants in central Henan province. In the late 1990s, his father, a factory worker, suffered an industrial accident that caused him to lose the lower half of his left leg to amputation, ending his working life. His mother, Hui-fang, was a wheat farmer, her skin coarsened by days working in Henan's broiling summer sun. The family used to live off a dirt road adjacent to the wheat fields in which Hui-fang toiled, in a tiny wooden house lit by a single light bulb.

No longer. Ma was an uncommonly brilliant student, and when he took China's famous (or, to its critics, infamous) college entry exam, he finished ahead of all the other students in his village. That earned him a ticket to Beijing's prestigious Tsinghua University, known as the "MIT of China," where he earned a degree in electrical engineering. That, in turn, led to a job at a company in Shenzhen, the bustling city that abuts Hong Kong, for a company that, back when he joined, few outside the country had ever heard of: Huawei. The year was 2001, and China was about to become a member of the World Trade Organization (WTO), formally rejoining the world trading system, and the global economy.

Today Ma still works at Huawei, as a senior engineer writing software. His parents moved to Shenzhen and live in a small but tidy apartment their son bought them shortly after he got his job at the company known as the Cisco of China. The value of that small apartment has skyrocketed since Ma bought it, as has the unit he bought for himself and the woman who is now his wife. From the day he took his college exam to the day he signed on at Huawei, it had been less than five years—and a poor family's life has been utterly transformed.

Stories like that one are commonplace in modern China. They are the product of economic transformation and hyper-growth, China's relentless charge from an impoverished, centrally planned economic backwater to the world's second largest economy.

The era that brought the Ma family—and so many millions of others—from poverty to relative economic security is now over. With every new economic indicator released, it's become clearer that the period of China's hyper-growth has passed. The decades-long push into manufacturing, export-led growth, and real estate and infrastructure investment—which propelled growth for more than 30 years—has run out of steam. Furthermore, since the global financial crisis of 2008-2009, China has relied on massive infusions of credit to prop up its economy, and data show that the growth bang for the credit buck has diminished considerably. In 2008, banks had assets of roughly $9 trillion on their balance sheets. By the end of this year, according to Charlene Chu of Autonomous Research Asia, that will reach $28 trillion. Yet growth is decelerating sharply, likely to sink to 6.8 percent next year and 6.5 percent in 2016, according to the most recent forecast by Wang Tao, the chief China economist at UBS.

The Shanghai skyline illuminates the night sky. Joerg Dickmann/Gallery

After years of double-digit annual growth, that's a level that makes China's leaders nervous. To the Communist Party of China, which has ruled the nation since 1949, social stability matters above all, and growth that falls too far below 7 percent could be dangerous for them. The prospect of young college graduates not being able to find jobs, or of poor farmers migrating to new urban areas only to be unable to find work, or of large firms going bankrupt, triggering layoffs, worries China's leadership.

"China's development model is obsolete and in need of urgent, not gradual, replacement," says Daniel Rosen, a principal at the Rhodium Group, a New York consultancy, and author of a lengthy new report published by the Asia Society on the prospects for economic reform in China.

This is not news to the leaders in Beijing. Indeed, exactly one year ago, President Xi Jinping and his government laid out, at the Communist Party's so-called Third Plenum, a road map for the reform necessary to replace the current economic model and reinvigorate China's growth. Known as the "Decisions Plan," the report at its core called for market forces to assume "a decisive role in allocating resources"—a phrase that pleased Western-trained economists the world over, and gave conservative cadres in China (who still want the state to drive the economic bus) heartburn.

But the government increasingly doesn't get much credit for good intentions. Skeptics contend that not a whole lot has happened since Xi and his prime minister, Li Keqiang, assumed office. Now the issue simply is how much urgency the government feels to drive a reform process that will inevitably cause pain (indeed, which already is causing pain).

The answer should be: a lot. "In order to get on the right track, you have to first get off the wrong track," says Patrick Chovanec, chief strategist at Silvercrest Asset Management, a New York-based investment firm. "For new sources of growth to develop, you can't be channeling resources in the wrong direction, which they continue to do. They are several years behind where they ought to be."

In the year since the release of the reform road map, the question of urgency has only intensified. A Western hedge fund manager with major exposure in China, who recently concluded a round of meetings with senior officials in Beijing, acknowledged that "Xi's administration came out of the blocks flying, but this dynamism has faded." The reason, he said, "is horse trading" with what in China are commonly called "the vested interests." Those interests are primarily, but not exclusively, in the state-dominated sectors of the economy—the so-called "commanding heights" of banking, energy, telecommunications, steel and autos, among others. Under the current economic model, these state-owned firms have done better than well, and in many instances they fiercely resist meaningful change.

The stakes in this unfolding struggle over the reform process in China could hardly be greater. At home, for those Chinese citizens who have not yet attained middle-class status—which economists estimate is still some 500 million people—its outcome will dictate whether they'll have a shot at it. To those who have already achieved the "China dream"—a decent job and ownership of an apartment or house and a car—they want those gains solidified, not put at risk. And for a government under pressure to create a reasonable social safety net—from a national pension system for a country aging rapidly (by the year 2020, nearly 25 percent of the population will be 65 or older, compared with just over 6 percent in 2005) to a modern health care system—a stagnant economy will cripple those efforts. For an authoritarian government whose legitimacy is tethered almost entirely to economic progress, failure to reform "could be a death sentence," says Minxin Pei, senior fellow at the Carnegie Endowment for International Peace.

The implications abroad are not as fraught but are nonetheless huge. Since it joined the WTO more than a decade ago, China has become the most important market for virtually every multinational company on the planet. Since Deng's opening in 1978—barely the blink of an eye, historically—the country has gone from a nation of bike riders to its largest car market. It will be so forever, just as it will consume the most oil, iron ore, shampoo, smartphones, toothpaste and beer.

A woman shops for groceries at a supermarket in Beijing, March 22, 2013. Kim Kyung-Hoon/Reuters

"We've gotten to the point where it's a banality to talk of China as the world's largest market for this or for that," says James McGregor, China chairman for consulting firm APCO and a former head of the American Chamber of Commerce in Beijing. "You combine 1.3 billion people with three decades of economic growth and yes, you have the world's biggest market for pretty much everything. Duh."

For business executives trying to figure out what the next China will look like, the questions now are: What assumptions do you make about future growth and thus investment? What assumptions do you make about demand from China, which was so crucial in driving a commodity price boom over the past decade, only to see everything from oil to iron ore to copper prices now in free fall as the economy downshifts?

The China CEO for a major U.S. multinational says, "After restructuring the state-owned companies in the late 1990s and then joining WTO, it wasn't rocket science to figure out that this was going to be a high-growth economy. It's very different now. Now we're having knockdown drag-out arguments over how much to invest, how much to count on China going forward. And the truth is, we don't know yet. It's not easy."

The uncertainty that now hangs over China's economic future is informed by preceding "economic miracles"—and subsequent busts—in East Asia. Exhibit No. 1 of course, is Japan. It, like China subsequently, became the world's second largest economy after decades of fast growth, prompting (as China does now) fears in the West about Japanese economic domination. Then, in the early 1990s, Japan stumbled and fell down. And two decades later, it still hasn't gotten up.

How We Got Here

Could this fate befall Beijing? There are unnerving similarities between the two trajectories. Both countries' growth was driven largely by investment, at the expense of consumption. Fixed-asset investment in China last year—that is, investment in plants, equipment and infrastructure—was 45 percent of gross domestic product, while household consumption was only 36 percent. A critical part of the reform process for Beijing is essentially flipping those numbers.

Japan also let a real estate bubble get out of hand, just as many economists believe China has. Indeed, the present slowdown has been led by a sharp reversal in housing construction, one that UBS economist Wang believes "will bring dis-inflationary or deflationary pressures through various demand channels." That, again, is uncomfortably evocative of the Japan syndrome.

Chinese workers assemble cars on the assembly line at the auto plant of Anhui Jianghuai Automobile Co., Ltd in Hefei city, east Chinas Anhui province, March 15, 2014. Imaginechina/AP

As its macro slowdown hit in the early 1990s, Japan had a hard time getting its banks to stop making loans to companies—whether they were real estate developers or manufacturers—that were already deeply in debt. Japan became known as the Weekend at Bernie's economy: You put the corpse in a corner, stuck a cigar in its mouth and pretended everything was fine. Thus was the phenomenon of "zombie companies" born.

One part of the comparison may be overwrought. In China the residential real estate market is nowhere near as leveraged as Japan's was (or the U.S.'s after that). The damage from a significant correction, which is undeniably under way, is less likely to threaten the entire system.

That's not China's main problem, though. It's the reality of new debt going to bail out bad debt across the economy that prompts the most bearish views on China. A year ago, a Reuters analysis of proprietary data about so-called trust loans—made by non-bank financiers that do not have to abide by the interest rate restrictions placed on the state-owned commercial banks—showed that more than 41 percent of all such debt issued in 2012 went to companies most likely to be using it to roll over old debt. Trust loans were the largest segment of the so-called shadow banking system in China, where regulators know the riskiest loans lie.

The trouble here is real. In the city of Wuxi, in the prosperous Jiangsu province near Shanghai, the head of a medium-sized metals manufacturer—a man named "Zhang'' who did not want his real name used—walked Newsweek through his company's recent experience. It had relied throughout the 10 years since 2000 on the state-owned Bank of China for its credit needs. "We built a factory plus two new warehouses, plus they gave us money for working capital," he says. But starting in late 2011, "our sales started to slow down, and the bank told us they had to cut back on lending—government orders. We were stuck. So I went to a trust company to borrow some money, which we basically used to pay back previous loans from Bank of China. We've been doing it ever since as the economy has gotten worse. The interest rate on the [trust] loan is high—14 percent, but I don't have any choice. The bank is urging us to do it because they want their money back."

The example is a small glimpse of the dilemma that a reform-oriented government confronts. Arguably, at the core of the reform agenda is financial liberalization in general and interest rate liberalization in particular. If market forces are to dictate where resources go in China's economy, then market forces should allocate credit—not government fiat. Currently, rates on deposits are set by the government—at levels barely above inflation, to the detriment of savers. This makes banking all too easy; even the most brain-dead manager can take money in at artificially low rates and lend it out profitably.

Among other things, the subsidized system has led to overcapacity across the manufacturing spectrum in China's economy. That in turn increases deflationary pressure, as too few companies have the pricing power to increase profits. Banks tend to lend money almost unthinkingly to favored local employers—often state-owned themselves, usually big employers in any case, with close ties to local party officials. Since local party officials were usually evaluated by the growth in jobs created in their own districts, all the incentives were aligned in one direction: more. More investment, more factories, more jobs—and more debt.

The sun rises over Shanghai as it overlooks the Huangpu River. Nigel Hicks/National Geographic

To its credit, the new government has "successfully chased stimulus out of the market" by cutting bank lending, says the hedge fund manager just back from meetings in Beijing. But that means investment is slowing and, therefore, the economy is slowing.

By lending to increasingly strapped companies, the shadow banking system keeps marginal companies afloat. The government has so far tolerated the emergence of shadow banks because it wants the state-owned banks to get used to competition, officials say. But the downside risks a Japanese-style zombie economy.

This, then, requires the government to confront "the vested interests," in this case the banks that want to get repaid on their original loans, or other state-owned firms that want the credit spigots to stay open so they can pay their previous debts. Some analysts have been disappointed that the government hasn't moved more quickly to sort all this out and move to a more liberal financial system. But the government has a simple response: It's not easy, but we're getting there.

Before interest rates can be completely liberalized, a deposit insurance system like the one that exists in the United States needs to be set up. According to Zhang Ming, a senior research fellow at the Chinese Academy of Social Sciences in Beijing, a national deposit insurance company will be set up by early next year, officials from the People's Bank of China have told him. That, Zhang says, "would pave the way for small and medium-sized banks to fall into bankruptcy without triggering widespread panic or runs on the remaining banks." Central bank governor Zhou Xiaochuan has said deposit rates would therefore be set free "within two years."

The princeling president

As the struggle in China over financial market reform illustrates, many more people, and many more interests, have stakes in how things are now than in previous eras of reform. Great fortunes have been made, and powerful companies have arisen; they will not let their ox be gored without a fight. Tough decisions, to be sure, have been made in the past. Former prime minister Zhu Rongji forced the first major restructuring of the state-owned companies, getting them ready for the WTO, and that resulted in massive layoffs. Still, in hindsight, the first two key steps in China's modern economic reform process—letting private entrepreneurs loose and encouraging an export sector that could compete with cheap labor (of which there was a virtually limitless supply)—were close to a no-brainer. "The era of low-hanging fruit is long gone" when it comes to economic policy, says Yukon Huang, a former adviser to the People's Bank of China and now at the Carnegie Endowment for International Peace in Washington. "This government needs to be very tough."

A woman rests in a yard of a Starbucks coffee at Qianmen Commercial Street in central Beijing, April 19, 2012. Jason Lee/Reuters

Which brings the focus squarely back to Xi Jinping, the "princeling" president (his father was a contemporary of Mao Zedong's), who became general secretary of the party in November 2012. Some analysts, both at home and abroad, have been spooked by his time in office so far. He has launched a tougher than expected crackdown on corruption, which has included an investigation of the family of a fellow member of the Politburo Standing Committee, China's highest ruling body. He has projected Chinese power abroad, cracked down viciously on dissidents at home and evoked nationalistic themes and ancient Chinese literature in trying to unite his citizens behind his own "China Dream," which he defines as "the rejuvenation of the great Chinese nation."

All of that, his critics assert, has obscured the pursuit of reform, which is what the party needs most, or so the argument goes. It has even drawn unflattering comparisons to Mao and the cult of personality he created.

The doubts are reasonable, but Xi's defenders believe he is moving to consolidate power—using very tough methods when necessary—in pursuit of the right ends. APCO's McGregor says Xi is "using the tactics of Mao to be Deng 2.0." He is still largely surrounded by reform-minded advisers and has given no sign that he will retreat from his agenda. He has until 2020 to get what he wants done, and the government is moving on key areas like financial reform and a host of other issues, such as allowing private companies to move into sectors now dominated by state-owned firms. Moreover, the reforms needed now are not the one or two sweeping changes that Deng initiated more than 35 years ago. They are, Rhodium's Rosen says, far more numerous and in some ways "far more complicated.'' Be patient, the China bulls advise.

Since opening up in 1978, China has probably earned the benefit of the doubt when it comes to its own economic management. The issue for Xi and Co., though, is this: With the miracle years gone for good, will the Chinese themselves be patient enough to endure a marked slowdown—and the pain that comes with it—in order to get to what comes next? That is what the world is about to find out.

This article originally incorrectly stated that Wuxi is in China's Zhejiang province. It is in the Jiangsu province.