China is at a crossroads where a wrong turn could lead to economic stagnation, says the chief China economist for Citigroup.
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Li-Gang Liu says without much-needed debt restructuring and privatisation of the state-owned enterprises that dominate the country's stock exchanges, China would simply "muddle through", relying on growth to pay down corporate debt until the economy stalled.
The alternative involved stake sales to employees and domestic retail and foreign institutional investors to clean up companies' balance sheets while opening up the country's capital markets, he says.
"Going forward, if the government does not tackle the medium-term challenges facing the Chinese economy. . . . we will see economic stagnation in China," he said during a visit to Sydney on Tuesday.
Economic slowdown
His comments come as world markets adjust to the economic slowdown in China, and take their cue instead from Britain's upcoming vote on EU membership. However, memories are still fresh of two bouts of market turmoil, in August 2015 and January this year, triggered by sharp movements in the Chinese yuan and heavy capital outflows.
The Chinese yuan has since stabilised against a trade-weighted basket of currencies, thanks in part to appreciation of the euro and Japanese yen.
However, slowing growth, overcapacity and high debt levels still have China-watchers nervous.
The Reserve Bank of Australia, in the minutes of its June board meeting, noted on Tuesday that China's "industrial production remained relatively subdued and growth in private-sector fixed asset investment had declined further". It also acknowledged that this had been offset by "elevated levels" of government spending.
China's debt-to-GDP ratio of 250 per cent mainly stems from the build-up of liabilities in the local government and corporate sectors during the massive infrastructure pushes of the past 20 years.
Another round of privatisation is necessary
Although not as onerous as in several advanced economies, China's debt burden has rattled some potential foreign investors, and led to a series of warnings about possible financial stress that could trigger another global crisis.
Mr Liu says much will depend on the government's strategy over the next few years.
"If the government is willing to engage in another round of privatisations, by selling down current state ownership from 80 or 90 per cent to, say, 40 per cent, they could use the money to honour bank debt, debt issued through bonds and other obligations," he said.
"However, if China still thinks they can muddle through, thinking growth in the future will pick up and those debts will be honoured eventually through economic growth, then we may see potential stagnation in China."
Mr Liu said a recent pick-up in residential and commercial property buying and investment, spurred by lower prices and monetary and regulatory easing, had helped reduce oversupply in the sector, alleviating problems in at least one of the country's biggest areas of overcapacity.
This improvement, in turn, had helped absorb excess steel, which had buoyed prices. Crucially for Australia, the price of iron ore, too, received a boost from the resurgence of real estate activity, although a clampdown by Chinese authorities on speculative activity in commodity futures markets forced a correction.
Rallies not sustainable
In any case, neither of these "mini-rallies" were sustainable, warned Mr Liu, and Beijing was committed to cutting steel-making capacity.
"The government is going to reduce China's steel-making capacity by 100 to 150 million tonnes in three to five years," he said.
There were also plans to reduce coal output by cutting average working days a year in the sector from 330 to 276, he said.
"This is a gradual approach," Mr Liu said.
"This year they are going to target two sectors; there are a further four overcapacity sectors which will probably be targeted in the following year."