Moody's: Finding new drivers of economic growth is key to China's reform success

Moody's Investors Service says that finding new drivers of economic growth that are less reliant on borrowing will be key to the success of the reforms announced at the November 2013 Third Plenum of the Communist Party and reaffirmed at its recently concluded Fifth Plenum.

"China's debt/GDP ratio -- which measures total government, SOE, private sector and household debt -- has risen from 150% in 2007, to close to 220% at end-2014 and is likely to be higher now", says Michael Taylor a Moody's Managing Director and Chief Credit Officer for Asia-Pacific. "If this ratio is to return to more sustainable levels, China will need to discover new sources of economic growth that rely less on investment funded by borrowing."

"Moreover, corporate debt -- especially debt incurred by SOEs -- within this total has also grown substantially, and most countries with a similar level of per capital GDP have much less highly levered corporate sectors, indicating a potential risk," adds Taylor.

In summary, the old growth model is no longer sustainable as it has experienced rising debt/GDP ratios, falling capital productivity and persistent producer price deflation.

"In such a context, reform and rebalancing is essential, but it involves a complex and potentially painful transformation. Putting the economy on a sustainable path involves accepting significantly lower growth rates than in the past," says Taylor.

On the prospects for a successful rebalancing of China's economy, Moody's notes that the current Five Year Plan contains a number of components that are intended to support growth that is less credit-intensive, and market-oriented reforms and greater innovation should assist in this process.

Nonetheless, the plan also envisages a relatively high rate of economic growth -- averaging 6.5% over the decade -- which will be challenging to achieve, given the current economic evidence.

"In fact, such a growth scenario may require even more policy support -- more monetary policy loosening and fiscal stimulus -- than we have seen so far," says Taylor. "There is a risk that while this may prop up short-term growth rates, it will work against the orderly deleveraging that is the key to successful rebalancing."

Rather than resorting to short term policy support, rebalancing really requires the identification of new drivers of growth in the economy that are less credit-intensive than in the traditional model.

Among the early and successful results, Moody's notes that the services sector, which requires less capital and therefore less credit than traditional manufacturing industries, has begun to pick up.

Another promising sign is the rapid rise of e-commerce, and as this involves new forms of retailing that are relatively less capital and credit intensive, the growth of this sector also helps support rebalancing.

Ultimately, however, successful rebalancing in the time horizon of the Five Year Plan will require measures that bring about orderly deleveraging in the economy.

China's debt/GDP ratio has -- as indicated -- deteriorated markedly in the past seven years and although the debt burden is not as high as Greece, Portugal and Ireland, it is worth remembering that these are all countries that experienced a rapid rise in public sector debt as a result of financial crises.

Japan also provides a salutary lesson of a country that carries a very high level of public debt and which has experienced a multi-decade period of deflation and lackluster or negative growth.

Taylor presented his views at Moody's & CCXI 2016 China Credit Outlook Conference: 2016-2020 China Credit Outlook - Planning for an Economic Transformation. The conference takes place in Beijing today, and in Shanghai on Thursday 3 December.