China's Other Big Problem: Debt - TheStreet

BEIJING (

TheStreet

) --The world continues to look at progress in China as a barometer for the global economic recovery and recent headlines have been less than encouraging. For the first quarter, Chinese GDP growth was seen at 7.7%. While numbers like these would be great for most countries, a performance like this is viewed largely as a disappointment, when Chinese growth rates of 10% (and above) have been seen for the last 30 years.

But the main question going forward is not whether China will encounter a hard or soft landing. It's also not an issue of the government's commitment to stimulate growth by injecting economic stimulus. The key point that most of the discussion fails to address is the fact that the era of elevated growth in China has peaked, and it is unlikely we will see anything like it again.

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Recent drop-offs in Chinese growth cannot be explained away as cyclical weakness or as a temporary side-effect of the sluggish global recovery. The Chinese economic model is structurally flawed and there is no easy fix in sight.

Roots in Government Stimulus

Capitalist reforms in China started in the 1980s, as the government devoted resources to modernizing infrastructure in roads, apartment buildings and factories. The country quickly rose to prominence as the world's first choice for low-cost manufacturing and China's version of state-capitalism has been a boon for favored industries ever since.

But this approach has a limited life span. The wide labor base that lifted companies like Foxconn into prominence has been compromised by China's one-child policy. An aging population has reduced the number of available workers and state-sponsored investment systems have wasted resources, ruined the credibility of the financial sector, and built a large number of crumbling, obsolete factories.

The reality that China faces today is a stark one, and significant overhauls will need to be undertaken if its goals to increase domestic consumption have any chance of being met.

Excess Investment

Always hoping -- by hook or by crook -- to gain an edge on future markets, China has set its sights on green energy as the next target. Chinese banks have pumped billions into the solar-panel industry, creating the world's largest market for what is essentially a moderately efficient source of power. But these excess investments have generated company balance sheets that are unsustainable, and failures like the

Suntech Power

bankruptcy can be viewed as one of many examples of misplaced allocation.

Other instances can be seen in the losses steel company investors have encountered, as the industry continues to ignore rising debt environments and pour more money into new capacity. Local factories in China are backed by officials that (at best) are overly concerned about generating jobs growth. But investments in these areas miss many of the larger costs involved. When state-owned companies are given subsidies, credit resources are directed away from private enterprises that are often run more efficiently.

Rising Debt

The country's biggest problems are starting to become apparent in its debt levels, which have risen at an alarming pace. For 2012, numbers from Fitch suggest that credit rose to nearly 200% of GDP, well above the 125% reading that was seen in 2008.

Government debt at the local level is now seen at $2 trillion (roughly 25% of GDP). Additional risks are created by the influence of "shadow banking." Here, unconventional lending sources go uncited on bank balance sheets in a practice that sounds disconcertingly similar to what was seen with the toxic securities traded during the subprime mortgage crisis.

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The real challenge for China's leadership will be to avoid these deepening threats to economic stability. But similar examples of debt increases in recent years have sent major economies into financial turmoil. This occurs as markets start to accumulate more and more debt as the only way to generate output comparable to what was seen previously. Scenarios like these are unsustainable and, at this stage, it is highly unlikely China will be able to implement sufficient policy measures to keep its growth model running at a consistent pace.

Dependence on Foreign Investment

One area where consensus can be found is in the idea that China needs to move past its dependence on foreign investment and re-balance its economic models to allow consumption to drive growth. Private consumption levels in China (relative to GDP) continue to hold at the lowest rates when compared to the globe's major economies. Government reforms have done little to address these issues, as badly stuctured health care and pension programs encourage household savings in low interest rate environments.

From a policy perspective, two potential paths can be seen. China's leadership will choose either to enact consumption-supportive reforms at a faster pace or maintain its reliance on outside markets (in exports and investment).

The likely outcome in both scenarios is a slowing economy as any transitions will take time (and meet political resistance); any adherence to the old model will only exacerbate the problems the country currently faces. In either case, the days of double-digit growth in China have come to and end, creating more attractive emerging market opportunities in other areas of the world.

At the time of publication, the author had no positions in stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Cox is a university teacher in international trade and finance. His articles appear on a variety of Web sites, including

MarketBulls.net

,

Seeking Alpha

, FX Street and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies and commodities). Trade ideas are generally based on time horizons of one to six months.