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China: a balancing act between growth and reforms

Economic Quarterly Report

  • Growth (y-o-y) of gross domestic product in Q2 was 6.7 percent. Our estimates put GDP growth closer to 4 percent.
  • Public investment and consumption keep the economy going while private investment and net exports are contracting.
  • The government is currently performing a balancing act between keeping the economy going and safeguarding social and financial stability. Authorities continue to resort to debt-driven investment, a proven policy for China, and follow a step-by-step strategy to reduce excess capacity in heavy industry state-owned enterprises.
  • The political tension between China and its neighbours around the South China Sea is rising. This is threatening stability in a region that is vital to Asian trade and growth, although we do not expect an escalation anytime soon

Activity appears to be stable, but lower than officially reported

Figure 1: Rabobank China Activity Indicator (CAI) points to lower growth
Figure 1: Rabobank China Activity Indicator (CAI) points to lower growthSource: Macrobond, Rabobank

Official growth of gross domestic product (GDP) in the second quarter of 2016 was 6.7 percent (y-o-y), the same growth figure as the first quarter. This is in line with the official growth target of 6.5-7 percent in the 13th Five Year Plan. But most economists place little faith in the official growth figures. The Rabobank China Activity Indicator (CAI) suggests a much lower GDP growth of around 4 percent (Figure 1).

Factors behind growth offer little comfort

Data on the underlying factor driving growth are not reassuring. First of all, net foreign trade remains weak (Figure 2). Although there was a brief pick-up in export growth in May, the 3-month moving average in June and July was once again in negative territory.

Figure 2: Foreign trade is still weak
Figure 2: Foreign trade is still weakSource: Macrobond, Rabobank

Growth in imports is also unconvincing, which could point to weakening growth of private consumption. So far, there are little signs that that the Chinese government’s efforts to steer the economy from an investment-heavy production economy to a consumption-driven services economy are bearing fruit (see Figure 3). But most likely it too early to make a proper assessment. Finally, we see that there has been a slight contraction in private investment in the second quarter (Figure 4), while there has been very strong growth in public investment.

Figure 3: Retail sales and private consumption on a downward growth trajectory
Figure 3: Retail sales and private consumption on a downward growth trajectorySource: Macrobond, NiGEM, Rabobank
Figure 4: Private investment contracts in the second quarter
Figure 4: Private investment contracts in the second quarterSource: Macrobond, Rabobank

Slow progress in bringing down excess capacity due to risk of social unrest

Policymakers still have some room to manoeuvre. They can boost economic growth by reducing policy rates and the corporate tax burden. Moreover, China a catch-up of labour productivity offers a huge growth potential. Tapping into those benefits, however, would require far-reaching supply-side reforms. The Chinese government has announced a reform package in its 13th Five Year Plan[1] which includes a proposal to raise the retirement age, a nationwide negative list which opens up opportunities for private investment in restricted sectors such as air travel, telecommunications, health care and education, and a gradual liberalising of the capital account.

Authorities face a challenging environment when it comes to the desired reduction of excess production capacity in heavy industries. Over the next five years, the government aims to reduce production capacity by 450 million metric tons in the steel sector alone. Recent research by Natixis shows that the challenge for China to transform its economy is rather formidable. The three best-performing sectors (air travel, health care and tourism) represent only 3 percent of the economy, while the three worst-performing sectors (real estate, infrastructure/construction and materials/metals/chemicals) account for 43 percent.

To increase efficiency, the Chinese government has been looking for a solution by merging large state-owned enterprises (SOE’s).[2] However, the mergers will probably not involve large-scale layoffs of personnel needed to improve efficiency, as this could trigger social unrest. Indeed, the actual development of unemployment and income inequality, two indicators of social stability, is probably worse than official statistics are suggesting (see Erken, 2016). Especially in relatively poor regions facing high reduction targets, like Hebei and Yunnan, the risk of social instability will be increasing (see Figure 5).

Figure 5: Heavy reduction targets in poor regions of Hebei and Yunnan
Figure 5: Heavy reduction targets in poor regions of Hebei and YunnanSource: Rabobank, based on Eurasia, Macrobond and Deutsche Bank. Note: many regions still have to announce their reduction targets for steel and coal production in 2016. These provinces are coloured grey in the figure 

Weakness in the financial sector

Figure 6: Banks increasingly under pressure
Figure 6: Banks increasingly under pressureSource: Macrobond. Note: The classification special mention loans refers to weak loans that are not yet qualified as non-performing, but does involve an unwarranted credit risk as borrowers are experiencing difficulties

The high level of excess capacity at SOE’s weighs on firm profitability, which in turn affects the stability of the financial system in China. The number of non-performing loans (NPL’s) reported by Chinese banks has been increasing lately (see Figure 6).

Since many banks are also active in the shadow banking system, the proportion NPL’s could well exceed official numbers. A recent estimate by BMI shows that the proportion of NPL’s could be as high as 20 percent. Reducing excess capacity at SOE’s will put additional pressure on Chinese bank balance sheets. This raises the question whether these banks have sufficient provisions to cover for these losses. Failing to deal with excess capacity means that banks will have to continue to roll over existing non-performing loans to zombie companies. This will only kick the can down the road. If the banks get into serious difficulties, we expect the government to guarantee their solvency. The Chinese central bank (PBoC) could also decide to recapitalise the banks by monetary financing, while attempting to keep the RMB stable.

Serious geopolitical challenges as well

Figure 7: Territorial claims in the South China Sea
Figure 7: Territorial claims in the South China SeaSource: Rabobank

For years now, China has been embroiled in a dispute with countries including Malaysia, the Philippines and Vietnam over the South China Sea, which contains large supplies of gas and oil (see Figure 7). China has been rapidly expanding its activity in the region by seizing islands and building artificial ones on which it has positioned naval bases, airfields and hangars. On 12 July, the Permanent Court of Arbitration (PCA) at The Hague ruled that many of China’s territorial claims in the South China Sea have no historic and legal basis. Prior to the ruling, China had already stated that it would not be bound by the Court’s ruling and it has recently stepped up its activities in the region.[3] While we do not foresee an escalation of the conflict, tensions are currently running high in a region that is vital to Asian trade and growth.[4]


[1] See Eurasia, China Reform Forecast, July 2016.

[2] The supervisory authority SASAC approved various mergers of state-owned enterprises in July. China International Travel Service Group is merging with China National Travel Services (HK) Group and grain producer COFCO is merging with textiles and grain trader Chinatex. SASAC is expected to announce the merger of several large state-owned steel producers in the near future.

[3] China has recently carried out a number of military routine flights over the Spratly Islands and Scarborough Shoal, both of which are the subject of territorial disputes. In August, Vietnam responded by placing a recently acquired rocket system on the Spratlys.

[4] After the annual meeting on July 25, ASEAN foreign ministers adopted a joint communique, stating that they were pleased with the progress of ties with China. They made no specific mention, however, of the earlier verdict by the Permanent Court of Arbitration (PCA). Cambodia prevented that necessary consensus was reached to be able to refer to the verdict.


The Economic Quarterly is a publication of Economic Research of Rabobank and a co-production with Financial Markets Research. The date of completion is the 6th of September 2016.

The views presented in this publication are based on data from sources we consider to be reliable. Among others, these include Macrobond. The economic growth forecasts are generated from the NiGEM global econometric structure models.

This data has been carefully incorporated into our analyses. Rabobank accepts, however, no liability whatsoever should the data or prognoses presented in this publication contain any errors. The information concerned is of a general nature and is subject to change.

No rights may be derived from the information provided. Past results provide no guarantee for the future. Rabobank and all other providers of information contained in this study and on the websites to which it makes reference accept no liability whatsoever for the content or for information provided on or via the websites.

The use of this publication in whole or in part is permitted only if accompanied by an acknowledgement of the source. The user of the information is responsible for any use of the information. The user is obliged to adhere to changes made by the Rabobank regarding the information’s use. Dutch law applies.

Abbreviations for sources: CBS: Statistics Netherlands, ONS: Office of National Statistics, OECD: Organisation for Economic Co-operation and Development, CPB: Economic Policy Analysis, IMF: International Monetary Fund, ECB: European Central Bank, BoE: Bank of England, BoJ: Bank of Japan, Fed: Federal Reserve.

Abbreviations used for countries/regions: UK: United Kingdom, US: United States, JP: Japan, EZ: eurozone.

For more information, please call the KEO secretariat on tel. +31 (0)30 – 216 2666 or send an email to economics@rn.rabobank.nl

Editor-in-chief: Wim Boonstra

Production coordinator: Christel Frentz

Hugo Erken
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO

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