Diana Choyleva: China Is Getting Serious About Reform

Enodo Economics chief says authorities are doing the right thing, but it's not without risk
March 23, 2017 Updated: March 23, 2017

There aren’t many people who understand China well without having lived there. Economist Diana Choyleva is one of them.

She has covered China for Lombard Street Research for more than a decade, and recently founded her own research consultancy, Enodo Economics.

Diana Choyleva, chief economist at Enodo Economics.

She successfully predicted the Asian financial crisis in the late 1990s, and she foresaw China’s rise to become a dominant global player at the start of the last decade. Before most other analysts, she predicted the end of China’s export-led growth model.

Now, she thinks China is getting serious about reform and will finally tackle the twin problems of debt and overcapacity, a process that will inevitably result in more risk and volatility.

Epoch Times: Why did the Chinese authorities revise their growth targets down to “around” 6.5 percent at the National People’s Congress in early March?

Diana Choyleva: The reason why they changed the growth target now, and didn’t wait until the Party Congress in the autumn, is that Party leader Xi Jinping has consolidated power. That became clear after the Party plenum in October last year.

The next thing on the economic agenda is reducing financial risks. That will be deflationary for the economy, less demand and lower growth.

Epoch Times: What is your estimate for Chinese GDP growth?


Ms. Choyleva: Looking at the GDP target of 6.5 percent in some ways is almost meaningless. Official GDP growth statistics don’t represent the reality of what happens in China, like the very violent cyclical moves of an economy that is so huge and is developing.

I estimate GDP for China using official data, just replicating what the National Bureau of Statistics of China says they are doing, although they don’t tell you exactly what they’re doing.

Based on those numbers, growth in the fourth quarter was 5.8 percent, not the official 6.8 percent. If we look at the last three quarters of last year, growth averaged just 4.3 percent in quarterly analyzed terms. So growth in China has slowed down already to below last year’s target of 6.7 and this year’s target of 6.5.

Epoch Times: But you say the official growth downgrade means the regime will now start economic reform in earnest, now that Xi has consolidated power.

Ms. Choyleva: The most important thing they have to do is to allow more defaults if we are to believe that there’s going to be a genuine change in the assessment of risk in the economy going forward.

Now, I don’t expect that they will allow all the zombie companies to go bust, but we need to see the trends that started over the last two years continue and accelerate even further.

Like telling the banks to stop rolling over bad debt. Start cutting some of these lifelines.

Epoch Times: Because debt is still the main issue, right?

Ms. Choyleva: A few years ago, people were thinking about a financial collapse, a banking crisis, but I wasn’t one of them. I acknowledged that the rate of increase in debt to GDP was alarming, but at that point in time, I kept saying that I don’t see this as having yet reached the point of reckoning.

However, looking at the data now, we’ve reached crunch time.

We look at non-financial, non-government debt as a share of GDP and compare China to Japan and Korea during their respective catch-up growth periods. A couple of years ago, China was nowhere near the peak reached in Japan or Korea. Now, China is above the peak in Korea and very close to the peak in Japan seen before their respective credit bubbles burst.

So from that point onward, as far as I’m concerned, we’re in uncharted territory.
— Diana Choyleva, chief economist, Enodo Economics

So from that point onward, as far as I’m concerned, we’re in uncharted territory. If you’re one of the people who say that debt doesn’t matter in China, I think in order to be able to say that, you have to have some ironclad story as to why this time is different. And I haven’t come across such a story.

There won’t necessarily be a huge financial implosion, but I don’t believe those who say that growth will be strong and there won’t be any volatility, that they can just smooth it over.

Epoch Times: They will try to make the adjustment process as smooth as possible, but there are risks.

Ms. Choyleva: If they raise defaults, but try to maintain the risk perceptions in the market, it’s least likely to cause systemic risk.

Now, of course, it’s a huge challenge, so there are bound to be accidents. I think looking at market participants now, everyone’s focused on Trump, everyone’s forgotten about China.

In my view, 2017 in that sense will be a different year. China will come back on the radar. Even if the authorities are trying to do the right thing and have a crack at reform, it may be perceived by outsiders as them losing control.

If this is to kick off at a time when growth has already slowed down a lot more than people think, and we have an overvalued Chinese currency, how can China manage it successfully?

So it’s more likely that the bulk of the push might happen after the Party Congress in the fall. But October, November aren’t that far off. And the scale of the issue is such that they have to deal with it, and dealing with it will involve pain and volatility.

Epoch Times: But you say it’s better to do it now rather than postpone it even more?

Ms. Choyleva: I think it’s a better strategy, even with the risks entailed. After the global financial crisis, China could no longer just throw money at unproductive investment as it used to do for years before.

Not only is the world not growing, and the global trade pie is not growing as fast as it used to, but also China’s ability to carve out larger parts of the pie is significantly constrained.

So export income has diminished dramatically, meaning that if they want to continue throwing money at unproductive investments without reforming, they will either get a debt explosion or inflation, and none of those dynamics are sustainable.

Epoch Times: We have already seen an uptick in producer price inflation this year. Where is it coming from?

Ms. Choyleva: The capacity cuts in raw materials, in particular coal and steel. They started cutting in earnest in 2016.

So those prices have shot up. Utilities have started losing money, which tells me that cost-push inflationary pressure has not fed through the chain and hit the consumer.

We continue to see decimated profits across the board in China. So the corporate sector takes the hit. 

It is highly likely that it will pass through to consumer price inflation, which so far has been muted because this is not a scenario of demand-driven inflation. 

It is very much a cost-push inflation, and we will end up during the course of this year with the worst of both worlds: slower growth and stronger inflation.