Wharton's Minyuan Zhao and Penn's Jacques deLisle discuss the state of China's economy.

As China last Friday reported a slowing economy in July 2016, fresh questions are being raised about the country’s policy directions and pace of growth. Uncertainty rules the air amid disconnects between policy pronouncements on a shift from state-led investments to a market-based economy on the one side, and a continuation of state dominance on the other.

The absence of worthy investment projects is driving a disproportionate amount of bank lending to real estate, which has also brought along the specter of bad loans. Jobs are scarce, and an aging population means more people are chasing the jobs that are available. Bright spots do exist, though, such as a promising high-technology sector and rising consumption spending, signaling some of the shift policy-makers desire.

The slowdown in private investment seen in the July numbers is among the worst indicators for the Chinese economy. A Wall Street Journal report of last Friday said a spokesman for China’s National Bureau of Statistics had acknowledged at a briefing that “many private businesses were reluctant to expand against a backdrop of cooling growth.” Industrial production rose 6.0% in July from a year earlier, slower than the 6.2% growth of June, the report added.

“Two years ago, we had a conversation on this and the key word was ‘uncertainty;’ two years down the road, that is still the case,” said Wharton management professor Minyuan Zhao. She was referring to a Knowledge at Wharton article from December 2014 in which Erin Ennis, senior vice president of the U.S.-China Business Council (USCBC) had said that U.S. firms “are particularly concerned with a lot of uncertainties in China.”

Private investment has fallen because China’s president Xi Jinping has said he wants to ensure that state-owned enterprises are “better, stronger [and] larger,” she explained. “If you are a smart [private] enterprise owner, what do you do?” she asked, suggesting that such policies would deter private investment.

“China is still a top-down economy.”–Minyuan Zhao

Zhao said that in her visits to China, she finds people struggling to correctly interpret government signals on where the economy is headed. That is because of disconnects between the government’s strong language on a shift away from the state sector to the private sector and ground realities, she explained. “China is still a top-down economy,” she said.

A Slow Switch to a New Normal

The big question is whether the “new normal” for China’s GDP growth of between 6% and 7% is sustainable, said Jacques deLisle, law and political science professor at the University of Pennsylvania Law School and director of Penn’s Center for East Asian Studies. Much hinges on how China’s new growth model is implemented, he said. The new model assumes slower growth, but not all the pieces are in place to make that policy successful, he added.

Zhao and deLisle spoke on the outlook for the Chinese economy on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

China is showing mixed results in its efforts to rebalance its economy from investments toward consumption and services, said deLisle. Rebalancing the economy from exports to the domestic economy is occurring to a degree, he noted. With the state sector still dominating the policy agenda, the de-emphasis on state-driven investments is not occurring fast enough, he added. The commitment to reform state-owned enterprises (SOEs) to put them fully on a market basis is “dead in the water … and is almost going in reverse,” he continued. Cleaning up China’s financial system to make it “more disciplined and more market-oriented” is another commitment on which he saw little traction.

Housing Boom: A Twin-Sided Blade

The picture is mixed with respect to increasing bad loans at Chinese banks, which Zhao rated as the other big depressing factor for the economy. “The housing boom is both the consequence and the cause for the slowdown,” she said. It is a consequence of the slowdown because the paucity of investment-worthy projects in the real economy compels banks to lend to the housing sector, she explained.

“That is one of the sources of malaise in the cities – people who are graduating and not finding jobs.”–Jacques deLisle

Such disproportionate lending to housing has brought a spike in nonperforming housing loans as well. But two factors have helped banks regain lost ground as a result of those bad loans. One, Chinese banks are hiving off non-performing loans to asset management firms and writing them off “in a big way,” said Zhao. Two, they have benefitted from an unexpected housing market boom in a slow economy. Shanghai and Shenzhen have seen real estate prices soar 50% or so in the last year. “In a sense, the individual households are bailing out the big banks,” she said. As a consequence, the balance sheets of the large state-owned banks “don’t look as bad as alarmists would like you to believe.”

The housing sector has traditionally been a favorite investment destination in China, according to deLisle. He said household savings have typically had few investment options. Bank deposits yield very low or negative interest rates, the stock market is similar to a casino and parking savings overseas is not an option for all, he said. “And so it flows into [areas] like the housing sector,” he added. Zhao said policy makers have placed high priority on taming housing prices because they tend to deter the desired increases in household consumption.

That housing boom has an inflationary effect on businesses elsewhere in the economy, making it difficult for them to survive, said Zhao. She said that many managers in Shanghai she recently interviewed planned to move out to other parts of the country because the young people they want to hire, especially those in the R&D sector, are unable to afford housing in the city.

According to deLisle, the employment outlook is uninspiring, and he explained why that was so. Demographic pressures include an aging population, and so people stay employed into their later years. He noticed a vast expansion in higher education — even if it is of uneven quality — producing college graduates looking for jobs. “That is one of the sources of malaise in the cities – people who are graduating and not finding jobs,” he said.

Job opportunities have shrunk also because China is no longer as inexpensive as it used to be, and manufacturing of cheap products has moved to places like Vietnam and Bangladesh. Consequently, businesses in China are trying to find opportunities in value-added manufacturing, but those are harder to come by and more difficult to manage, said deLisle.

“It’s not a disaster story. It’s a decline from a super-heated, happy-days-are-here-again-forever [scenario], and it is a concern about how to keep it rolling going forward.”–Jacques deLisle

Pockets of Optimism

On the other hand, Zhao sees “pockets of optimism,” especially in the technology sector. “If you are riding the high-speed rail while browsing the web, ordering dinner for you, waiting for you at home when you arrive, [you would say], ‘This is a wonderful China — the Wall Street Journal is painting such a negative picture because it is so good, so convenient and so ahead of the U.S.’ But after dinner when you talk with your friends, they would talk of the uncertainty on where to go next. So it’s a very mixed picture.”

While manufacturing jobs are scarce, “the transition [to the new service economy] is happening,” said Zhao, citing bright spots in the July data on spending on travel and entertainment. Both she and deLisle said a big positive sign is consumption spending growing at 10% annually. “That is rebalancing towards consumption,” said deLisle. “It’s not a disaster story. It’s a decline from a super-heated, happy-days-are-here-again-forever [scenario], and it is a concern about how to keep it rolling going forward.”