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China’s economy has rebounded since mid-2016. But some still worry that massive structural issues mean a cyclical recovery will not last. In particular, there is concern that deleveraging is necessary before economic growth can recover on a two- to three-year basis.

We disagree. China’s debt level is high and still rising, but not in every sector. Borrowing is concentrated in state-owned enterprises (SOE). These SOEs started 2017 owing around RMB85 trillion (about USD12 trillion), which is about half of China’s system-wide debt and around 70 per cent of all corporate-sector debt – even though these enterprises now account for just 16 per cent of jobs and less than a third of industrial output.

The private sector is now the main engine of China’s economy but has debts of just RMB33 trillion – about 20 per cent of system-wide debt and 30 per cent of corporate-sector debt. Indeed, private-sector debt has declined since 2014 while the SOEs’ increased.

The private sector’s liability-to-asset ratio has fallen from a peak of over 60 per cent in 2003 to around 50 per cent in 2016 with a swift decline since 2012 reflecting significant restructuring and balance-sheet adjustment as economic growth slowed. Meanwhile, the SOEs’ liability-to-asset ratio has increased further over the past decade.

The best approach to de-leveraging the economy is thus to focus on the SOEs.

Reforming SOEs is important, but their contribution to the Chinese economy has declined rapidly, reducing their output and labour-market share to historic lows. Even in the 1990s, the sector accounted for over half of urban employment, industrial production and exports; now it is responsible for only 10 per cent of exports, 16 per cent of jobs, and less than a third of fixed-asset investment.

By contrast, private-sector businesses, just small pocket of China’s economy in the 1990s, account for most output, more than 70 per cent of investment and over 80 per cent of employment.

Unlike SOEs, private firms are productive and innovative – a key driver of manufacturing’s steady progress toward the value-added products that are leap-frogging China’s consumer sectors into the digital age.

And after five years of slowing investment and some de-leveraging, the private sector is now in a good position to capitalise on better overseas demand for exports.

China’s dual-track economy raises policy implications. Firstly, the overwhelming importance of the private sector means macro policies must be geared toward it. Counter-cyclical policies that provide stable growth and inflation with policy visibility are therefore very important.

The reform agenda should thus be driven by sector-specific policies and regulators. For instance, China’s central bank has raised short-term interest rates to de-leverage the financial system. But this blunt economy-wide measure increases the risks to growth. Instead, sector-specific regulators – for banking, securities markets or insurance – could use micro-level powers to address individual issues and defuse risks more locally.

Policymakers have the opportunity to tackle China’s debt problem in a more local manner, using more specific policies. Reforming inefficient SOEs – through debt restructuring, industrial consolidation, improved management and the closure of ‘zombie’ companies – would go a long way towards reducing leverage risks.

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