In mid-January, the National Bureau of Statistics of China proudly unveiled 2017’s economic data and a Gross Domestic Product (GDP) growth of 6.9%, not only exceeding the year’s goal of 6.7% but demonstrating to audiences at home and abroad that the Chinese Communist Party (CCP) has tight control over its economy.

2017’s growth numbers were lauded in Chinese state media as proof that the nation had come of age as a true global economic power. But the number reflects not just growth, but also debt - particularly debt incurred by investing in projects that do not generate value in the real economy. Based on expert projections and provincial level case studies, these “bridges to nowhere” make up a shockingly large percentage – possibly more than half - of reported GDP growth.

Though Xi Jinping’s “new era” of socialism with Chinese characteristics has warned future GDP numbers will be lower, it is not yet clear if this will be enough to staunch the flow of debt or if the CCP will be able to take on the painful task of deleveraging.

Growth and Debt

Accounting standards in China discount bad investments differently from standard practice in market economies. When a Chinese entity invests in a project that does not yield profits, reported GDP in the short term is still pushed upward by the amount of wasted investment. Over time, as those investments fail to yield real value, GDP is gradually pushed down until the net effect of said investment is zero.

This accounting practice in isolation might be relatively harmless, but economic indicators themselves motivate behavior. With the CCP’s legitimacy at home and abroad being intrinsically tied to GDP, there is enormous political incentive to continue pushing, or at least make minimal efforts to curb, debt fueled growth.

This practice unambiguously contributed to 2017’s GDP numbers. To take one example, last January authorities announced preparatory work to build or expand twelve airports in Xinjiang province – five of which would be underway in 2017 alone. This would be in addition to the four airports already under construction, not to mention the 18 airports already in Xinjiang, which Xinhua reports is more than any other region in China.

Xinjiang has a population of 21.8 million (1.5% of China’s total population), and is notorious for periodic domestic and international travel restrictions. While it is possible these airports could serve a secondary military purpose, that does not change the premise that these are commercial airports built with the intention of generating revenue —all of which begs the question of how much market demand there is for these new airports.

Historical Precedents

The Soviet Union and Japan both after over a decade of rapid double digit growth and ballooning bad debt saw that growth suddenly reduced to a crawl. Neither was able to recapture their miracle levels of growth despite both fostering close relationships between government, industry, and financial institutions.

Japan was able to spend its growth years creating a comprehensive healthcare and national pension system to care for the basic needs of its citizens. Though the Chinese government has been able to incrementally improve healthcare and social security, they have yet to create a system that similarly provides for everyone.

These precedents also paint an intimidating political picture. “Japan was a total bubble — with stocks and real estate inflating at the same time. The euphoria was social and political as well as economic and financial,” author and expert on Japanese economic history Peter Tasker said to The Financial Times. Once the bubble popped, Japanese voters for the first time in 40 years ousted the Liberal Democratic Party from power.

The CCP is well aware of these analogies. Xi himself in 2010 in his capacity as vice president requested that the Central Party School research Japan’s bubble and subsequent crash. It is not unreasonable to assume that economic policy under Xi is at least partially informed by this history.

Economic Devolvement in the New Era: Mixed Picture for the Future

The new slogan for China’s economic development is “quality” not “quantity.” The Central Economic Work Conference and the State-owed Asset Supervision and Administrative Commission of the State Council have pointedly not included quantitative goals for this year and 12 provincial governments have already set lower GDP goals for 2018. These can both be viewed as positive steps towards cutting down future increases of non-performing debt. Even so, these moves do not erase current debt, estimated by the National Development and Reform Commission to be 260% of GDP, and by outside scholars to be even higher. Victor Shih, professor at University of California San Diego, estimates actual debt to GDP could be as high as 328%.

The main tool Li Keqiang (李克强) and the State Council have endorsed to eliminate current debt is through expansion of debt-equity swaps. At a meeting in early February 2018, the State Council announced the creation of targeted business guidelines meant to strengthen market oriented debt-equity swaps.

Debt-equity swaps are a useful tool for allowing entities unable to pay off their debts to give stock to lenders or third parties who then cover the debt in exchange for future profits. While this tool is commonly used in market economies and can give relief to companies in crisis, it does not erase the burden of non-performing debt from the economy – it only rearranges who must bear the costs.

This problem is currently taking place in Inner Mongolia. The provincial government publicly admitted in early January that the region’s fiscal revenue for 2016 was 26% lower than was originally stated, and two major subway and rail infrastructure projects totaling over 80 billion RMB (12.7 billion USD) of sunk capital were shelved after only partial completion.

Reportedly, the disingenuous figures were published to bolster Inner Mongolia’s credit ratings and ensure access to cheap debt. This prompts speculation on what deleveraging options Inner Mongolia will have with lower credit ratings and a greater known percentage of non-performing debt.

An important question to consider is how quickly Chinese GDP goals will be lowered. So far, the only confident prediction is that they will be lower than last year’s 6.7%. Whatever the goal, we can expect it to be achieved on paper. Depending on where the goal is set compared to the real economy, bad debt on the whole may still rise too quickly to escape a major crash.

Setting the GDP goal too low has its own costs. China’s GDP is a source of great political clout both at home and abroad. A dramatic decrease in GDP will call into question how genuine earlier numbers were and deny the CCP of a major source of soft power and performance legitimacy. Stringent reductions of debt and cutting infrastructure projects may reduce jobs and could lead to overall societal instability.

In a recent speech, former Minister of Finance Lou Jiwei (楼继伟) warned that though the country cannot afford more “white elephant” projects, in order for China to eradicate poverty by 2020—a goal Xi included in his 19th Party Congress Report—the country must maintain “an appropriate level of growth.”

A Strong Central Leader: Man for the Job or an Emperor with No Clothes?

There is wide diversity of opinion on how Xi’s centralized leadership will handle the looming debt crisis, depending on each individual analyst’s take on Xi’s priorities and character.

Michael Pettis, Economics Professor at Peking University and long-time critic of China’s debt based growth, hypothesizes that in order to tackle this problem there must be political will to break through the hold of interest groups who benefit from it. He asserts that after the major push for GDP to improve the political atmosphere for the 19th Party Congress, Xi will be able to take his political clout to force through the uncomfortable work of tackling bad debt.

Others, such as Jude Blanchet, engagement director and political research leader at The Conference Board’s China Center, worry that the current centralized power structure creates disincentives for reporting bad news and is antithetical to reform. Xi has already tied his political identity to supply side structural reform. To challenge it becomes by extension challenging the party, or at least Xi’s leadership of it. This makes it difficult to consider the policies Xi throws his weight behind as unsuccessful, regardless of their real effects on the Chinese economy. As a result, policy experimentation becomes far more difficult.

While 6.9% may look like an achievement, it should be understood as standing under a looming wave of non-performing debt. And it is still too difficult to say what China will look like should that wave crash. This coming March, national level GDP goals will be released and we may have a better sense of the role GDP will play in China’s “new era.” Xi Jinping and the Politburo Standing Committee might be prudent, incorporating the lessons from history they are evidently studying.

Facing this problem head on may force Xi into the politically vulnerable position of having to walk back his promises to the country. Having tied his name to the construction of a “moderately prosperous society” and poverty eradication, if Xi were to fall short of these goals as a consequence of dealing with China’s debt, this could open the door for critiques of his leadership from within the party as well as from without.

But if Xi can be defined by one characteristic, it is his ambition. After solidifying his position as the most politically powerful man in the People’s Republic of China since Deng Xiaoping, Xi made clear his plans to eradicate poverty, turn China into a center of innovation, and make China a leader on the world stage. After getting a taste of being known as one of the most powerful men in the world and committing to infrastructure spending abroad for his ambitious Belt and Road Initiative, it would be understandable if Xi were to prioritize his “China Dream” over prudence and tell himself, “This time it’s different.”

Will Xi and the CCP be able to navigate what Japan and the USSR were not? To truly meet the people’s needs for a better life in the long run, Xi will have to resist relying on GDP numbers to give the Chinese economy and political system legitimacy and tackle the monster of growing debt.

Image Credit: Iqilu.com