SHENYANG, China (Reuters) - A flurry of construction in the Chinese city of Shenyang belies a regional economy in crisis, a striking example of the increasingly diminishing returns from a policy of investing heavily in infrastructure to prop up economic activity.

People shop at a market in Dalian, Liaoning province, China, June 9, 2016. REUTERS/Stringer/File Photo

A new exhibition center has just opened its doors in the city, the capital of Liaoning province in northeastern China, and the skyline is dotted with cranes working on high-end shopping malls and apartments.

But beyond Shenyang’s building sites, the real Liaoning is different. After years of investment in infrastructure, some of it encouraged by the central government, Liaoning is China’s only shrinking provincial economy, its population is in decline and its debt is almost three times annual revenues.

Liaoning highlights the risks of relying on repeated borrowing to invest in infrastructure and fuel economic activity - a regular fall-back policy China has used when GDP risks missing annual targets, including in 2016.

It also points to the urgency for China to move away from a reliance on state firms, which for decades provided China’s economic backbone. Most other provinces have reduced their reliance on state-firms to a much greater extent than Liaoning and its neighbors, Heilongjiang and Jilin. But they still wield considerable influence nationwide.

Traditionally, state-raised investment funds have been channeled through state-owned enterprises (SOEs) because they are big tax payers and employers. This has provided a life support mechanism for many dying state industries while crowding out the private sector on which China is staking its future.

Some local authorities have provided all sorts of preferential support to state firms, said Han Liang, a section-chief in the Liaoning government pricing bureau, “over protecting them and making them lose their motivation to innovate.”

Liaoning’s provincial government, and its local development and reform commission, declined repeated requests for comment.

HOPES REST ON GOVERNMENT SPENDING

Nowhere are Liaoning’s challenges more evident than in Benxi, a city 29 miles (46 km) from Shenyang and dominated by a single SOE: the struggling Benxi Iron and Steel Group (Bengang).

Like Liaoning, Bengang is well past its economic heyday. Its chimneys, smelters and stockyards stretch nearly a mile along the banks of the Taizi river flowing through Benxi.

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It provides around 60,000 jobs and most tax income for the city government, but it is struggling to compete with coastal plants because they have better access to markets and cheaper foreign feedstock. In 2015, it reported its first net loss since the global financial crisis in 2009.

The firm is being squeezed by central government efforts to reduce steel production nationwide and so has branched out into real estate investment, in turn crowding out private players.

General manager Chen Jizhuang said in a pep talk delivered at a meeting with company employees in December that its “indomitable, evergreen genes” would enable it to overcome all its difficulties. But the firm appears to be resting its hopes on yet another round of government spending.

“The year 2017 is a new round of the central government’s Rejuvenate the Northeast projects and it is also a key year for Bengang to set off on a new road and seize new opportunities,” Chen told staff, according to the firm’s website.

Bengang declined several requests seeking interviews with senior officials.

LEGACY

Liaoning, Heilongjiang and Jilin were once powerful industrial bases responsible for much of the coal, steel and heavy industry that underpinned China’s economy in the 1960s and 1970s.

That legacy keeps the investment flowing into the region today under a program called Rejuvenate the Northeast –originally designed to head off unrest after punishing national economic restructuring almost two decades ago laid off millions of workers and sparked strikes, protests and a surge in organized crime.

“We have to consider historical context,” Zhou Jianping, a senior government official at the state planning agency in charge of the Rejuvenate the Northeast project, told Reuters in an interview. “Northeast China made big contributions to China’s economic development.”

But the provinces have struggled to adapt to another central government push - reducing the influence of heavy state industry and provide room for private firms to thrive.

“What does the government want Liaoning to do?” asked the manager of a joint venture manufacturer in Shenyang, who declined to be identified because he was not authorized to talk with the media.

“It’s all very well pumping money into the economy but if you’re not pumping it into the right places, it is just good money after bad,” he said.

Liaoning’s economy shrank 2.5 percent in 2016, the only Chinese province to contract, while growth nationwide hit 6.7 percent.

While the decline was partly attributed to corrections in 2015 data following a crackdown on statistical fraud, the province remains riddled with debt and dependent on the sluggish state sector.

Liaoning government debts are 287 percent of revenues. State-owned firms in the northeast provinces hold around half of the industrial assets, compared to a 10 percent national average, the China Institute for Reform and Development said.

The result is a region dependent on “big but weak” state firms, said Li Kai, vice-president of the Northeast Rejuvenation Research Institute, a government think-tank.

Nicholas Zhu, a senior analyst at Moody’s Investors Service, provides a bleaker assessment.

“It’s a vicious circle just like Detroit,” he said, referring to the U.S. city that filed for bankruptcy in 2013 following a long-term economic and population decline.

“Detroit defaulted not because of short-term events but because 20-30 years ago people started leaving, corporations started leaving, and then there is hollowing out. Eventually you get to the point where they couldn’t finance themselves.”

For a graphic on China's local economy click here