China's dual-track challenge can be won

With China's economic slowdown more apparent than ever, its prospects of avoiding a hard landing are weakening. Whether policymakers succeed will depend on whether they can navigate the challenges stemming from an increasingly divided dual-track economy.

The latest year-on-year data, from January, highlight the danger. The consumer price index dropped to 0.8 percent; the producer price index fell by 4.3 percent; exports contracted by 3.3 percent; imports were down by 19.9 percent; and the growth of broad money slowed by 1.4 percent.

Moreover, the renminbi has come under downward pressure, owing partly to the economic recovery in the United States, which has fueled capital outflows. Given huge declines in industrial profit growth and local government revenues from land sales, there is considerable anxiety that today's deflationary cycle could trigger corporate and local-government debt crises.

China hopes to secure its long-term economic development by shifting from a State-directed to a market-led economy, but the process has created significant discrepancies in economic performance, with State-owned enterprises performing significantly worse than their private-sector counterparts, despite having better access to credit. And there is a widening disparity between real-estate prices in China's thriving first-and second-tier cities and its lagging third-and fourth-tier cities.

The authorities' task now is to determine how to support continued growth on the better performing track, the private sector and the first-and second-tier cities, while eliminating overcapacity and boosting productivity on the weaker track of SOEs and third - and fourth-tier cities. To succeed, they must address the fallout of the previous approach, which, by providing more money and preferential policies to the lagging track, ended up fueling overcapacity and unsustainable local debts.

In other words, China must confront the sunk costs of bad local-planning decisions. Instead of continuing to hope that bureaucratic intervention can repair flawed projects, officials should take a market-based approach, allowing losses to be allocated through the bankruptcy process, thereby enabling all stakeholders to move on to more productive activities.

The Chinese economy's dual-track structure also presents unique challenges for macro-financial management. As the fast-growing sectors absorb an increasing amount of resources, a shift toward more market-oriented interest rates is needed to ensure efficient allocation. Meanwhile, the slow-growing sectors risk falling into a "balance-sheet recession", with highly indebted SOEs and local governments becoming so focused on paying down their debts that they stop investing in needed infrastructure, even when interest rates fall. As a result, conventional monetary and macro-prudential policies are caught between competing demands for credit, with one track needing to support productive growth and the other attempting to buy time for restructuring.

Efforts to address these structural challenges are being frustrated not just by institutional barriers, but also by entrenched official corruption. The problem is that anti-corruption measures, despite enjoying broad public support, undermine bureaucratic effectiveness in the short term.

Institutional reforms aimed at combating corruption, reducing overcapacity, and dealing with unsustainable local debts will generate long-term dividends and sustainable payoffs. But short-term stimulus measures, such as tax cuts and higher fiscal deficits, will be needed to minimize growth disruptions. This would mean reversing the recent decline in the government budget deficit, which narrowed to 1.8 percent last year, from 2 percent of GDP in 2013.

The transition from a dual-track economy to a market-based economy will not be easy. The Chinese economy is clearly in urgent need of repair. But the news is not all bad: a substantial portion of the economy continues to expand, underpinning much higher overall growth rates than in most other economies. Moreover, despite some concerns about capital outflows, China's consolidated net foreign-asset position, which stands at $1.7 trillion, (17.6 percent of GDP), remains sufficient to sustain China through this tough transition.

China's leaders recognize the long-term imperative of serious institutional reform, even as concerns about slowing growth heighten the temptation to embrace short-term fixes. The authorities are taking strong action to curb pollution, improve energy efficiency, implement pension reform, and expand access to healthcare and low-cost housing.

More immediately, China's leadership is committed to excising the cancer of corruption. The key, as with any critical surgery, is to ensure that the necessary life-support systems are in place. In China's case, that means maintaining adequate liquidity.

In the end, sustainable development will require that China's two economic tracks merge. With the right approach, relatively stable and rapid growth can be maintained throughout the reform process. Avoiding a hard landing would be good not only for China; it would ensure much-needed growth and stability for the global economy.

The article is written by Andrew Sheng and Xiao Geng. Andrew Sheng is distinguished fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng is director of research at the Fung Global Institute.