A critical shift is taking place in China ― and it could have brutal consequences

ChinaGetty ImagesShanghai, China

China is beginning to “talk the walk.”

That is according to Wei Yao, a strategist at Societe Generale, who published a note on Friday on the country’s need for capacity consolidation.

Capacity consolidation is another way of saying that China needs to cut back on heavy industry, which sucks up resources and capital.

That sector of the economy has been allowed to continue production despite overcapacity, or a glut of supply, for too long.

“To us, capacity consolidation holds the key to addressing China’s most pressing economic issues: capital misallocation, looming growth in non-performing assets and deteriorating productivity,” the note said.

Supply-side reform is now the number one catchphrase in Chinese policymaking circles, according to Yao. That marks a key change, as in the past China has focused on three areas of aggregate demand: consumption, investment and exports.

“It is encouraging that the authorities are no longer beating around the bush, at least rhetoric-wise, on the inevitability of some serious restructuring programmes. To us, this sudden sense of urgency is a clearly response to negative developments this year.”

The economy has been allowed to continue production despite overcapacity. Photo: ChinaFotoPress/ ChinaFotoPress via Getty.

To recap, negative developments this year include: A sharp drop in the mainland’s stock market, a sharp drop in exports, a devaluation of the yuan, and a fresh round of stimulus measures.

Yao even goes so far as to set out what a potential restructuring might look like. It is pretty brutal, and involves making 1.7 million workers redundant. She said:

  • Scale: The programme could begin with the most distressed sectors. The obvious candidates are coal mining, ferrous metal mining and ferrous metal manufacturing.
  • Size and time horizon for restructuring: SOEs in the three sectors above together have CNY5trn [$780 billion] in liabilities and employ 8.6m people. Assuming 20% SOE capacity reduction as the target (that is, over average 10% for the sectors as a whole), potential non-performing debt would be CNY1trn [$156 billion] and 1.7m workers could be made redundant, equivalent to 2% of bank loans and 0.3% of urban employment.
  • Size and format of fiscal assistance: The amount of assistance would be determined by the cost of soothing unemployment pains and debt write-down. We estimate that the fiscal support needed would be CNY325bn [$50 billion], thus CNY75bn [$11 billion] per year if implemented over five years.
  • Further expansion of the programme: If the initial programme is successful, the authorities could then adapt the restructuring model to other sectors. The total cost of restructuring of the troubled sectors could run up to CNY1trn. The pace would be subject to social stability, fiscal scope and the financial system’s ability to absorb non-performing assets.

Clearly, such a plan isn’t going to be easy. Chinese policymakers and citizens alike are likely to be especially sensitive to the prospect of increased unemployment. But Yao, who is one of the leading lights on China economic analysis, said any kind of programme to speed up capacity consolidation will be a clear positive for China’s outlook.

The note said: “The restructuring programme may still come slowly, but with the authorities shifting their attention to supply from demand, a critical shift in macroeconomic management looks likely.”

Following this it has been revealed that the slow down in China’s economic growth has eaten further into Australia’s national budget.

The budget deficit is now expected to be at least $5 billion bigger than forecast this financial year, according to the latest estimates from Deloitte Access Economics.

The economists predict an underlying cash deficit of $40.3 billion in 2015-16, about $5.2 billion worse than projected at the budget in May.

This is worse than the $37.9 billion deficit in 2014-15.

Business Insider’s Chris Pash has more.

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