This article was first published in the September 2016 China edition of Accounting and Business magazine.

China now accounts for more than 10% of world output and imports and is a major source of foreign investment in both developing and emerging economies. Given this large footprint, it is crucial to understand how the growing challenges its economy faces will unfold. 

The Chinese economy has slowed significantly since 2014 and, despite huge government efforts to boost demand, the deceleration is persisting. Moreover, the massive accumulation of debt has brought the ratio of China’s total debt to its GDP close to an eye-popping 250%, the corporate sector alone accounting for 156% of this. With the country suffering persistently falling producer prices since 2012, the real burden of this soaring debt threatens the corporate sector’s finances. 

Investment amounts to close on half of the Chinese economy and, given over-capacity in many industries, excessive debt, and over-supply of real estate, it is virtually certain that private investment, which grew in May at the slowest pace since records began, will slow further or even contract. Since private investment is about two-thirds of total investment, it will take an impossibly huge surge in public investment to offset this deceleration. 

Of course, the economy has the benefit of some positive drivers. Urbanisation generates growth. The online retail revolution is sparking off substantial investment in logistics and transportation. And China is also reaping tremendous supply-side efficiency gains from the massive rollout of new road and rail links.  

Meanwhile there are two worries about the financial sector. First, corporate debt surged sharply over a short period in a system where the credit culture is still weak. Second, shadow banking has also expanded in the context of an incomplete regulatory framework. These are serious issues but we are not convinced that a Lehman-like financial crisis is likely. A combination of bank re-capitalisation and regulatory forbearance can probably take care of the mounting bad debts in the formal banking sector. 

The risks in the shadow banking sector are difficult to assess given poor information. However, most of this risk appears not to have been repackaged in the form of the leveraged securities in the way it was in the US prior to 2008 – ie, in a manner which could lead to a chain reaction of financial shocks. The risk now in China remains principally with the banks where, as outlined above, the risks can be contained and where the banks continue to have a strong incentive to manage those risks by negotiating restructuring deals with those parts of the system which might be encountering stresses. 

Clearly, effective policy is crucial if these risks are to be contained. If the economic and financial stresses are to be adequately managed, policymaking has to be anticipatory, carefully calibrated and implemented quickly. So far, the track record of Chinese policymakers has been remarkable. The system has already been stress-tested: the north eastern provinces have suffered an economic crash as the old industries there have taken the brunt of the economic slowing, while many parts of the real estate sector have deflated sharply as well. The economy and the financial system have held up reasonably well, indicating a degree of resilience in the system as a whole.  

So, as long as policymakers continue to devise effective responses to China’s ongoing economic and financial stresses, the Chinese economy is likely to weather this difficult patch. But if economic policymaking is disrupted, the risks to China’s economy and hence to all of us will increase.

Manu Bhaskaran is CEO of Centennial Asia Advisors in Singapore