What are China's vulnerabilities? What are the top economic risks for this huge country that drives global growth and is running ahead of the pack of developing nations?

Recently,  Andrew Sheng[1], a fellow at Fung Global Institute, wisely noted that China is preparing for a great transformation that will propel the Chinese state out of the shadow of Deng's reforms and allow it to enter a new dimension. It sounds almost like a sci-fi novel. In fact, it's possibly the closest thing on earth that combines space and time travel.

However, there are some speed bumps in the present Chinese system that have to be resolved before China can embark on this great journey. We shall only dwell briefly here on the reasons for these bumps, as well as possible solutions. The stakes are great in any event. The problems could be so huge that they bog down, stall, and eventually kill Chinese growth. The flip side that solving them could bring a huge new boost to China's economic performance.

The potential problems:

1) Financial costs are many times higher than the international market. Money now costs 6-7% a year in China and in reality it can cost at least three times as much even without notable inflation. The reason is basically that the financial system is primitive, cumbersome. It's also overloaded with the debts of local governments and state-owned enterprises can cannot be simply erased. This creates a huge, useless burden on the economy, which could grow much faster without this burden. The solution lies in nothing short of a complex overhaul of the banking system along with some real privatization efforts. State officials must also carefully monitor the changes. Recent statements by Finance Minister Lou Jiwei[2] indicate the determination to move in this direction.

2) There are enormous inefficiencies in internal logistics. Things have improved in the last decade, thanks to the huge investments in railways and roads. But moving coal from Shanxi to Shanghai can still be more expensive than shipping it from Shanghai from the U.S. Experts estimate that the logistic costs of moving goods within China can be three times more than, say, moving them within EU.

The problem stems from many hidden fees. Logistics management is also and fragmented into too many phases, with little or no integrated management. Despite these problems, the time required to move freight in China is still much faster than in India. Sending stuff from Mumbai to Chennai can take three months.

But this is scant consolation since the loopholes in China's transport system could dramatically slow and even unwind many efforts of the new “One Belt One Road” initiative. If you can't ship merchandise cheaply enough to Kashgar, what's the use of trying to move it to Berlin? The key is bringing in companies that can provide an integrated logistic service.
3) Prices for land development in many Chinese cities are higher or murkier than those in comparable cities in Europe and U.S. This is because in the past decade over 50% of municipal tax revenues came from land sales for real estate. Land was auctioned to the highest bidder — or it was given for free to projects that promised bigger investments in the city or a brighter limelight.

The root problem lay with the soaring overhead costs of the Chinese bureaucracy. This doesn't mean that official salaries were too high. It means that the system has far more employees than necessary and much bigger and more luxurious offices and perks (restaurants, cars, etc.) than almost anywhere else in the world. It's possible the central government has no clear idea of how much this bureaucracy costs or how much office space it occupies. One short-term solution might be the fire-sale of much of the excessive office space concentrated in the provinces. This would recover some money and cow greedy officials. A longer-term solution would be to keep an accurate balance sheet of state assets.

Previously, developing an alternative to this system was useless because the state owned everything. Now that private enterprises, small and large, are expanding and it clear that some officials have abused of their positions by treating state property as personal possessions, taking action is key. This, in a nutshell, is the focus of the present anti-corruption campaign. State assets must also be clearly accounted for.

This will allow the government to know exactly what it owns. It also allows officials to draw up rules on what localities, SOEs, or the military, central ministries, and other departments can do with what they possess. Currently, there's no reliable information. Everything is confused or confusing. Another downside is that there's plenty of room for businessmen and local officials to exchange favors and money in return for state assets.

Tackling the above would alleviate the financial cost and local debt problems alluded to in the first point. The central government, SOEs, or others could sell assets or bonds based on the assets. This would create the financial resources to clear China's mountain of outstanding debts.

4) Government expenditures and financial reform also pale in comparison to the consumption issue. Consumption still needs to reach full fruition in China. The solution here may not lie in focusing on any specific economic sector. Rather, it may be better to consider cities as pulsing centers of growth, consumption, and distribution.

However, there are two problems. a) Too many key cities are located along China's coast. The coastal phenomenon reflects a groundbreaking strategy launched by economist Wang Jian in the mid-1980s. But many of the cities on China's east coast are now bursting with people and the demands that they create. Many cities in the center and the west of the country still suffer from the diversion of population and resources. b) Services within the eastern coastal cities are poor, while general living costs are as high or higher than in many western cities. The combination of these two problems are objective blocks to consumption, which doesn't move inland and is slow to trickle down beyond an explosion of sales of luxury goods.

The problem is that the most attractive places for ordinary people and youth to live are these eastern cities. One way could be to follow the American or German model of dispersing state functions to different cities. For instance big, important universities from Beijing could be moved to the western provinces of Xinjiang, Gansu or Qinghai. Government offices could be moved to the smallest most needy towns in each province. With these simple decisions, growth would migrate. Of course, these measures would meet with opposition from officials or professors. But right now, an authoritarian China can still enforce such solutions. But in a few years, this might become more difficult.

5) The fifth problem is the trickiest. There is an internal and external lack of long-term confidence in China. This, in turn, stifles long-term investments, and thus, consumption.

The situation has improved somewhat because most Chinese now own their homes due to the cheap sale of state apartments to their assignees in the late 1990s. This makes new home-owners active stakeholders in the stability and welfare of the country. Things are also improving because insurance policies (taking care of health care expenses or retirement benefits) are spreading. This frees disposable income for spending.

However, even these improvements fall short of what is needed. As I wrote, there are no short- and medium-term reasons to worry about China's stability. But in the long term (about 10 years), there will be many question marks. These questions basically center on the internal and global long-term trust in the stability of the Chinese political system. Democracy, though highly unstable day to day, is very stable over time. This is just the opposite of the Chinese system. The present anti-corruption campaign and the bitter power struggles every decade or so are a painful reminder of this inherent systemic weakness in the Chinese system. Solving this challenge is pivotal to cracking the other four challenges. But here is the conundrum: Xi Jinping needs a high concentration of power to address the first four challenges in the short and medium term. But he needs a different system to cope with the long-term implications China is facing. There is no clear way to address both needs. The practical Chinese solution would be to rely on a tyrant (no matter how enlightened) for now and then bring a liberal leader onstage, in ten years or so.

The question then is: Will Chinese and the rest of the world believe that such a transformation is possible? Xi cannot offer much clarity on this point since it would undermine his present anti-corruption and overhaul efforts. Yet, without a deeper trust in this metamorphosis, anything Xi wants to accomplish will be more difficult for him to achieve in the short and long term.

[1] “China's Next Massive Transformation,” May 9, 2015,
[2] China risks fall into middle-income trap Global Times, 2015-4-29 18:08:02