China GDP Sends Troubling Signal on Economic Reform

Slower growth rate would have indicated country was tackling excess industrial production, rising corporate debt

By Mark Magnier

BEIJING—China maintained its growth pace of 6.7% in the second quarter—a bad sign to those who were looking for indications of economic restructuring.

Economists say a slower growth rate in the second quarter over the first quarter’s 6.7% pace would have sent a welcome signal that China was tackling excess industrial production, rising corporate debt and state-owned enterprise reform.

Instead, by ramping up government spending and opening the credit taps, Beijing is likely to fuel overcapacity and see private companies crowded out by risk-averse state banks and bloated state companies.

This comes despite repeated calls by Prime Minister Li Keqiang and other senior officials to foster innovation, entrepreneurship and structural reform in order to shift the economy from credit-fueled infrastructure to high-tech industry and services.

“It’s a pretty clear picture with the big, overcapacity state-owned enterprises getting credit and reform plans not getting support,” said IG Markets Ltd. analyst Angus Nicholson. “The government talks a good story about helping the private sector, pushing through supply-side reform and lowering investment to state companies, but you’re not actually seeing any of this in the statistics.”

The state’s heavy hand can be easily observed in the data, economists say. The first and second quarters both saw weak growth during their first two months followed by a rise in credit and spending in the final months of the quarter, which pushed up the growth figure. Total social financing, a broad measure of credit in the economy, more than doubled in June over May and tripled in March over February.

As credit has coursed through the economy, most of it has been tapped by the less productive state sector, real-estate speculators and struggling industries at the expense of the entrepreneurs and private companies that leaders have looked to for job creation.

While officials have repeatedly called on state banks to lend to promising startups and established private companies, banks tend to favor state-owned companies with their implicit guarantee that Beijing will bail them out if they stumble. “Banks should not discriminate when providing financial services to private companies,” China’s bank regulator said in a statement on its website Friday.

Approaching banks for a loan often means navigating much more intense scrutiny than state firms face over credit ratings, loan-guarantee conditions and asset-liability ratios, said Jackie Xiang, a director at International Engineering Group Co. in the city of Jiangyin in eastern China. “Country-financed projects really should be open to capable private companies, not just state-owned companies,” Ms. Xiang said.

Even as Beijing touts plans to cut excess steel capacity by around 10% in coming years—amid growing complaints by foreign trading partners that China is selling steel below its cost of production—daily crude-steel output in June set a record.

State-owned firms have seen their losses narrow significantly in the first half of this year, according to official data released Thursday, as government stimulus projects ramp up. And property sales in 2016 have jumped by up to 50% year on year in top markets, forcing authorities to impose buying restrictions, even as empty apartment towers ring smaller cities.

During the first five months of 2016, large steel mills posted a combined profit of 8.7 billion yuan ($1.3 billion) compared to a loss of 64.5 billion yuan for all of 2015, according to the China Iron & Steel Association.

Many economists, including those at the IMF and World Bank, have called on China to drop its obsession with growth targets in order to reduce the amount of artificial economic stimulation, and to focus on reforms toward more meaningful growth and a faster transition from traditional manufacturing and infrastructure.

“There’s less rebalancing towards the new economy as it’s propped up by very lax fiscal and, even more so, monetary policy,” said Alicia García-Herrero, leading to “good but cooked” growth figures, she added.

With an annual growth target of 6.5% to 7% on the line, Beijing raised its government deficit target to 3% of gross domestic product this year from 2.3% of GDP in 2015, a figure it is likely to overshoot when off-book government spending is included, economists say. Government spending in June rose nearly 20%, the Finance Ministry said Friday, a more than two-percentage-point rise over May levels.

While investment by state-owned companies expanded 23.5% year on year and state infrastructure investment jumped 20.9% in the first half of 2016—both a modest increase over first-quarter figures—private investment rose a paltry 2.8% in the first half, a decline from the first quarter’s 5.7% level.

“The private sector is really getting crowded out of investment,” IG’s Mr. Nicholson said. “You can’t in a command economy direct the private companies to invest the way you can with state companies.”

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