And the award for the province that is rebalancing the fastest goes to…Shanxi!

Official Chinese state media often points to the growing service sector has a sign of China rebalancing away from an unsustainable investment-driven model of growth to a service-based economy that is more modern, environmentally-friend and represents the future of Chinese growth. Recently on the front covers of China Daily[1], the state paper proudly presents that 50.5% of the Chinese economy is now service-based and the process of rebalancing is moving along smoothly. However, if we inspect under the hood of the rebalancing process, several important questions emerge regarding the relevancy and sustainability of this figure.

1) Much of Chinese growth is driven by an expanding financial sector

Analysis of China’s nominal GDP growth is quite telling. The most often quoted GDP statistic in China is the real GDP that removes the effect of price changes to calculate the actual changing production capacity of the economy. However, when analyzing the financial sustainability of the rebalancing process; especially the sustainability of the firms in the real economy to meet their financing cost, nominal measures matter and represents a more accurate description of the cost pressures of enterprises. If we analyze the rebalancing process in China using nominal GDP, it is clear that since 2012 the growth in the tertiary sector has by far outstripped that of the secondary sector.

Nominal GDP by sector.JPG

The tertiary sector, as defined by the National Bureau of Statistics (NBS), is the summation of several broad categories, mainly: transport; storage & post; wholesale and retail trade; accommodations and catering trade; financial intermediation and real estate. Surprisingly, the NBS used to publish many other categories when calculating the tertiary sector (i.e. leasing of commercial services, education etc.), however, they stopped releasing the data for these categories after 2012. The five categories I listed currently represents 60.7% of the tertiary sector. The missing 39.3%, I will denote as ‘Other’. Conversations with contacts in Beijing indicates much of this ‘Other’ category is associated with government spending. With that in mind, let’s look at the evolution of the components of the tertiary sector overtime.

Nominal growth in tertiary sector.JPG

From the graph above, it is quite clear that much of the strong growth in the tertiary sector, and hence a fair chunk of GDP growth, actually comes from strong growth in the financial sector. Without the strong contribution from financial intermediation, in 2015, the tertiary sector would have grown at 9.6% and nominal GDP at 5.1% (as compared to respectively 11.7% and 6.4%).

In itself, there is nothing wrong with growth in the financial sector. However, having a booming financial sector in the backdrop of a slowing economy is a receipt for disaster. Financial activity can be productive that enhances the efficient allocation of resources in the economy. However, as the Global Financial Crisis can attest to, financial activity can also be speculative that misallocates resource and distorts the pricing signals of the economy. With widespread evidence of financial excesses, as seen in the equity bubble in the first half of 2015 and the exponential rise and subsequent failures of P2P funds (i.e. E Zhubao) recently, it is safe to say that at least some of this financial activity is unproductive and is likely to harm the economy. Estimates from by Logan Wright from Rhodium Group demonstrates that, finance as a sector, is a now larger in China than in the US (see chart). Historical experience consistently demonstrates that, a rapidly expanding financial sector is often linked with financial crises.

financial sector as a share of GDp.JPG

2) Many unlikely provinces are experiencing a boom in the tertiary sector

What is more shocking to me is not that the service sector is driving Chinese growth. The government often touts e-commerce and the rise of firms like Alibaba with their dominant online payment system, Alipay, as the solution for China’s sagging growth. What is shocking to me are the provinces that are experiencing the fastest growth in the tertiary sector.

The chart below details the year-over-year growth of the tertiary sector versus the secondary sector of 25 Chinese provinces in 2015. NBS keeps track of 31 provinces but only 25 to date has uploaded their provincial GDP data by sector for public use. The 6 provinces that have not yet provided their 2015 data are: Liaoning, Heilongjiang, Yunnan, Tibet, Gansu and Xinjiang. It would definitely be interesting to see the rebalancing process in the North-Eastern provinces, but these six provinces are not the drivers of Chinese growth and the remaining 25 should provide us with a decent picture of the overall situation.

secondary versus tertiary sector growth.JPG

If we measure the rebalancing process as a booming service sector compared to a slowing industrial sector (essentially the difference in growth rates between the two), then clearly Shanxi is the winner. If we recalculate the data from the chart above, purely in terms of differences between the growth rates of the tertiary sector versus the secondary sector, then list would look like the following chart.

rebalancing index.JPG

What I found astounding in this chart is that Shanxi won by a huge margin. Shanxi led the nation not only in terms of contraction of its industrial sector, but also in terms of increase to its service sector. My immediate reaction to this result was one of skepticism. From my general recollection of news in China, there has not been any amazing innovation coming out from Shanxi to justify a nominal tertiary sector growth rate of 19.6%. In addition, because of the dominance of heavy industry in Shanxi and the collapse of that sector in 2015, Shanxi’s nominal GDP growth was actually 0.3%. One possible explanation for this intense growth in the tertiary sector is heavy government spending to prop up the local economy. Preliminary data released by Ministry of Finance shows that in 2015, the combined (both local and central government) on-balance sheet fiscal deficit was 3.5% of GDP, up significantly from 2.1% in 2014. The increase in the fiscal deficit does not included the off-balance sheet spending conducted by other arms of the government (i.e. the policy banks, LGFVs and SOEs etc) which also saw significant increase in activities in 2015. If the huge growth in the service sector is caused by a strong surge in government spending, it calls into question the sustainability of this growth and the entire rebalancing process itself. One of the intentions of the rebalancing process is to move away from a debt dependent model of growth. If my observations are correct, essentially the government is substituting corporate debt used for investments to public debt used for consumption: this is a trend that is neither sustainable nor desirable. Despite having better environmental effects, the continued dependency on debt does not change the core of Chinese growth model and continues to accumulate financial sector vulnerabilities.

Moreover, to connect my second point to my first point, we know nationally, much of the increase in the service sector is supported by strong growth in the financial sector. The 2015 data for the provincial breakdown of the tertiary sector by components has yet to be released, however, logically we can expect many provinces to experience strong growth in financial intermediation[2]. Can we imagine the provinces that are rebalancing the quickest to be productive users of increased financial services? If we look at the top five provinces that are rebalancing the fastest: Shanxi, Qinghai, Shanghai, Hebei and Shaanxi, outside Shanghai all the other provinces are dominated by heavy industries associated with China’s current slowdown. Is their strong growth in the service sector productive or is it financing for zombie companies that will inevitably need to be restructured?


Official media often regards economic rebalancing as switching growth from the secondary sector to the tertiary sector. Much of China’s current growth in the tertiary sector is driven by increased activities on the part of the financial sector. Finance ultimately is a tool that attempts to better allocate current resources and does not create new wealth in the economy. Ample amount of evidence points to the financial sector supporting unproductive activities in the Chinese economy and brings into question towards the sustainability of this growth. When we define rebalancing as the difference between tertiary and secondary sector growth, we find some unlikely candidates to be rebalancing the quickest. These unlikely results question the underlying GDP data itself, and combined with the national trend of increased financialization, paints a picture of a dangerous situation where much of the financing occurs in economically weak areas of the country.


[2] Since the national average growth rate in financial intermediation was 23.2%, many provinces would actually have seen finance grown faster than this.

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