My answer on Quora:

As it stands right now, China’s economy is not sustainable.

The good news is that the Chinese authorities know what they need to do. The bad news is that it is a lot easier said than done, not just for political reasons but for economic ones too.

At the heart of China’s economic challenges is the health and development of its financial sector and its central role in China’s transition to becoming a consumer-led market economy.

The problems center around:

1. The size and dominance of state-owned enterprises (especially state-owned banks). These government backed enterprises make up some of the largest banks and construction firms in the world. On one hand, they crowd out private sector development in these industries and restrict their competitiveness, efficiency and innovativeness. On the other hand, the state-owned banks create major distortions in lending and borrowing decisions. Anything backed by the state is assumed to be a safe investment because the state won’t let the investment fail or create big losses. State-owned banks have played a major role in financing the debt-financed stimulus package after the financial crisis. Their continued presence in the financial sector is a major distortion, but they cannot be unwound so easily without disrupting the entire system.
2. Government interventions to support stability in financial markets. In short, the Chinese prize stability, but markets are volatile. When markets fall fast enough, the authorities intervene by suspending trading or even by injecting capital. This one-way market dynamic is unsustainable and has led to pressure for massive corrections that can be destabilizing. The best approach is to have a stable policy framework within which markets can function. Otherwise, only greater distortions will push capital not to where it is productive, but where it is “hot”. Ultimately, China’s fixation on stability creates economic risks.
3. The availability of safe assets for households to save, freeing up other resources for consumption. This is especially important for two reasons. One is to prevent excessively high precautionary savings by households so that more resources can be freed up for consumption needs. The other is that China’s population is aging (they recently abandoned the one-child policy) and households need safe assets to invest in to finance retirement. Currently, the flow of capital in and out of China is restricted to prevent destabilizing flows of capital.

I will now say a word about why China’s old economic model that served it so well has run out of steam, then turn to why China’s transition to a newer economic model needs the above challenges to be overcome in order for the transition to be sustainable.

THE OLD MODEL HAS RUN ITS COURSE

China’s objective is to transition its economy away from the old model where investment and exports led growth and toward a new model where the domestic consumer drives growth (see China’s 13th Five-Year Plan).

The old model has run its course. More investment in new buildings, factories, and towns won’t add much to growth anymore because there is too much excess capacity, and will also add to its debt levels without much growth in return. There is a debate around how worried China (and the world) should be of its high and rising total debt as it approaches 300% of GDP (see Should China Deleverage?). The common points are that although the existing level of debt is not a reason for urgent concern (China has lots of fiscal firepower, high savings rates, and the world’s largest stockpile of reserves), the urgency comes in transitioning its overall economy onto a path where growth is sustainable so that its ability to service that debt remains solid, and that it no longer relies on debt-financed investment to drive growth.

On the export side, global demand is too weak to keep China’s export sectors growing fast enough and to employ more people. And besides, in recent times it was only 2005–07 when net exports contributed significantly to GDP growth. China’s very high investment rates have been the main driver of growth in the old model (and have also been the main driver of the “commodity super cycle” in the 2000s that supported fast growth across other developing economies in Latin America and Africa).

THE NEW MODEL NEEDS DEVELOPED FINANCIAL MARKETS AND INSTITUTIONS

A consumption-led economy — like that of the United States (where consumption accounts for about 70% of GDP) and other advanced economies — needs consumer demand to be strong and durable for overall economic growth to be strong and durable. This depends on a variety of factors that will only become more important to the Chinese economy over time.

The major factors include strong employment/low unemployment, strong/growing real household incomes, a thriving and competitive “product market” where a variety of goods and services are sold to meet consumer needs (this is also where innovation comes in, which in turn needs a skilled workforce), an effective social safety net, and safe assets to invest in to avoid excessive precautionary savings (freeing up resources for consumption).

Well developed financial markets and strong institutions that support the right regulatory and policy framework are crucial for such a model to develop and work for a broad majority. Access to capital is necessary for small firms to set up shop and for businesses to grow, hire workers and innovate. A range of marketable securities and instruments helps capital to flow between a wider variety of savers and borrows. Strong corporate accounting standards and transparent auditing procedures are crucial to support the stability of the financial system and strengthen investor confidence. These standards are also important in keeping investors from flocking to where someone “cooked the books” or to where they know they can’t make a loss because the government won’t let it happen through implicit guarantees that are not on the balance sheets.

This last point is especially important, and it brings us back to the ultimate reason why China’s economy, the way it is right now, is not sustainable.

Ultimately, a strong economy whose model is sustainable requires, among other things, a strong legal and institutional system that is trusted and considered fair, or fair enough, by all stakeholders.

Such a system depends on more than an economic plan, however. It requires the values of an entire society to be behind it.