China's transition now at a critical stage

China Beige Book (CBB), which had touted the Chinese economy's resilience in the third quarter amidst bad headline numbers, has now done just the opposite: despite recent headline figures showing fourth quarter stabilization, it reports a comprehensive deterioration of conditions.

Tellingly, CBB's Leland Miller argues that the vaunted transition from manufacturing to services is stalling:

The survey shows "pervasive weakness," Miller wrote in the report. "The popular rush to find a successful manufacturing-to-services transition will have to be put on hold for a bit. Only the part about struggling manufacturing held true."

With manufacturing's percentage share of GDP in the low-40's and services' share in the low-50s, China has apparently hit a wall, but who seriously expected these figures to shift by more than 5 percentage points from 2012? With a per capita GDP of $8,000, China can and should remain a heavily manufacturing and investment-based economy; its program to create a social safety net to support a consumer-oriented economy has barely taken baby steps, meaning the savings rate should likewise remain very high.

That said, China's transition has reached a critical stage. This quote says it all (my emphasis):

"More concerning than overall growth weakness was degradation of two components of the economy that were previously overlooked as sources of strength: the labor market and the impact of inflation," Miller wrote. Given growth in input prices and sales prices slipped to record-lows while firm performance metrics fell, "it looked like firms were encountering genuinely harmful deflation," he wrote.

So after more than a year of fiscal and monetary stimulus, there's little confidence that much can be done to stimulate activity simply because demand is struggling as much as ever with crushing deflationary deadweight. In fact, as has been pointed out repeatedly throughout 2015, the so-called "stimulus" has mostly not been stimulus at all, but merely stopgap liquidity injections to counterbalance the vicious cycle of monetary tightness and high real borrowing costs, which the massive capital outflows since summer have only exacerbated.

So it's no wonder that "supply-side reform" is now the buzzword in Chinese economic policy circles. The Beige Book outlook confirms that it's now or never for Beijing to tackle the oversupply and deflation problem, because the downward spiral is on the brink of spinning out of control, forcing on the economy precisely the labor dislocations that the authorities have put off corporate reforms and restructuring in order to forestall. As of the start of 2016, the time will have run out. Either the government cuts the zombies down to size and lets them shed superfluous workers as they should have done in 2013, or the country will have to watch the living dead effectively devour the living living to keep living even though they're dead.