Chinese military power was on display Thursday as 12,000 troops, about 200 aircraft, the Dongfeng 21D "carrier killer" missile and other cutting-edge arms marched or rolled through Beijing. The lavish parade commemorating the 70th anniversary of Japan's World War II surrender followed a speech by President Xi Jinping. In it, Xi pledged China's commitment to peace. He also promised the "great renewal of the Chinese nation" and noted that an even "brighter future" lay ahead for China under the Communist Party.
These expressions of confidence and displays of strength were made despite the country's deepening economic problems. Once touted as supreme technocrats and economic managers, China's leaders now appear uncertain about how to manage their economy. In the past few months, authorities have tried to put a floor under falling stock prices and suddenly devalued the Chinese currency to help exporters. A fortnight ago, banks' lending rates and their reserve requirements were lowered to ease credit flows. This was a seeming reversal of recent policy to control national debt, already approaching 300% of gross domestic product.
As worrying as any slowdown might be for any government, it is not obvious why panic appears to be growing inside the Zhongnanhai compound, a government and party nerve center. The Chinese economy is now six times larger than it was 20 years ago. With that economy at $10 trillion, a 4% to 5% growth rate would bring enormous expansion.
As far as national power projection is concerned, one would assume Beijing already has a huge chest to fund continued improvements in its military, regardless of any downturn. Already, China officially spends well over three times what Japan does on defense.
In fact, the fiscal consequences of the slowdown are widely underappreciated outside China. In the past, government coffers swelling with taxes on exporters and with proceeds arising from growth achieved through a state-dominated fixed or capital investment-driven model made decision-making easy. Few difficult public funding decisions had to be made.
In today's "new normal" world of more modest growth, however, the threat of a fiscal crisis is becoming real. Low single-digit growth could seriously undermine the Communist Party's aspirations for China to return as the region's pre-eminent power.
From 1993 to 2013, government revenue each year grew an average of 20%, while total fiscal outlays, including those of central and local governments, advanced an average of 19%. In the first seven months of this year, as the slowdown took hold, revenue grew only 7.5%, while outlays advanced 13.4%.
This may not sound so bad. But the government knows fiscal revenue will be disproportionately affected even by a moderate slowdown because of the country's unusual tax base. More than one-third of government revenue comes from a domestic value added tax that companies pay at every stage of production. One-fourth comes from corporate taxes. Only 6.5% of revenue comes from income tax.
This shows that China's fiscal income is overwhelmingly reliant on an industrial and property boom that is ending. China lacks the stability of income tax-derived revenue.
If revenue is a concern, the expenditure side of the budget is even more of a problem. Before the tax code was reformed in 1994, the central government received about 55% of total government revenue and was behind about half of all government expenditures. Now, the central government receives about 60% of revenue but only accounts for 15% of outlays. The shortfall in revenue for local governments -- about $800 billion a year -- is largely made up with proceeds from land and real estate sales. This means that any property market correction will have a dramatically negative impact on local governments' fiscal revenues, which are already under strain.
With real estate proceeds likely to come in at almost half of where they were in the peak year of 2013 -- the result of the fading property boom -- shortfalls of up to $500 billion will be the norm over the next few years, based on current levels of spending. At the same time, local government demands for more central government revenue will increase because it is at the local level where responsibility lies for providing almost all social and public services.
Even then, China only spends half the amount on these services that other low- to middle-income countries do, as measured as a proportion of GDP.
Significant amounts of money must be found, given total government revenue in 2014 was about $2.8 trillion.
But official budget items are only part of the true fiscal story. The central government is ultimately responsible for maintaining the stability of the state-dominated financial and banking systems, and preventing the unregulated but interconnected shadow-banking system from doing too much damage to the economy.
At the heart of the problem is the indebtedness of local government financing vehicles. It is estimated that these vehicles have borrowed up to $5 trillion, with much of it tied to an inflated property market. More recently, these vehicles are believed to have poured money into the country's two stock exchanges.
These vehicles are desperate; they are using up to one-third of all new borrowings just to prevent existing loans from defaulting. That the situation is precarious was evidenced in 2014 when Beijing forced banks and other lending institutions to roll over $800 billion worth of maturing loans to local government financing vehicles and to continue doing so for three years. No mass defaults or financial panic here.
Still, there will no longer be a rising fiscal tide to lift all boats, which is why Beijing is increasingly agitated about any evidence of a hard landing. And we can be sure that artificially helping its exporters or temporarily putting a fragile floor under stock indexes are short-term moves that will make little long-term difference. Under any scenario, China will have to choose from a number of competing priorities -- loosening credit further to squeeze even more out of an inefficient fixed-investment growth model, offering more and better social and public goods, and strengthening its military among them.
The announcement in Xi's speech that the People's Liberation Army will slim down by 300,000 troops -- from an estimated 2.1 million -- is unlikely to offer significant fiscal relief. A time frame for the reduction was not given. And even when it occurs, it is almost certain to come from an already poorly equipped land-based army. High budget items, such as research and development in advanced weaponry and technology used to bulk up the navy and air force will remain increasingly costly.
Despite this week's show of wartime pride and confidence, the Communist Party knows an economic slowdown is inevitable. And as that takes hold, there is much more at stake for China than the bragging rights that come with being Asia's fastest-growing economy.