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Matt French and Trish McAlaster/The Globe and Mail

CHINA'S NEW ECONOMIC REALITY

To understand the devaluation of the yuan and the changes in the Chinese economy today, look to the growth in its services sector rather than heavy industry, reports Nathan VanderKlippe

A few seconds past 9:25 a.m. on Tuesday, the People's Bank of China released an 85-word statement explaining why it had just lowered the value of its currency by 1.9 per cent, the biggest one-day cut since 1994. It was, the bank said, "for the purpose of enhancing the market-orientation" of the yuan, whose notes still bear the likeness of Mao Zedong.

Markets responded as if the old Communist Party chairman had himself come back to run the second-largest economy on Earth. Within moments, commodities, stocks, currencies and hopes were sinking. In their place was indignation.

"Currency war!" screamed bank analysts. "China has rigged the rules," complained Charles Schumer, the U.S. Senator. "They're just destroying us!" yowled Donald Trump.

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By Thursday, after a series of extraordinary interventions by the central bank, calm returned; on Friday, the yuan ticked back up a few notches.

In doing so, it offered a reminder of the yuan's trajectory over the past 15 months, in which it has done the exact opposite of decline. It has, instead, quietly soared. Relative to the Euro and the Australian dollar, the yuan is up more than 20 per cent since last May. By early this week, it was by some measures the most overvalued of the world's biggest currencies. China is now growing at the slowest pace in a quarter-century, a key reason for global slowdown worries. But as faltering economic prospects have brought widespread devaluation of currencies – the loonie included – in China itself, authorities were letting the yuan fly.

For China, the high yuan has become another powerful tool in propelling a shift that is upending China's economy, a change whose global reverberations have only just begun.

After decades of overseeing a country wedded to industry, Chinese planners have in just a few short years watched the factories and steel mills that were once their chief growth engines take a back seat to the captains of the new economy – the investment banks, restaurant chains and airlines that make up the services sector.

China has long sought to jack up its services sector, in hopes of fashioning itself after more developed countries. Now it's happening, propelled in part by a series of financial policies that are reshaping the country – and, in the process, substantially altering the role China will play as a world consumer in years to come, a shift with important implications for resource-heavy countries like Canada.

This year, for the first time, China is likely to see services represent more than half its economy – a remarkable change from 2012, when services, at 44.6 per cent, still lagged industry. (China still lags far behind other countries; in Canada, services are roughly 70 per cent; in India, 57 per cent.)

Shoppers and pedestrians walk past a Rado Watch Co. store on Russell Street in the Causeway Bay shopping district of Hong Kong, China, on Sunday, Aug. 9, 2015.

Shoppers and pedestrians walk past a Rado Watch Co. store on Russell Street in the Causeway Bay shopping district of Hong Kong, China, on Sunday, Aug. 9, 2015.

Xaume Olleros/Bloomberg

The change has come with little help from Chinese consumers, who have largely stuck to old saving habits rather than spending their way to a modern retail economy. In the U.S., consumer spending makes up two-thirds of GDP. In China, it's half that – a figure that has only just begun to rise after a decades-long slide from 51 per cent in 1985.

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And China has had other reasons to keep a high yuan, which has been useful in stemming capital flight. Bureaucratic inertia has also played a role: after opting to march in lockstep with the U.S. dollar, China simply kept going as the greenback climbed a mountain.

But along the way, the strong currency has also helped speed the country's transformation. Combined with high interest rates and a rising consumer class, the currency has brought heavy pressure to what Ken Courtis, chairman of Starfort Investments Holdings and a former managing director of Goldman Sachs, calls China's "old smokestack, industrial, capital-intensive companies."

It is, he said, "a recipe for killing off highly indebted companies that can't generate profit" – a tidy way to describe the industries that built China, and whose recent struggles have made the country's National Bureau of Statistics a dealer in ugly figures.

Growing numbers of steelmakers are now losing money, and steel output is expected to fall 2 per cent this year. Seventy per cent of coal firms are in the red, and coal production is down 4.5 per cent. Cement profits are down 67.6 per cent, and output has tumbled 5.3 per cent.

Some manufactured goods are faring worse: industrial boiler production has fallen 13.5 per cent this year; smelting equipment plunged 26.7 per cent in June. Nationwide, Chinese exports fell 8.3 per cent in July.

As just one example of the scale of change, "this idea that we've seen peak steel is completely plausible," said Nicholas Lardy, an author and fellow at the Peterson Institute for International Economics who has written extensively on the development of the Chinese economy. "And if that's the case, the 20 to 30 per cent growth in steel output that was driving everybody for a decade – that's long gone."

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The idea that Chinese demand has crested, and the likelihood that no other nation will replace it, suggests waning commodity prices are a preview of a greater reckoning that looms for Canada and other nations whose race to build resource extraction capacity was based on a belief that the pull from across the Pacific would continue for years. That no longer seems likely.

In China, meanwhile the services sector – those hotels, banks, cellphone providers and spas – is roaring. In the first half of 2015, the GDP among services rose 8.4 per cent, some 2 1/2 times the growth rate in the primary, or extractive, sector. Businesses in catering and retail sales are surging at a double-digit clip, and they're pulling the rest of the country with them. If China continues at its current pace, its service sector will help create a third more jobs this year than in the heyday of big industrial expansion.

"The relationship between industrial growth and GDP growth has completely broken down," said Mr. Lardy.

The change is profound, but "grossly underappreciated."

In other words, to understand the Chinese economy today, you'd be better to look at its hotels than its factories.

The 100 employees at Healthyland Industry Co. Ltd. pumps out pillowy red leather recliners and other furniture for export. Owner Lawrence Ma sells sofas in 30 countries; in Canada, they're sold at International Furniture Distribution Centre in Concord, Ont.

Recent years have not been kind to China's furniture-makers.

A big sofa factory stuffs and ships 100 containers a month. In 2008, Dongguan was home to more than 100 such firms. "Now you can't find 20," said Mr. Ma, whose own firm has kept its head above water. Industrywide "exports are down more than 30 per cent."

In the past year, the strong yuan has further eaten away at profits already made thin by soaring worker costs. It's also increasingly hard to find good people among a new generation of highly educated youth born to middle-class families. "They don't want to work in a factory. They want to work in an office," Mr. Ma said.

They are being called by the siren song of the service sector.

"If I had the money, I wouldn't make sofas," Mr. Ma said. But it's not clear what he would do, even if he had the cash. "The whole of China is slowing down, and there's more and more risk," he said. "It's not so easy to make money."

Chinese auto workers assemble cars at the FAW-Volkswagen plant in Chengdu, southwest China's Sichuan province.

Chinese auto workers assemble cars at the FAW-Volkswagen plant in Chengdu, southwest China’s Sichuan province.

GOH CHAI HIN/AFP/Getty Images

Flipping an economy on its head is not easy, particularly in a place that has long exercised strong central control. In building a new economy, China has been forced to confront a raft of problems, including an instinct for heavy-handed management.

For China to modernize, entrepreneurs say a lighter touch is required.

The tension between the two came glaringly into view in recent months. China's high-flying bourses and its devaluation of the yuan both exemplified a new bid to let markets flourish. But when stocks crashed and the yuan began to fall, Beijing quickly stepped in with shows of massive force, barring funds and executives from selling shares and ordering state-owned banks to spend enough dollars to keep the yuan riding high.

Authorities "worried that market overreaction would exceed what they could control. So they reverted to old-style command and control thinking," said Wang Fuzhong, an economics professor at Central University of Finance and Economics.

For entrepreneurs, the persistence of old ways creates tensions that occasionally boil over. This spring, a Chinese hotelier grabbed public attention by posting online a startlingly direct letter to Premier Li Keqiang. In it, Wu Hai, the founder of China's Crystal Orange Hotel Group, complained that government stifles growth through dense red tape and the dominance of state-owned companies he called "big brothers."

"After our left cheek has been slapped by the big brothers, we sons of bitches can only turn our right cheek for another slap," he wrote. He lamented the "shackles" placed on entrepreneurs in China.

It was hardly a diplomatic letter – and as it blazed its way through the Chinese Internet, he feared he would be shut down. Instead, he gained hero status and was invited to Zhongnanhai, the secretive Beijing compound home to China's most powerful people, for a meeting.

He was told Mr. Li personally read the letter, which underscored a central problem: even as China tries to remake itself into a more modern economy, its service sector has yet to break free from government control.

Piles of steel pipes to be exported are seen in front of cranes at a port in Lianyungang, Jiangsu province March 7, 2015.

Piles of steel pipes to be exported are seen in front of cranes at a port in Lianyungang, Jiangsu province March 7, 2015.

REUTERS

An analysis in China's New Place in a World in Crisis, published by Australian National University, found that as recently as 2007, state firms mopped up 92 per cent of the profit and held 94 per cent of the assets among the top 500 service-sector companies. The years since have brought only modest change to government dominance in the sector.

"There's been a whole lot of positive inducements to try to encourage the growth of services, the growth of small and medium enterprises. But there hasn't been any real significant cutting away of the state sector and the administrative privileges and special access to finance they have," said Charles Horne, the economy portfolio manager at Beijing research and advisory firm China Policy. "It's been stalled because there's a lot of vested interests."

Adding to those problems is a bureaucracy stuck in another age, Mr. Wu said.

When local leaders set out to encourage innovation and new growth, they do it with money in hand, trying to pick winners and losers. In the process, they create "a new unfairness. They don't know how to help," he said. "They need to let the market play the role."

Still, his own business is mirroring the broader service sector, and growing at breakneck speed. His network of 72 hotels will, in roughly a year, expand by another 60.

And if he ever worries at the future of his industry, he need only look at his young staff, who may provide the best sign that China's grey days of concrete and steel are increasingly giving way to designer clothes and glitzy vacations as a new generation discards the old consumer reticence. "They travel a lot. They go overseas. They're willing to spend money," he said.

"That's a big change to me. They don't save money like our generation did. And with consumers willing to spend, China is changing from a manufacturing base to a consumption economy. That's a really good thing."

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