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China’s leaders place high hopes on the vibrancy of the economy’s service sector, but in reality it has not been able to fill the void left by the decline of manufacturing. The inability of services to pick up the slack in turn creates a temptation for the government to delay overdue structural reforms while maintaining a reliance on investment-driven growth.

Workers sort parcels at a distribution center in Wuhan.

China’s economy is facing tougher times. Export-oriented mass production is no longer the growth driver it used to be and the transition to a higher-value added, innovation-driven industrial model has only just begun.

Thus there are big hopes riding on the service sector’s performance. First some facts: services accounted for 50 per cent of GDP for the first time in 2015, according to official statistics. At an expansion rate of 8.3 per cent, it was the only sector that grew faster than overall GDP, outperforming industry and agriculture.

Consumer spending made up 66.4 per cent of economic growth, an increase of 15.5 percentage points over the previous year. In the first half of 2016 this share was further expanded to 73.4 per cent.

Short-lived upsurge in growth

This all sounds like a healthy transition in train. But a closer analysis reveals a more sobering picture.

The sharp increase of services’ contribution to GDP growth was not the result of a sudden boom, but of decreasing momentum in other parts of the economy. Service sector growth did not accelerate compared to the previous five years but merely remained relatively stable, before slowing down to 7.5 per cent year on year in the first six months of 2016.

Had it not been for a temporary upsurge in financial services as a direct result of the stock market frenzy in the first half of 2015, growth in overall services would have been weaker. Financial sector growth registered at a record 15.9 per cent in 2015, but it fell sharply to just 6.7 per cent in the first six months of 2016.

After confidence in the stock market was shaken in the summer of 2015, the next bubble has been building up as investors rushed into the real estate market, leading to an upsurge of demand for real-estate-related services. This trend, too, will hardly be sustainable. Already local governments are desperately trying to cool prices in first-tier and second-tier cities.

Such frailties could have important implications for the service sector’s viability as a job creation machine. The Chinese government pins much hope on the internet economy to create employment for laid-off industrial workers and, indeed, the labour market has remained resilient to the economic slowdown so far.

China managed to create 13.1m new jobs in 2015 and another 7.2m in the first six months in 2016. This corresponds with a surge in enterprise registrations as 4.4m new companies were established in 2015, with 3.6m following in the first 8 months of 2016, an increase of 28.9 per cent over the same period last year.

This upsurge, which is at odds with bleak private investment in the economy, seems to be the direct result of a start-up initiative pushed by Li Keqiang, the premier. But this boom may prove to be little more than a temporary job creation scheme as start-ups by their nature face an uncertain future.

Limited impact on job creation

Even if confidence in the internet economy were to continue, its impact on the economy will be limited as it often only complements or replaces existing business sectors.

For example, a surge in e-commerce has increased the pressure on the traditional retail sector, where demand for labor has decreased sharply, though not as dramatically as the demand for low-skilled labor in China’s overall economy.

Similarly, a surge in services to drive the automatisation and digitisation of industrial manufacturing will increase demand for highly skilled labor, but will do nothing for the laid-off steel worker who cannot transition into the role of a software engineer.

Focusing on the internet economy also distracts from the fact that major service sectors such as transportation or finance remain tied down by government monopolies.

China’s leaders are bound by an overambitious GDP growth target of at least 6.5 per cent in 2016. The target is partly driven by the need to keep the labor market buoyantly on track toward a proclaimed goal of creating 50m new jobs by 2020. Crucial structural reforms will only make significant progress within a stable economic environment.

But with growth momentum in the industrial sector is falling, frailties in the service sector have coalesced into a bottleneck for overall structural reforms. But at present the service sector alone cannot compensate for lost momentum in other parts of the economy.

In the absence of a strong service sector, China’s leaders are likely to defer structural adjustments while continuing to prop up growth and employment through government stimulus and intervention, entering a dangerous spiral of building up even more industrial overcapacity and even more debt.

This course of action may ensure stability in the run-up to the ruling Communist Party’s upcoming centennial celebration in 2021 – but it creates the risk of a hard landing after 2020.

This article was first published on the Financial Times' beyondbrics blog on 17 October 2016.