There has been a lot of interesting debate recently; mainly between the China bulls and the China bears.

While this is an interesting debate for economists, it is not the real debate for Chinese government officials and business people in China.

The real issue is that costs are getting high in China, and profits for many companies are wearing thin. In an unregulated company, this would mean that companies would lay off people in order to cut costs. But China’s economy is highly regulated, and the performance of Chinese officials is measured by the numbers of people they keep employed. Since China doesn’t have unemployment insurance, the costs are passed on to businesses. In recent years, this has been turned into legislation on the national level with the Labor Law, which makes it very expensive, especially for non-Chinese companies, to lay off personnel.

In late 2008, when the global financial crisis broke, local government tax offices in China routinely visited larger employers to find out about their employment situation. The implicit threat was that if they laid off people at this time they would be inviting a tax audit which obviously would not work in management’s favor. Employers struggled, but the economy recovered, and through 2009 and 2010, it looked like China’s economy had dodged the bullet.

This time, it’s different. China’s domestic growth and consumer spending have continued to grow. If there are significant layoffs though, it will hit Chinese consumer confidence hard, especially when people hear stories about other people being laid off from their jobs. Immediately, Chinese will go into savings mode again, which will put a damper on domestic economic growth.

Now, the real battle which is going on will be

• Between local companies and local governments
• Between local governments and Beijing

Now, local officials are again visiting local companies to make sure that they don’t lay off employees. But this strategy won’t work well for many factories which depend on export sales, which are anemic and where margins are razor-thin. They will not want to continuously pay the wages of workers who have nothing to do. Soon, they will turn to local governments to ask for “incentives” to keep these workers on their books. Where will these cash incentives come from?

Local governments will increasingly turn to Beijing for monetary and/or fiscal relief so that these companies can keep the workers on their books, forcing Beijing to decide between bailing out these companies, or letting them lay off workers. Local government debt levels are already high in China, can Beijing afford to “lend” more which most likely will never be repaid? Please keep in mind that many of these employers will be state-owned enterprises with huge payrolls, which have been hugely profitable while China’s economy is growing, but will quickly turn into big money losers when China’s economy slows down.

What will Beijing do?

At the same time, within the party, officials will press within the party to stop using employment statistics as a KPI (key performance indicator) for measuring the performance of local officials. If employment statistics are no longer used, then local governments will have to quickly switch over to local tax collection to fill in whatever holes have been created. This, in a society, which doesn’t have a strong tradition of paying taxes or even honestly reporting them.

When the China bulls and bears debate, they are just debating the rate of the slowdown, not the general trend direction. They agree on the trend, and it’s not good.

The questions are how investors, business persons, local governments and Beijing are going to resolve these issues? It won’t be easy for Xi Jinping when he becomes president later this year.