Outlook 2014 - China: balancing reforms and growth
After an ambitious start, China’s new leadership seems to have eased back on its reform drive. Maintaining a sufficiently strong growth rate is still the priority. For 2014, this implies only incremental reforms and a growth rate of around 7¼%.
Tolerance for lower growth has its limits
Hopes for reform in China were high after the leadership transition had passed in March 2013. Under newly appointed President Xi Jinping and Premier Li Keqiang, it quickly became apparent that the new Chinese government understood China’s economic growth model had to change. In the first half of the year, the authorities remained in a state of unusual comfort when economic growth slowed to 7.7% and 7.5% year-on-year (y-o-y) in 13Q1 and 13Q2 respectively. Instead of stimulating growth, the government was willing to let growth slow further, as it took measures to address rapid and inefficient credit growth. The lending rate was further liberated as well; a signal to Chinese banks that the government mandated high bank margins, which guarantee high profits, would come to an end. Not the quantity but the quality of growth was most important under the new leadership and a slower growth rate was tolerated in favor of reforms. At least, to a certain – initially undisclosed – degree.
From mid-2013 onwards, it became clear that the tolerance for lower growth had its limits. When growth threatened to slow to below 7% y-o-y, the government reverted back to its old habits; the government ramped up infrastructure investment, largely in railways, to support growth. Again, public investments, financed by commercial bank credit and benefitting state-owned enterprises were deployed to support short-term growth. The plan worked, as positive signals started to emerge again a few months later. Industrial production growth accelerated and purchasing managers’ confidence improved (see figure 1). Real GDP growth picked up to 7.8% y-o-y (see figure 2) in 13Q3. However, the development also showed that China’s policy makers found it difficult to support GDP growth other than by actively increasing credit-driven investment growth.
Reforming will not be easy
The new leadership’s reform drive was also proved more difficult than anticipated when it attempted to address one of the most pressing problems: the risks in the banking sector. The central bank sent a ‘warning’ to banks in June by tightening liquidity in the market. The move was meant to rein in the strong growth of wealth management products and other forms of alternative means of financing, which carry more risk and are largely unsupervised. At the same time, the aim was to bring liquidity risks within the banking sector that resulted from such practices to the surface. The result was that the overnight (o/n) SHIBOR rate shot up to 13.4% (see figure 3) and some local banks indeed experienced liquidity problems. It appears that the authorities had underestimated the impact of their ‘warning’ and quickly returned to providing ample liquidity to the market. The o/n SHIBOR rate fell rapidly again, but settled at a slightly higher rate than before the event. The episode showed that China’s debt stock has become so large that the impact of reforms, or in this case even the warning of reform, can lead to major volatility. This means that it will be difficult to implement real reforms if the government also prioritizes on maintaining stable economic growth. As the government reverted back to a forbearance stance, all types of credit grew rapidly again in August following four months of slowing credit growth (see figure 4). This will, again, help short-term economic growth, but, again, also implies that longer term problems remain unaddressed.
House prices, meanwhile, remain under upward pressure. It seems that the measures to cool the real estate market have depressed supply more than they have suppressed demand. While real estate developers scaled back on their operations, demand remained strong. Aside from many Chinese having a desire to own their own house, the fact that savers have limited alternatives for storing wealth also continues to drive demand for real estate. As a result, house prices are rising again in most cities and by double digits in some of them (see figure 5). Another potential long-term problem thus remained unaddressed.
The positive reading of the developments in 2013 is that the new leadership is sending clear signals, or warnings, to the market ahead of major reforms. The market has taken notice of these warnings. Chinese banks, for example, have become more aware of their own responsibility in adequately managing their balance sheets, as well as the fact that the high margins they have counted on in the past may not be there in the future. In this view, the lack of deeper reforms is because the leadership is still gathering political support for such reforms. After all, not all factions within the Communist Party favor reforms. Many Party members have flourished under the existing growth model and will thus lose out when reforms are implemented. There is also ideological resistance to reform, as some factions within the Communist party continue to favor an economic model based on state-owned enterprise development. There is also fear of economic volatility that might accompany a freer market-based Chinese economy. In this view further reforms will be implemented in the coming years after the new leadership has secured the needed political support.
A more depressing view, however, is that implementing the necessary reforms is simply too painful for the government’s comfort. Actually tackling the problem of overcapacity would encounter fierce political resistance, as this would lead to unemployment and lower revenues for especially local level governments. Too many restrictions on shadow banking and off-balance sheet lending would likely lead to major problems in the financial sector and hurt growth, as companies would no longer be able to refinance their loans. The government’s goal to implement reforms while at the same time maintaining sufficiently strong GDP growth rates are incompatible. In this view, market forces will continue to be subdued, implying the inefficient allocation of resources will worsen as China continues to rely on its credit and investment-driven growth model. The amount of debt will continue to increase, while the investments that are financed with it continue to become less effective. In due time, a financial crisis will be the start of an economic crisis, at which time reforms are inescapable.
The truth is likely somewhere in the middle. There is indeed political opposition to reforms that are vital for China to make its next development step. Xi Jinping and his team are enhancing their control over the party, which should reduce some of the political opposition. The ambitious anti-corruption campaign - that has led to a slate of high-ranking officials being charged and sentenced – is for an important part targeted against Bo Xilai (sentenced to life in prison in September) and his neo-leftist - and thus anti-reform - allies. However, even if political support is gathered, implementing reforms will be very difficult to combine with the party’s goal of maintaining sufficiently strong (roughly 7% a year) growth rates. In this regard, the government has clearly shown that it continues to prioritize on this goal. This reduces the risks of social unrest if unemployment would increase. It also lowers the risk of potential debt repayment problems that could arise if companies’ en (local) government revenues decline due to weaker growth, which would pose a threat to the financial sector’s health. However, it also means that the scope for reform is more limited.
All eyes on the Third Plenum
The Third Plenum of the Central Committee of the Communist Party of China, which will be held in November 2013, will set China’s economic agenda for the coming years. In the past, Third Plenums have been the basis for major reforms. In 1978, for instance, the Third Plenum started China’s reform and opening up policies, which has led to three decades of exceptional development and growth. Hopes are therefore high that a deepening of reforms will be announced at this year’s session, with likely candidates being tax reforms, reforms meant to address environmental issues, household registration reforms, and, last but not least, financial sector reforms. Some of these reforms are relatively easy. Tax reforms, for instance, will likely include consumption tax reforms, which will boost local government revenues amid fears about their financial strength. Other reforms are more difficult, though. Addressing the problem of environmental issues will be done by introducing resource and environmental taxes, which would hurt many state-owned enterprises and thus the interest of Party members that control these companies. Household residency registration (hukou), which prevents rural immigrants from accessing a wide range of public services, is highly desirable, as it will make rural-urban migration easier. However, the potential costs involved present an obstacle.
Of all reforms, the government’s plans regarding financial sector reform will be most closely watched. Given China’s massive and rapidly increasing debt burden, with which increasingly inefficient investments are being financed, financial sector reform is key. At the same time, such reforms will be amongst the most difficult to implement, as their economic impact will be large. Liberating the deposit rate would be an important step forward. It would increase the spending power of households - that save a large part of their income – and is necessary to adjust China’s growth model from investment-driven to private consumption-driven. Furthermore, it would greatly help to reduce income inequality. However, as bank margins would come under severe pressure as a result, this reform is unlikely to be implemented in the short-term. Therefore, it remains to be seen how quickly the Chinese government is willing to implement the needed financial sector reforms.
Incremental reforms expected
Reforms announced at the Third Plenum are not expected to have an immediate impact. Most likely, roadmaps for the implementation of reforms will be presented. As the government continues to prioritize on maintaining economic stability, any reforms implemented in the short term will most likely be incremental; small steps that are evaluated before continuing with further small steps. The newly installed Shanghai Free Trade Zone, in which interest rate will allegedly be set by markets and where the Chinese currency will be more convertible, is an example of this. Outside the Free Trade Zone, financial sector reform will likely revolve around developing the bond market. This will allow private capital to flow directly to companies, thereby reducing their dependence on bank loans. Such reforms are steps in the right direction, as bonds yields are not restricted by the government. In addition, private capital is more independent from established relations between state-owned enterprises and China’s banks. Although such reforms should reduce the risks to the financial sector, they are not a solution to China’s increasing and unsustainable dependence on credit.
As reforms are expected to be only incremental, while real GDP growth rates will be government supported to at least 7%, China’s economy is estimated to grow by roughly 7.¼% in 2014. Although private consumption growth is expected to become a more important growth driver next year, investment growth will still remain the most important driver of growth. Growth could turn out stronger if the government would maintain its forbearance stance with regard to credit growth, as it did in the second half of 2013, while external demand recovers. Would the Chinese government be more forthcoming with particularly - but not exclusively - financial sector reforms, which is not expected, GDP growth might fall below 7%.