Throughout recent years, China unleashed economic stimulus to prevent growth from slowing. But that ambition has stalled some of the nation’s much anticipated reform program. In various policy areas, from state-owned enterprises to China’s welfare system, progress has been delayed by growth prioritization.
With growth now stabilizing, policymakers have the opportunity to clear fog over China’s economic direction by further acting on the much-touted change promised by President Xi Jinping. In this interview, Janet Henry, chief economist at HSBC, rates China’s roll out of reform, assesses growth, and shares how to boost confidence in the renminbi (RMB).
The Diplomat: How do you score China’s reform program?
Janet Henry: Contrary to some more pessimistic comments by many Western observers, the Chinese government has in fact pushed through significant reforms in recent years. These include interest rate liberalization (for bank deposit and lending rates), a new fiscal framework for local governments (allowing bond issuance subject to quotas and restricting special purpose vehicle funding), abandonment of the one-child policy, gradual hukou [household registration] reform, and a deposit insurance scheme. On capital account liberalization and foreign exchange reforms, the commitment is also high and they have made impressive progress in promoting the use of RMB in cross-border trade and investment. The inclusion of RMB in the [International Monetary Fund’s] SDR basket is a reflection of this.
However, other, significant reforms, especially in the area of state-owned enterprise (SOE) reform, have been harder to deliver against a backdrop of weak growth and deflation. Many provincial and local level SOEs are still operating with soft budget constraints and high inefficiencies, and are drawing substantial credit funds. In addition, the government has also failed to roll out a property tax, a policy that would help to address local government revenue problems and tame the real estate cycle. Other urgent reforms include the creation of a financial super-regulator or at least better coordination among existing agencies to avoid regulatory arbitrage by borrowers and lenders (partly responsible for soaring shadow bank financing). Overall, China’s reform program is incomplete, with major imbalances still not sufficiently addressed.
Reform-wise, what are top near-term priorities?
First, SOE reform. This entails shutting down inefficient enterprises, raising opportunities for the private sector to compete with SOEs, and reducing the role of the state in remaining SOEs by clearly separating ownership, managerial, and regulatory responsibilities.
Second, a property tax would raise local governments’ revenues and make them less reliant on land sales and borrowing. It would also reduce speculative demand and raise rental unit supply.
Lastly, to deleverage and regulate the financial system. China’s central bank, the People’s Bank of China (PBoC), is working to roll out a new macro-prudential framework (MPA) to put a risk framework around banks’ wealth-management products. The China Banking Regulatory Commission (CBRC), the nation’s banking regulator, is also signaling more micro-level regulations to limit arbitrage activities. This is the first attempt at such comprehensive regulations since 2011 (before which the “shadow banking” sector was very small).
What is your outlook for this year, and what are alternative methods to assess growth other than GDP?
We are looking for 6.7 percent yoy [year-on-year] GDP growth in 2017. This reflects a slowdown in infrastructure spending growth and housing market activity from the elevated 6.9 percent growth rate in Q1. But we see continued improvement in manufacturing and private business investment given the recent revival in industrial profits.
Various alternatives to GDP are always being proposed as gauges of activity in China, which were often quoted in 2015 when the economy was slowing down. But currently most indicators are pointing in the same direction. The PMIs (both Markit and official PMIs) have improved since late 2016 and the well-known Li Keqiang index (which includes bank lending, electricity consumption, and rail freight) hit a three year high in February.
What are risks of proactive fiscal policy and how to mitigate them?
Fiscal policy needs to encourage private sector investment and drive stronger productivity and wage growth. Otherwise, rather than raising long-term potential growth, it will simply lead to higher budget deficits and debt-to-GDP ratios. China has already made plenty of use of its fiscal capacity to offset the weakness in private sector investment by supporting infrastructure spending. This has helped to support GDP growth at a time when exports have been weak, but according to the IMF, the augmented general government budget deficit (which includes local government off balance sheet borrowing) is already running at over 8 percent of GDP. To drive long-term growth and improve fiscal health the government needs to do more to support private investment. It could reduce the cost of doing business, particularly the social security business contribution (35-60 percent of monthly salary) and move faster on SOE reform.
If, over time, the government stops providing support to inefficient, loss-making SOEs, it would not only allow private firms to compete on a level playing field, but it would also free up resources for fiscal measures that would support the ongoing structural shift toward consumer-led growth. This could be reinforced by other key reform priorities, such as reform of the welfare system. Putting in place better publicly funded pensions and healthcare might make households more likely to lower their very high savings rate.
How to restore confidence in the renminbi?
Capital outflows have been mainly driven by low business confidence among Chinese companies. Domestic business investment slowed to a decade low last year while companies paid down dollar debt in anticipation of Fed rate rises and for increased outbound direct investment (+55 percent yoy in 2016), prompting tighter capital controls. Maintaining growth stability is the first step toward restoring confidence. Continued fiscal expansion and monetary accommodation is already helping to improve sentiment, but policymakers must go a step further and spread the benefits of the growth stabilization to the private sector. Tax and non-tax revenue increased from 14 percent of GDP in 2006 to over 30 percent of GDP in 2015. It is time to ease the burden on the corporate sector. SOE reforms, such as closing “zombie” SOEs and accelerating debt resolution, would help to give more business opportunities to the private sector and boost confidence in the outlook for the economy. The temporary restrictions on capital flows can then be eased and liberalization of the onshore markets can resume.
How to approach China’s capital account liberalization?
There are several benefits of capital account liberalization: to provide greater monetary policy independence; to help accelerate China’s transition from a bank-dominated financing model to one featuring a more prominent role for capital markets (a key developmental goal in the 13th Five Year Plan, covering 2016-20); and to improve the allocation of capital and resources for China’s (and the rest of the world’s) households and firms. Hence, worries that temporary controls on outflows represent a U-turn in RMB internationalization and liberalization are overblown. China continues to reach out to the world in areas, such as trade, investment, and the internationalization of its currency. We believe the Belt and Road Initiative will play a central role in this process.
That said, the travails of other emerging economies’ capital account liberalizations provide plenty of cautionary tales regarding the impact of destabilizing capital inflows and outflows. So there are clearly reasons to tread carefully. External risks such as the impact of a much stronger dollar and/or trade-related risks have receded over the past few months. If the PBoC becomes more confident that these are fading, it may well move quickly to further liberalize inflows into onshore markets. But if the dollar rebounds significantly and/or trade/geopolitical tensions heighten, we would expect the PBoC to be more cautious and gradual in its approach, particularly with regard to further liberalization of outbound channels.