China: Reform worries

by: Maritza Cabezas

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China’s authorities announced an ambitious agenda after the Third Plenum in November last year, leaving no doubt that they are committed to rebalancing the economy. Financial reforms have become a priority this year, but the kickstart has been somewhat bumpy. It is clear that China is experimenting with financial system reforms. Indeed, recent efforts to control rapid credit growth and reduce the risk of shadow banking activities have caused unrest in markets. This, in turn, has increased concerns regarding the ability of China’s authorities to balance growth and reform. One of the questions is whether financials can withstand the higher costs of financial discipline. We have adjusted our GDP forecast downwards to 7.5% from 8% in 2014 to reflect the increasing uncertainty caused by the on-going reforms. We maintain our forecast of 7% for 2015.

Recent developments: steady growth in 2013

GDP growth in 2013 was 7.7% overall, down from 7.8% the previous year. This rate is much lower than the double digit growth rates of a decade ago, but slightly above the target of 7.5% set by authorities for 2013. In fact, fears of a faster-than-expected slowdown in the first half of 2013 led to a “mini” stimulus round and tax breaks to support the economy. The details show a somewhat lower growth in fixed investment throughout the year and stronger export growth to the US and eurozone, mainly in the last quarter. Growth of industrial production picked up from July, but ultimately lost some momentum in December. Retail sales stabilised after the fight against corruption took its toll in the first half of the year. All in all, GDP growth was steady in 2013.


Looking beyond the cycle: early signs of rebalancing

Some positive structural changes took place last year. First, inequality is declining as rural household per capita income growth continues to outpace that of urban households, with real growth rates at 9.3% and 7%, respectively, in 2013. Migrant workers’ real income growth accelerated the fastest at 10.8%. This is a positive development since consumption-led growth requires that the rural population improve its purchasing power. Second, the service sector share of GDP rose to 46.1%, exceeding the manufacturing sector for the first time, with value-added growth rates at 8.3% and 7.8%, respectively. The growth of the service sector is consistent with improving incomes. Third, growth in the inland central and western parts of China continues to outpace that in the eastern coastal regions. The inland region’s share of GDP rose by 0.2pp to 44.4%.


The start of 2014, mainly financial reforms

Financial liberalisation has become a priority under the new leadership. The financial system has played a key role in intermediating growth by mobilising cheap savings to investment though returns are sometimes questionable. Authorities are introducing a wave of experiments aimed at tightening credit while reducing the risks of shadow banking. A new directive for shadow banking was issued at the end of last year to assign regulatory responsibilities and contain risks. But the tone was somewhat more balanced towards shadow banking, signalling that it is part of the development of the financial system. At the same time, the interbank market experienced another stress episode this year, as part of what we think is a deliberate policy to rein in credit growth. However, the central bank rapidly resolved the issue through an injection of liquidity. More recently, authorities have taken a strict stance on one of China’s shadow banking entities, China Credit Trust, to raise awareness of the risks in the sector. This was also followed by a last minute agreement to avoid a default of the trust fund, as fears of systemic risks crept up. All this shows that efforts to discipline the financial system are not always easy and that shifts in policies can be expected in the coming time.

The outlook: steady growth facilitates reforms…

Looking at the cycle, the government will continue to implement ad-hoc policies to support the economy if necessary. An unexpected slowdown in economic activity could derail the reform process for both the financial sector and local governments. In the short run, we think that higher income and CNY appreciation will support private consumption. Meanwhile, fixed investment will slow a bit, but private investment should begin to play a larger role in total investment growth. Meanwhile, external demand should improve as the global economy recovers. Some analysts have expressed concern about China’s competitiveness as a result of increasing production costs, particularly wages, but the Asian giant continues to benefit from high productivity growth rates, which should offset the impact of these costs. We expect fiscal policy to remain ‘prudent’ in practice, and monetary policy to sustain a ‘tightening’ bias. Hence, we think short-term interest rates will likely remain elevated in the near term, with the CNY likely to appreciate further on capital inflows (around 1%). We don’t think China’s authorities will allow the economy to slow down below their average growth target of 7% announced in the 12th Five-Year Plan. It is in their interest to have a steadily growing economy that can absorb the debt incurred without requiring an abrupt adjustment.

…but with small steps

As for structural reforms, we do not expect authorities to experiment on too many fronts simultaneously. Although the demands for reforms are high, given worsening pollution, high levels of inequality and a lot of room for improvement in the state-owned enterprises, the government will likely focus on containing financial and fiscal issues while it is rebalancing. China will continue taking baby steps to liberalise its capital account, through the RMB internationalisation, as well as interest rate reform. As part of these plans, authorities have launched the Shanghai Free Trade Zone pilot programme, which is an on-going project. Another priority is dealing with local government debt, which has risen at a rather rapid pace: 67% over the two and a half years to June 2013, reaching 33% of GDP. This will need to be curbed. Earlier this year, the government decided to allow local governments to roll over the debt by issuing long-term bonds. This provides a temporary solution. However, the concerns are more related to the returns on investments of local governments and whether the bonds will eventually be paid off. Hence, we should be focusing on the profitability of the projects that are being financed. In the first half of 2013, local governments had already amassed RMB 2 trillion in new debt.


Risks to the outlook: sequence and timing of reforms

Implementing reforms can conflict with growth, given that some reforms may have a negative impact on economic activity in the short run. For instance, putting government finances in order and reducing the scope of the risks of shadow banking can weigh negatively on economic growth. And while it takes time to manage this process in an orderly fashion. There are, however, increasing pressures from markets to accelerate the pace of reforms. This will be difficult to manage, particularly if a sounder financial system and an orderly reduction of debt negatively affects the interests of certain groups. Indeed, the systemic impact of the reforms is also a downside risk. This was one of the considerations in averting the potential default of the China Credit Trust some days ago, despite the moral hazard surrounding this decision. Hence, the transition will be tainted with uncertainty and we expect volatility ahead. Although we think this is part of a credit normalisation process, the market is concerned about whether the parties involved can withstand the higher costs of financial discipline. In short, with a long list of issues to juggle ahead, the risks to economic activity in the short run are tilted to the downside.


This publication is part of the Quarterly publication “Emerging Markets Outlook 2014Q1”

Deze publicatie is onderdeel van de kwartaal publicatie “Emerging Markets Visie 1e kwartaal 2014”