Confidence in China policymakers' ability to manage robust growth during significant economic reforms has never been lower. Some of the views from China watchers and economic pundits have moved to a narrative where growth is collapsing, and China’s leaders have lost control, rolling back reforms in a panic, and fabricating economic numbers to contain the story. Many headlines and news stories recently contain parts or all of those elements. In a country where meaningful change moves at a snail's pace, recent reforms are brisk relative to the last 40 years of very gradual transition. The notions that Xi and his regime are losing control of the economy and rolling back important reforms in a panic to counter a hard landing are premature.
This blog posting will cover the question of reforms. For my view on GDP data reliability see my blog posting Should We Believe China's GDP Data?. We are seeing evidence of restructuring taking place in recent years (see my posting Rebalancing To Consumption Is Grinding Forward, But Don't Expect Chinese Consumers To Revive Global Growth.)
Reforms Are About Control
It is important here to point out the rationale for China leadership's recent acceleration of economic reforms. China's economic reform plans are primarily about ensuring the Communist Party of China (CPC) stays in power for the foreseeable future. A great deal of the leadership's legitimacy is based on consistent improvements in living standards and rapid economic development leading to a strong China in control of its own destiny. After years of accumulating imbalances from a hard-driving industry and investment-centric economic policy, risks to longer-term economic stability put CPC future legitimacy at risk.
Restructuring too soon may derail economic stability in the short term; not fast enough, and risks will derail stability in the long term. Reforms need to balance control and stability now with control and stability later. The CPC knows very well the existential threats of economic turmoil in the short term as well as economic turmoil sometime in the future. Collapsing wealth and the end of economic prosperity brought about by inept handling of the economy would not end well for leaders already under the gun for deadly pollution and massive corruption. Many reforms, like capital market and financial market liberalization, are grinding along. But, reforms that expose the soft underbelly of control, like reforming employment-supportive SOEs or judicial independence, have been hollow announcements without real action.
Backtracking on reforms is nearly as dangerous as squashing short-term growth. Every currency devalue is a tax on consumers to support the export industry. Every boost in credit will need to be paid in defaults and potential financial sector turmoil in the future. Every leadership override of a judicial case leads to less innovation and lowers the chances of moving manufacturing beyond assembling cheap goods that don't match rising wages. And, every push-back of SOE reform to protect short-term employment creates another zombie firm to eventually face collapse at an undetermined time in the future. Economic reform decisions are a choice of how much stability and control now vs. how much stability and control later. To that end, China's leaders don't need to match economic reform feats akin to Lee Kuan Yew or Park Chung Hee. They just need to manage reforms enough to maintain control and stability.
With that in mind, how are reforms in some key areas progressing?
Though the commentary on China's yuan policy has become negative lately, capital control reforms are grinding along. The Chinese yuan is stronger than most major currencies and slightly more market-based than two years ago. In July last year, the trading band was increased to 2% on either side of the fixing vs. 0.5% in 2012. The August devalue was accompanied by adding more market information into the yuan fixing. The CNY is on track to become a reserve currency and earlier this month the yuan became the world’s 4th largest payment currency after the USD 45%, EUR 27%, and GBP 8.5%, at 2.8%. Programs for letting investment capital in and out of the mainland (QDII, QFII, etc...) are grinding higher. This month policymakers announced that they are poised to remove all capital controls by 2020, integrating the third largest bond market and second largest stock market with the rest of the world.
A financial reform milestone came last week with the announcement that the PBOC would end mandated deposit rates, the final and riskiest piece of interest rate market liberalization. China began interest rate liberalization in 2013 by removing mandated lending rate ranges. With the removal of the mandated deposit rate based on the PBOC's benchmark rate, policymakers have effectively allowed for markets to set interest rates. However, not all control has been given up with the liberalization moves. The PBOC still has significant control over banks and has indicated that it will "discipline" banks that use unusually high interest rates and disrupt the market, and reward those with low deposit rates. Rates have been officially freed-up, but the PBOC will probably exercise influence in other ways.
Liberalizing rates is a milestone for reforms intended to roll-back decades of financial repression, whereby households subsidized rapid growth in industry and investment via cheap loans funded by artificially low bank deposit rates.
Financial system risk has been moderated by restructuring efforts in the last couple of years. Beijing has not curbed the debt burden expansion, but continues to make efforts to move debt from non-transparent shadow banking and opaque local government borrowing schemes to transparent forms of debt. That can be seen in the credit growth numbers and the local government bond swap program, which is now up to 3 trillion RMB. Bond markets and equity financing have picked up some of the slack left by slowing shadow banking activities. The debt burden growth has also slowed from a rapid pace this decade as credit growth has moved closer to nominal GDP growth.
But, China's main source of debt risk is the 125% of GDP in debt on the books of Chinese companies. Household debt and government debt are mild compared to the burden carried by companies. There has been no real progress with company debt burdens yet, other than rolling a very small portion into equity and allowing some small firms to default.
Beijing’s explicit plan to increase private banks seems to be gaining ground. As of mid-year about 40 firms have applied to open their own banks following the success of Alibaba and Tencent entries into the sector. Five new private banks were given the green light this year. Bank depositor insurance covering 99% of depositors launched in May this year will continue to drive the move to get more private lenders involved in the financial system that historically has been dominated by state-owned firms.
Lack of real tangible restructuring of China’s state-owned enterprises (SOEs) has been one of the main disappointments of Xi’s reforms. State firms have half of the return on assets of private peers, and many are saddled with debt while private firms have been deleveraging. In September, Beijing announced more plans to reform SOEs, but like plans in the past, details and a timeframe were lacking. Following the announcement, an official stated the need to “make more efforts in reforming ‘zombie enterprises’, long-time loss-making enterprises and in disposing those low-efficient and non-performing assets.” Announcements are in essence saying, “there is something wrong, and this is on our to-do list”, but there have been no significant actions. Addressing “zombie enterprises” would be a significant step forward, but there are many vested interests who want to keep SOEs unchanged. And, SOEs allow the party to influence key industries and ward off employment instability. Those factors inhibit meaningful SOE changes.
In the 1990s, Premier Zhu liquidated and privatized thousands of SOEs, dramatically shrinking the states sector and resulting tens of millions of layoffs. Current reform plans are much less bold, looking to mostly improve the SOE sector and force SOEs to pay more dividends back to the state.
Private Entrepreneurship and Innovation
One of the key areas of promoting innovation is moving closer to an independent judiciary in a country where the Party has had traditionally been the last word in legal rulings. Judicial reform is second to SOE reform in delayed progress. The October 2014 plenary session included some strong language for improving the legal system. China’s supreme court this year launched a set of reforms to prevent official interference in court decisions. More judges and legal professionals have been hired. China is approaching 200,000 judges (more per person than in the US), and boasts over 400 law schools. However, the crackdown on "Rights Defence" lawyers and muted progress reported by legal experts run counter to reform announcements. In spite of weak judicial reforms, innovation seems to be accelerating. R&D spending nearly doubled between 2010 and 2014. Patent applications have also doubled in that time, from 1.2 million to 2.4 million. Long-term sustainable innovation from the private sector will require independent judges to protect patents and copyrighted assets.
China needs to allow more firms to default on bad debt. Defaults are needed to let zombie firms fail and champions grow, one of the key hallmarks of Korea's execution of the Asian industrial policy that China has adopted. Allowing defaults has begun with small insignificant firms, a coal firm and real estate developer for example, but a meaningful amount of firm failures is slow in coming. A start, but a long way to go.
Xi's administration has been successful in pushing China's service exports overseas. Recent deals to build a nuclear plant in the UK and ultra high voltage transmission capacity in Brazil highlight the success of China in development beyond manufacturing. Nearly all peers with similar per capita GDP would need to bring German or French firms in to build advanced infrastructure. Shifting to the export of "know-how" is a significant move to get away from simply being the world's factory floor.
Tax cuts for small businesses, allowing private firms more access to state projects, a pivot towards letting markets play a more decisive role in the economy, and a push to get more lending to small firms all seem to be gradually improving private entrepreneurship. According to the Economic Times, China has seen over 10,000 new start-ups a day this year, many of which are tech startups promoted by China's relaxing of ChiNext listing rules and allowing sabbaticals for University students pursuing the next app or social media project. Successes of the likes of Alibaba and Tencent in creating new billionaires has lead to a rise in animal spirits, and reforms appear to be fostering those animal spirits for now.
Slow Progress, But Enough Progress
Progress is being made and reforms have not been rolled back. The reform pace is most likely enough to keep the wheels on the rails, but nothing to earn high grades. Until we see Beijing allow more defaults to rid the country of zombie firms, progress on corporate debt reduction, and finally start implementing SOE changes, it is hard to give Xi a great review. On a scale with Lee Kwan Yu as an A+ and Hugo Chavez as an F, I would give Xi's regime a C/C- so far; not stellar reform progress, but enough to keep the wheels on the rails and start putting long-term prospects on a stable footing for now.