Alicia Garcia-Herrero is the chief economist for emerging markets at BBVA. George Xu is an economist with BBVA in Hong Kong.
China’s transition from a centrally planned economy to a market economy has neither been easy nor linear. The government has tried to liberalize some sectors, although not all, privatize some industries, but certainly not all. Overall, one can argue that the dominance of the state-owned sectors has been maintained with a special emphasis since the 2008 global crisis. Such strategic choice is also behind the continuation of an investment-driven growth model. The cost of such a model, however, cannot be underestimated. Resource misallocation, overcapacity in capital-intensive industries, rising domestic financial fragilities as well as many social and environmental problems, are some of them.
China’s annual economic growth remained above 8% entering the 21st century, before moderating to 7.7% in 2012 and 2013. Despite having once again averted a hard landing scenario as was feared earlier in the year, economic rebalancing towards domestic consumption has been very slow, with investment continuing to support growth. In fact, in 2013, the Chinese economy was sustained by exports and supportive government policies, including a “mini” stimulus package focused on infrastructure investment. However, high-frequency economic indicators in early 2014 point to a further slowdown, coming on the heels of sluggish exports and soft domestic demand due to the authorities’ tightening measures to curb financial fragilities.
Regarding 2014, the government announced its GDP growth target during the annual National People’s Congress in early March. The target remained the same as in 2013, namely 7.5%. However, in the face of the recent growth headwinds evidenced by quite gloomy data outturns, Premier Li Keqiang recently hinted that the government will fine-tune economic policies to sustain the economy within a “reasonable zone,” which is interpreted as a combination of two limits: An upper bound of 3.5% for inflation, and a bottom line of 7% GDP growth. Against the background of moderating GDP growth and other poor data for the first quarter, maintaining growth above 7% actually means more fiscal and monetary stimulus as Li acknowledged.
The need to push demand policies further and underpin the growth above the floor target comes at a time when China really needs to deliver on structural reforms. In fact, China’s long-awaited “blueprint” was released after the Third Plenum in November 2013 and aims to enhance the quality of economic growth and facilitate the rebalancing of the economy. The document is ambitious and encouraging for its wide range of scope, reflecting the commitments of China’s new leadership after formally taking the power in March 2013. The key elements of such a blueprint can be classified as follows. The first is financial sector liberalization, which includes greater private entry into the banking sector, further interest rate liberalization and opening of the capital account as well as a more flexible foreign exchange regime.
The second is fiscal reform, including anti-corruption and anti-waste campaigns, as well as expansion of the VAT pilot program. The third key area is urbanization with additional public housing construction and more channels for public housing finance. The fourth one focuses on the always difficult nexus of the private and public sector. One aspect is state-owned enterprise governance, for which mixed-ownership structures in SOEs will be explored as well as market pricing for utilities and natural resources. Finally, there is a set of important social measures in the reform package including the relaxation of the one child policy as well as a further streamlining of public administration through reducing the number of administrative tiers and cutting red tape.
The question really is whether China can introduce all of these reforms in a lax environment in terms of liquidity or actually needs to restrain credit to force firms to change. While some of the reforms may not be influenced by the availability of credit, it seems clear that changing the incentive structure in which Chinese corporate and banks operate will not be achieved without financial constraints, not to talk about the reduction of overcapacity and the improvement of environmental concerns. This is where the tradeoff between growth and reform comes from.
In order to meet a bottom line of 7% GDP growth this year, the new leaders have already fine-tuned the policy stance towards a laxer one, at least in terms of fiscal policy. In fact, the government will disburse fiscal funds in a more timely manner, continue social housing construction and accelerate public infrastructure investment (railway, highway and water conservation). As for monetary policy, interbank rates have been kept at lower levels than those in December. Further easing in the coming months cannot be ruled out, including cuts in the reserve required ratio.
We are still optimistic about China’s medium-term growth outlook as long as China continues with its reform agenda. However, we cannot forget that China’s potential growth rate will inexorably come down given its population trends and its rising income per capita. In any event, potential growth will be higher with reforms that without. That is what matters.