Research and analysis

China’s Economic Reform-Progress and Prospects

Published 6 February 2015

1. Summary

In September 2013, it was judged that ‘a major push on economic reform is beginning’. Significant progress has since been achieved in at least three areas: finance, fiscal and administration. In other areas, like reform of the central State Owned Enterprises, the process has barely begun. Why the pace of reform is likely to accelerate (a little) in 2015. What this all means.

2. Detail

Nearly 18 months ago, it was judged that China was poised for a major push on economic reform. Expectations were raised further by the Third Plenum, held in November 2014, which outlined more than 300 economic measures the Party wanted to implement ahead of 2022, the presumed final year of the Xi/Li administration.

There has since been a steady flow of announcements. The Party say they’ve implemented 80 of the Third Plenum’s measures. The attached table provides an assessment of what’s happened. Particularly significant progress has been achieved in the following areas:

2.1 Financial reform.

Rates charged on both loans and deposits were previously set by the People’s Bank, rather than markets. Low deposit rates penalised savers and subsidised loans, which favoured the state-owned (and primarily industrial) companies that had better collateral and connections. The exchange rate was also held low, subsidising exporters, leading to the build-up of $4 trillion in FX reserves.

The lending rate has now been fully liberalised and the deposit rate partially liberalised. Greater exchange rate flexibility support allows sustained appreciation of the RMB and more day-to-day volatility. The Hong Kong-Shanghai Stock Connect has made a significant window in China’s capital account, within a tightly-controlled framework.

2.2 Fiscal reform.

Many of China’s economic problems have a fiscal foundation. Local governments lack resources to cover spending obligations, requiring them to rely on land sales and local government financing vehicles (LGFVs), fuelling an unsustainable boom in both property investment and local government debt. The tax-base depends on indirect taxation: cigarette duty historically earns more revenue than income tax.

Finance Minister Lou has prioritised fiscal reform. He has pushed through a new Budget law that had been under discussion for the past 10 years. LGFVs have effectively been banned. Pilot provinces have been allowed to issue municipal bonds. More spending responsibilities have been centralised. Public-private partnerships have been encouraged. The tax burden on both small and services’ companies has been reduced.

2.3 Administrative reform.

China came 90th in the World Bank’s 2014 Ease of Doing Business survey, below Namibia. Common tasks like setting up a new business required endless approvals from countless organisations all purportedly doing the same thing (and many of which only communicated by fax). Vast sectors of the economy are effectively closed to foreign businesses.

200 approvals were abolished last year, adding to the 400 removed in 2013. Premier Li personally launched a pilot Free Trade Zone in Shanghai in late 2013, with further pilots announced for Tianjin, Guangzhou and Fujian. Consultations have started on a much simpler national investment law. Economic ministries now focus on regulating, not approving.

3. Comment

3.1 Glass half-full or half-empty?

In some areas reform is still awaited.. The capital account remains largely closed. Many sectors, including financial services, remain effectively closed to private (and foreign) companies. Progress hasn’t been linear: creditors were ultimately paid back following Chaori Solar’s bond default last February, illustrating endemic moral hazard in China’s financial system.

However, this is the start of an 8-year project. More lending is flowing to small and medium companies. Registrations for new firms are rising. Foreign investment in China’s services sector is growing alongside China’s booming outward investment. A stronger RMB is increasing pressure on companies to move up the value chain. Consumption and services are displacing investment and manufacturing as the main engines of growth.

3.2 What to expect in 2015 and beyond?

Stability remains important. President Xi’s ‘New Normal’ involves a gradual not precipitous slow-down in growth. Further bursts of stimulus, like the 50bps cut in the required-reserve ratio announced on 4 February, are therefore likely. Those expecting a ‘big-bang’ approach to reform will also be disappointed: this isn’t how Chinese policy works.

The pace of reform, however, ought to mildly accelerate. Groundwork was laid in 2014 for reform of the rural land system, the state-owned enterprises and the household registration (hukou) system. Furthermore, the global economy ought to be stronger, supporting exports, and lower oil prices will help. Finally, provincial-level officials will face better-aligned incentives. Tighter budget constraints will start to bite and the New Normal implies a lower focus on economic growth as an end in itself, as illustrated by Shanghai’s recent abolition of its annual target.

3.3 What does this all mean?

Three predictions:

a. day-to-day bumps will become more common, even if the annual growth trajectory remains smooth. The Party’s economic goal is to allow ‘the market to play a decisive role in the allocation of resources’. Policymakers’ controlling desires will be tested and there will be set-backs and missteps along the way. The overall direction, however, will be towards less intervention and a greater tolerance of volatility; and

b. doing business in China will remain challenging. Ministries need to learn how to exercise their regulatory muscles and lawmakers to effectively implement existing legislation. Foreign businesses will have to adapt to the new environment and deal with home-grown firms that are both increasingly competitive and have a better understanding of local mores; but

c. the long-term impact will be positive. A reformed Chinese economy provides greater stability to the world economy. The UK ought to benefit more than most, given the two economies’ complementary strengths. This is illustrated by recent data: the Chinese say the UK is now their second most important European trading partner after Germany and has been the top major European destination for Chinese investment since 2012.

4. Disclaimer

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