China's Reform Traffic Light: More Red Than Green

Ever since Xi Jinping and Li Keqiang took over the leadership of the Chinese Communist Party in November last year, there has been keen interest in their reform orientation and emphasis. In line with tradition, the new leadership has in the last 12 months or so been taking stock of China’s key challenges and the need and room for reform.
 
The new leadership’s statement of principles and directions of economic policy and reform is meant to be approved at China’s Third Plenum of the 18th Party Congress on 9-12 November.
 
High hopes
Expectations run high for the new leadership’s reform plans for several reasons. For one, many people have been wishing for reforms in various areas. In the economic and financial realm, many people have been looking forward to market-oriented reforms.
 
Expectations have further been boosted by the view that, at least in the economic realm, key new senior leaders are relatively reform-minded. While not much is known about President Xi Jinping’s views on economic policy and reform, Prime Minister Li Keqiang has advocated economic reform principles such as changing the pattern of growth, raising domestic demand, improving the quality of urbanisation, and recently also with changing the role of the government in the economy.
 
Also, key economic and financial positions are taken up by people that are considered to be reform-minded, including the Minister of Finance, Lou Jiwei; the PBOC governor, Zhou Xiaochuan, who kept his job; and the head of the NDRC, Xu Shaoshi.
 
Another factor raising expectations is the idea that the reforms to rebalance the pattern of growth are urgent because, without such reforms, China will soon suffer from a hard landing or hit a wall, and that the government knows this and is acting accordingly.
 
What we expect
The current discussions and negotiations do not start from scratch. Many of the specific areas of economic reform have been advocated and discussed for many years. Nonetheless, at this stage in the policy cycle, we do not expect many announcements on speedy implementation of reforms.
 
Rather, we expect the leadership in November to present a statement with objectives and directions of reforms toward rebalancing the pattern of growth more towards domestic demand, consumption and services; and upgrading the industrial structure and moving up the value chain.
 
The broad principles are likely to be about market orientation, opening up and integration with the world economy, improving the quality of urbanisation, innovation and “changing the government’s management mode” (the role of the government in the economy).
 
We expect the political economy of reform to play an important role in determining the relative emphasis in different areas. In line with developments in recent years, we expect further headway in areas where there is not much vocal resistance, but little or no progress in areas where resistance is vocal and strong. Thus, we think the leadership will:
 
Set reasonably concrete principles and directions in areas with fairly broad agreement on how to move forward. In our view, this is so for financial and monetary reform, pricing and taxation of raw resources, and more government spending on health, education and social security.
 
Set some general objectives and principles in areas that senior leaders have emphasized, but where the political economy is an obstacle to ambitious reforms. This includes “the new urbanization,” which calls for important but politically difficult reforms such as on the hukou system; the fiscal system; and rural land and its conversion into urban use. In spite of high expectations, signs are that there is limited scope for speedy movement on fiscal and land reforms.
 
Shy away from setting clear principles and directions of reform in areas where the political economy is an obstacle and that have not been emphasised by senior leaders. In our view this includes areas such as levelling the playing field between SOEs and other companies.
 
We expect the leadership to repeat calls for raising the role of domestic demand and boosting consumption, as part of the objective to rebalance the pattern of growth by focusing more on services, domestic demand and consumption rather than industry, investment and exports.
 
However, in our view the government is less convinced about the need to reduce investment. The Prime Minister’s report to the National People’s Congress in March stressed the need for more investment in many areas and that “in the current stage, the role investment plays in promoting economic growth cannot be underestimated.”
 
Implications of disappointment
Thus, in our view, those with high expectations about reforms to rebalance the pattern of growth are likely to be disappointed by the outcome of the November plenum.
 
In particular, investors who think that China’s economy is in for a hard landing or worse, if there is no quick implementation of an ambitious set of reforms and swift rebalancing away from investment, should become very bearish on China, in our view.
 
What would a not-so-ambitious reform outlook mean for those, like us, who think that China definitely needs to implement reform to rebalance its pattern of growth to keep growth sustainable over time, but who don’t expect China to be in for a hard landing or hitting a wall any time soon?
 
It would confirm that reform in China is still a gradual, long-term process. If the government ends up presenting a roadmap for reforms that falls short of the high expectations, that does not necessarily have to be a major issue.
 
Is everything fine then? Not necessarily
 
In our view, the recent and current reform dynamics underscore the importance of politics and the political economy of reform. Indeed, as vested interests get more entrenched, such political economy factors have become ever more important in driving the dynamics of reform.
 
This situation is not unique to China and it does not mean resistance cannot be overcome. Other countries have faced similar issues. Internationally, and in China’s own past, strong leadership at the highest political level has sometimes been employed to push through difficult reforms.
 
Arguably this has not happened recently in China. Policymaking these days tends to be consensus-driven, with different ministries, agencies and interest groups all having to “sign off” on reforms. This tends to make policymaking cautious and oriented towards measures that do not face strong resistance from vested interests.
 
In principle, this cautious approach could change, but it calls for strong leadership at the highest political levels.
 
Medium-term risks
We remain reasonably comfortable about the ability of China’s economy to continue to grow and develop robustly in the coming years. We also expect the government to make progress in the politically difficult areas in the coming years.
 
However, there are medium-term risks associated with the reform agenda.
 
If needed but politically difficult reforms are not pushed through enough, China’s overall reform process could become skewed. For instance, if China continues to make decent progress with necessary and politically easy “welfare state” types of rebalancing reforms, but cannot make headway with the politically difficult but essential growth- and productivity-enhancing rebalancing reforms, the country could end up with a rebalanced but slower growing economy.
 
Also, if the reforms to adjust the economic structure and the domestic financial system cannot be implemented, but the government presses ahead anyway with capital-account opening, the risks of financial instability would rise while misallocation of capital may actually also increase.
 
A detailed look at reform prospects
The reform agenda continues to be guided by the two key objectives of China’s 12th Five Year Plan, which ends in 2015.
 
The first objective is rebalancing the pattern of growth more towards domestic demand, consumption and services. In our view, and the government would probably agree, this objective is largely motivated by efficiency-related, social, environmental and energy-related considerations, rather than driven by the need to prevent a financial crisis.
 
The second objective is upgrading the industrial structure and moving up the value chain, with an emphasis on technological upgrading, investment in “new strategic industries,” and innovation. We think that China is already making decent progress in this direction, but this second objective will continue to influence policymaking in the coming years.
 
Broadly, the overall reform agenda encompasses measures to:
 
  • improve the allocation of resources, ensuring they are channeled to new sectors, products and processes, and encourage innovation; and
 
  • support more full urbanisation, with migrants able to behave and spend like normal urban citizens
 
Go, Slow and Stop
We summarise our assessment of what can be expected in the key areas in terms of directions in November and/or measures in the coming two years. For a quick take-away, the table below shows the areas and indicates our “traffic light” judgment as to the mandate for reform.
 
Click image to enlarge 
Green for go, red for stalled
Source: RBS
 
We summarise our expectations below, with the reform actions grouped under the nexus of improving allocation and the nexus of supporting more full migration.
 
Improving allocation
Pricing and taxation of raw resources: Removing subsidies to industry by raising prices and taxation of inputs such as land, energy, water, electricity, and the environment.
 
Expect good further progress, building on steps already taken and recent announcements that reflect a mandate, including mining resource pricing reform, electricity pricing and subsidies for renewable energy
 
Tax reforms: Removing the industry-bias of local governments and mitigate distortions and economic inequality, including by more taxation of assets (property, equity) and less taxation of labour
 
Expect small incremental steps on already existing pilots and initiatives, including:
  • replacing the business turnover tax by VAT in the service sector
  • further piloting of a property tax
  • adjusting the consumption tax to include energy intensive and highly polluting products
  • changing tax rates for some luxury products.
 
Adjusting the economic structure: Reducing excess capacity, promoting new industries, upgrading the industrial structure and stimulating domestic demand led growth, and continuing SOE dividend reform and actually channelling the revenues to the Ministry of Finance
 
Expect continuation of plans to “eliminate outdated capacity” and reduce overcapacity, although the track record of such initiatives is poor; follow-up actions on the recent guidelines to boost demand and supply in “information services”, elderly care, and green and energy saving technology; but little movement of SOE dividends.
 
Institutional and administrative reform: Levelling the playing field between SOEs and the private sector by removing barriers to several sectors, increasing private-sector participation; fostering truly independent regulatory bodies, and generally delineating more clearly the role of the state and that of the market.
 
Expect some attempts/guidelines towards more private sector participation; limited progress on levelling the playing field between SOEs and other companies; but decent progress on simplifying and reducing the scope of government approval procedures and relaxing government regulations.
 
Financial sector reform: Towards more competition and more non-bank financing, as well as better access to finance for under-serviced firms
 
Expect quite clear directions and movement on
  • improving access to finance for SMEs and in rural areas, following on recent State Council guidelines
  • stimulating the bond market and developing the capital markets; and
  • introducing a deposit insurance system and liberalising deposit rates
 
Monetary, exchange rate and capital account: Increasing the role for the interest rate in the conduct of monetary policy, introducing more exchange rate flexibility, and opening the capital account
 
Expect the following:
  • directions and movement toward a more interest based monetary policy
  • gradually, in a fairly controlled fashion, relaxing outbound portfolio investment and more generally opening up the capital account; and
  • introducing more exchange rate flexibility.
 
Senior officials have indicated that they want to start on opening up of the capital account before the domestic financial reforms are finished and the exchange is fully flexible, thus challenging mainstream advice.
 
Supporting more full migration
Reforming the hukou, or household registration system
 
No major breakthrough soon. Expect language on exploring offering hukou for migrants in small and medium-sized cities
 
Public finance: Reforming the inter-governmental fiscal system to give local governments the means and incentives to fund public services and affordable housing for migrants
 
No major reform soon. Expect language on exploring some more revenues for local governments; central government taking over some responsibilities for certain public services; more bond issuance on behalf of local governments.
 
Land reform: Pursuing land reform to give individual farmers property rights, or at least transferable management rights; let farmers/migrants benefit more from urbanization related rural land sales
 
No major change. Expect some directions on transfers of management rights and general language on farmers’ compensation for land sales.
 
Conclusion
In all, as we noted above, the type of language in the November document and steps announced in the coming two years would amount to varied movement across the key areas of reform.
 
This would disappoint those with high expectations. While we are not so worried that this would cause a hard landing or crisis, the difficulty of implementing reforms that are needed but resisted imply medium-term risks of too little or skewed or bad-quality rebalancing, and higher risks of financial instability upon implementation of financial and monetary reforms.
 
About the Author

This article is excerpted from “Top View: China,” a report by Royal Bank of Scotland and affiliated companies that was published on 10 October 2013. It has been re-edited for conciseness and clarity. ©Copyright 2013 The Royal Bank of Scotland plc and affiliated companies (RBS). All rights reserved.  

 

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