All nations wrestle with opposing economic impulses: sustain current activity or undertake reforms that reduce short-term growth while bolstering long-term prospects. China is no exception: in fact, as the most populous nation on earth and the biggest marginal growth contributor among all countries during the past four decades, China faces the most profound struggle between these urges. This is especially true because even by its own appraisal, China has much to do to modernize its system. That appraisal can be found in President Xi Jinping’s Explanatory Notes for the “Decisions of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening the Reform,” penned in November 2013 to accompany the far-reaching reform program announced that month, or in now–Vice Premier Liu He’s May 2016 People’s Daily broadside on the urgency of carrying through stalled reforms to avoid systemic risks. What these statements share is a broad-spectrum diagnosis for China’s economic potential and the threats to it if policy changes are not enacted.
Outside China, these acknowledgments of the importance of policy improvements have fostered confidence that long-term objectives were shared. The advanced economy consensus on fostering sustainable growth broadly coincided with Beijing’s 2013 objectives. This is a big idea: a Chinese reform plan could both support China’s potential growth and be consistent with advanced economy policy norms. Despite some Chinese voices promising to overturn the normal rules of economic logic, the reality is that no one in Beijing has elaborated a viable improvement upon the directions set out by Xi and Liu in the documents noted above. No more recent plan is remotely as comprehensive as the 2013 plan, or as definitive in its message. Even in China, stimulus not guided decisively by the market will lead to resource misallocation – bad debt – and inevitably to downturns as adjustments are necessary. Reform is critical for long-term sustainable economic growth, and monitoring China’s progress, as we do in Dashboard editions, is in turn the key to good policy abroad.
In 8 of the 10 clusters we track, meaningful reform progress is lacking or even backsliding.
We see clear examples in this Dashboard review period of why reform matters. In 8 of the 10 clusters we track, meaningful reform progress is lacking or even backsliding (see our Net Assessment graphic below for our current assessments). In many cases, such as competition or labor reform, stalled reform undermines corporate performance and investment momentum – for example, by stifling mobility in the labor market, failing to mitigate against high risks of intellectual property leakage, or using regulatory means to artificially skew the competitive landscape toward state-owned entities and away from domestic private or foreign players. In areas where the progress is evident – such as environmental policy or innovation – the improvements shown in our indicators are largely driven by state-led industrial policy mechanisms. This is less an overhaul of the system than a recalibration in pursuit of a market alternative.
Note: The chart above is a visualization of the China Dashboard’s conclusions about reform progress in each of the ten clusters we monitor. These assessments are based on the study’s primary indicators. The movement in the chart tracks how our assessments change over time. Clusters listed near the “neutral” center line display no meaningful progress or backtracking; clusters slightly in positive or backsliding territory display outcomes that we assess might be fleeting based on the extent of data changes or policy direction, while clusters deeper in positive or backsliding territory show changes we assess are more likely to last in future quarters.
Of all the reform clusters we monitor, the one at the fulcrum of China’s reform outlook today is financial policy. A credit-deleveraging program has been conducted since late 2016. This was essential, as the nation’s ballyhooed growth was too much a product of indebtedness. From 2008 to 2016, nominal GDP grew by $6.6 trillion, but that took banking system expansion of more than $25 trillion. At the end of 2016, bank assets were rising by 15.8% year-on-year (yoy) – a marginal increase of $2.7 trillion, and clearly unsustainable. From a deleveraging reform perspective, a reduction in that rate of growth by more than half, to 6.8% today, is a real success. But consider the side effects. It means significantly lower GDP growth, unsteady equity markets, a falling renminbi outlook, corporate bankruptcies and defaults, severe pressure on local fiscal affairs, aggravated trade policy friction due to excess capacity spilling into international markets, greater likelihood of industrial firms cutting corners on environmental controls to avoid losses, and innumerable other unintended consequences. No sub-component of reform can be properly understood in terms of cost without this full “life-cycle accounting” in mind, in terms of either costs or benefits. The parts of reform must be related to the whole.
The unintended consequences of deleveraging today are causing second thoughts about the balance between reform and avoiding pain. Just as the consequences of environmental policy led to a heating crisis and reversion to burning coal this past winter, outbound investment capital account opening turned to reversal in 2017, equity market reforms caused a rethink in 2016, and interbank credit market reforms caused panic in 2013. In each case, policymakers fell short on implementation in order to boost short-term growth, palliating immediate needs but aggravating longer-term problems for sustainable growth and the odds of future crises.
At mid-summer 2018, there is discussion that austerity is once again slipping, and policy shifting toward stimulus. There is evidence for this. In its 2Q2018 Monetary Policy Committee statement, the central bank dropped all mention of interest rate and exchange rate reform, signaling more focus on growth and stabilization instead. The top-level Politburo of the Party -moved to encourage domestic demand this spring and has signed off on a series of growth-supportive measures since then, including cuts to bank reserve requirements that effectively loosen liquidity. Perhaps the most important indicator is whether financial policymakers, under the People’s Bank of China’s (PBoC’s) lead, stay the course in rule making for asset management including wealth management products (WMPs). New regulations are intended to clean up Ponzi scheme–like investment offerings and their associated risks, by – among other things – prohibiting “guaranteed returns.” The only problem is this reform works, and the threat of draining the market of risky finance chokes off growth and reveals the nation’s dependence on debt, thus producing the slowdown now in evidence.
The question on every China watcher’s mind is whether Beijing will water down this clean up to stoke the economic hearth. Though the WMP regulations have retained their teeth, policymakers are of two minds about implementation, some counseling easing, others austerity. One can still make a strong case that despite signals of relaxing, the main attribute of Chinese policy through this year will remain austerity, relative to past practice. A full-blown market rout is in no one’s interest, including reformers. In June and July, selling pressures swept markets for China’s currency, equities, and debt, eliciting signs of easing to avert a freefall. But nothing about current policy signals, and nothing likely to be introduced over the coming quarters, will restore bank asset growth to the 15%–16% range seen two years ago. At most, we expect that pace to reach 9%–11% in 2018, as bank asset growth in the first half of the year is only half that in the first half of 2017.
In the near term, 10% credit growth would be read as a bounce back from first-half 2018 lows, and no doubt some animal spirits will chase this bullish news. But pull back the camera and look at this situation in a broader perspective and you see a different picture. A new normal of slower credit growth – if sustained – would force hard choices: debts marked down or written off, debtor and lender bankruptcies, more hesitant investors for a period of time, sales of assets including state-owned assets, re-prioritization of public expenditures, and more urgent implementation of tax reforms. This is what real reform looks like; if it happens, then our indicators will improve in myriad ways. Recession, write-offs, and distribution of pain rather than distribution of largess would mean profound changes in the political debate. The Party and government would be prevented from pursuing whatever ambitions they espoused without regard for financing questions. Beijing would need to moderate breathless promises to fund “Made in China 2025” industrial policy plans at home and “Belt and Road” Initiative plans abroad.
Some of these hard realities, such as pruning back industrial policy obligations, are already happening. We can see the changes. Others will likely show up in the quarters to come, though the picture will be clouded by the conflicting news about “easing” measures to stabilize growth. Indeed, as we finished this edition of the Dashboard, the State Council instructed financial institutions to ensure adequate funding for shadowy local government financing vehicles to avoid projects under construction being abandoned – a seemingly blanket invitation to fiscal expansion that would balloon government debt.
It is important that these reforms stay the course. This process of financial system reform is the foundation of a broader rationalization of the economic model that Chinese economists including Vice-Premier Liu have been suggesting for years. The main reason for deleveraging is domestic: the weight of debt run up to fuel past growth is stiffling. Ironically, it is not U.S. trade and investment policy pressures that are behind China’s present macroeconomic dynamics (although those external pressure add to China’s challenge of making a transition) but policy choices made in Beijing years ago.
And yet, the elements of reform China needs for its own sake – an agenda that Xi Jinping and the Party laid out five years ago and have tried but come up considerably short in implementing so far – are by and large the same set of adjustments that advanced economies are asking of China today. Let markets allocate resources and inputs, including finance and labor; withdraw government from running the economy through policies like Made in China 2025; and take a pro-competitive regulatory role that maximizes consumer welfare, not national champions. In other words, watch for signs of reform in China because that augers well for China’s performance and also because such signs are the scenario offering a more peaceful path for China to walk in partnership with other leading economies.
Ironically, it is not U.S. trade and investment policy pressures that are behind China’s present macroeconomic dynamics but policy choices made in Beijing years ago.
The View from Abroad
Trade tensions between the United States and China escalated during the review period. The United States implemented tariffs on Chinese steel and aluminum imports as well as on $34 billion in additional imports seen to be benefiting from industrial policies, while President Trump promised that the entirety of Chinese exports to the United States might face tariff impositions. The U.S. Congress also moved forward reforms to national security investment screening that would put higher barriers to inbound investment from Chinese firms. President Trump is signaling that he is willing to disrupt not just bilateral trade but also investment and people flows if China does not change course. The United States is not only seeking increased U.S. exports but also fundamental, systemic changes in the Chinese economic system, including the curtailment of industrial subsides and industrial policy more generally. Our Dashboard affirms that the White House’s diagnosis that China is behind on economic policy reform is correct. Time will tell whether increasing tariffs is an effective way to prompt reform.