November 25th, 2013 | By Nick Sargen
The origins of China's economic miracle are rooted in a series of reforms that were implemented by Deng Xiaoping in the late 1970s. Deng's vision was to transform China's centrally planned economy into one that was more market-oriented, but which retained a prominent role for the central government in overseeing the evolution. The approach was to proceed by implementing a series of experiments with various sectors and studying the outcomes, rather than embarking on "shock therapy" as some Eastern bloc countries did after the collapse of the Berlin Wall.
Deng's starting point was the agriculture sector, which had been a major disappointment for the Soviet Union as it attempted to modernize. Soon after the agricultural reforms bore fruit, Deng began to implement reforms designed to modernize China's industrial sector. They included liberalizing price controls on industrial output, allowing workers' compensation to be tied more directly to their performance, decentralizing the economy by allocating a larger portion of the central government's revenues to local authorities, and opening the economy to foreign investment, among others.
In the 1990s a new generation of leaders emerged headed by Jiang Zemin as party leader and Zhu Rongi as Premier. They concluded that a new set of reforms was needed in which increased privatization of former state-owned enterprises (SOEs) was pivotal. As a result of these reforms, privatizations of SOEs accelerated, and by the mid-1990s the private sector surpassed the state sector in terms of share of GDP. The crowning achievement at the beginning of the new millennium was for China to join the World Trade Organization. The ensuing decade witnessed unprecedented growth in China's exports, which rose from 3% of world exports at the beginning to nearly 10% at the end of the decade.
By the middle of the past decade, the pace of reforms slowed considerably, as China's new leaders became concerned that liberalization was proceeding too rapidly, especially in the financial sector. And while China was able to counter the effects of the 2008-09 global financial crisis through massive government spending and credit expansion, growth has since slowed from about 10% per annum to 7%. Many observers, in turn, wonder how long the economic miracle can last when growth is so heavily reliant on exports and capital spending. Most economists believe future growth must be more consumer-oriented and that China must achieve greater efficiency as the pace of capital spending moderates eventually.
Against this backdrop, the Chinese government's reform blueprint that was recently released will guide the country's development in the coming decade. The reform document is designed to be comprehensive, promoting major changes including altering the country's "one child" policy and relaxing the household registration system, or hokou, which ties employment, healthcare, education and welfare to the place of birth. The plan will give greater rights of urban residency to about 250 million migrants who seek temporary employment in cities.
Regarding economic reforms, the main breakthrough claimed by Chinese leadership is that market forces will be granted the "determining" role in shaping the economy, while the government will recede to a supportive position. The three key areas affected include (i) pricing for financial markets including the interest rates and the value of the RMB; (ii) pricing resources such as water, energy, transport and telecom; and (iii) pricing of land, particularly in rural areas. The reforms are intended to lessen government involvement in business decisions (with the exception of some sectors that concern national security, environmental issues, and some strategic industries.) At the same time, the focus of the government's involvement in SOEs will shift from daily management of these companies to improving the return on capital through state asset holding companies.
Ultimately, the Chinese leadership remains committed to foster strong economic growth to overcome the country's problems. It will also strive to improve its governance while limiting political reforms. Therefore, the inherent conflict between an increasingly prosperous population and an authoritarian political regime will continue to fester.
To get a handle on what these reforms mean, I have read assessments from a variety of knowledgeable sources. For the most part, the reforms are regarded positively, subject to the caveat that one needs to see whether they are implemented successfully. The main outlier is Andy Xie, an economist formerly with Morgan Stanley, who believes China is a "bubble economy" and is skeptical of the reforms.
My starting point was to read an interview of Wu Jinglian, a preeminent economist who helped formulate many of China's reforms over the past 35 years. His take is that the decisions to allow market forces to play a decisive role in resource allocation are critical to building an open, competitive and orderly market. Without the latter, Wu said, "nothing is effective, no matter whether you call it a basic or decisive role." Wu also believes several issues have to be addressed before a strong foundation is laid including (i) clarifying property rights; (ii) allowing prices for factors of production –land, labor and capital – to be set near market levels; (iii) putting anti-monopoly measures in place and (iv) implementing regulatory reform. At the same time, Wu foresees challenges in implementing the reforms coming from both ideological and vested interests, especially concerning the role of SOEs.
Researchers at Bank Credit Analyst (BCA) also view the proposed reforms positively. A report entitled "Understanding China's Master Plan" (November 20, 2013) observes the latest market-oriented reforms are more comprehensive than previous ones, in which the vision of "building a socialist market economy with Chinese characteristics" deemed market forces as secondary to government regulations and macro controls. According to China's new leadership a major breakthrough of the plenum is that market forces will now be granted a "determining" role, which suggests the government will recede to a supportive role. The report goes on to conclude: "The latest reform measures hold the promise of further improving overall economic efficiency and lifting the economy's long-term potential. This adds to the structural appeal of Chinese stocks as an asset class, which has gone through a massive de-rating in the past few years."
An accompanying BCA report (see Emerging Markets Strategy, November 20, 2013) is also bullish on Chinese stocks over the long-term, but adds several qualifiers about the short-intermediate outlook. The assessment in this piece was that the implementation of market-oriented policies would inevitably lead to "creative destruction," as less efficient firms would be unable to compete and would ultimately fail: "Given that many entities (often quasi state owned ones) involved in capital spending are over-indebted and have poor cash flow, the move to a market-based system means they should not be bailed out by the central government. This in turn will weigh on banks, trust companies or other creditors, and will slow down credit flows to the economy."
The latter report acknowledges that while financial liberalization is desirable over the long term, over-indebted entities will face pressure from higher borrowing costs, which could lead to debt-servicing problems: "These factors…make our downbeat assessment on the capex cycle even more likely to play out in the intermediate term." Therefore, it concludes Chinese stocks could underperform for a while longer.
To get a complete perspective, I also read an article by Andy Xie, a leading skeptic of China's economy, entitled "No Sugarcoating It: A Hard Landing Is Likely" (November 19, 2013.) Xie, who was formerly Morgan Stanley's chief economist for China, believes China is a "bubble economy" that is increasingly reliant on financing from the shadow banking system. Previously, he believed the economy would experience a soft landing, because China's banks are government owned, and the banks would likely roll-over loans when property developers faced a liquidity crunch. However, if as a result of the proposed reforms interest rates are allowed to rise to clear the markets, there is a greater threat that financial institutions which are not under the government's umbrella will fail, setting off a financial crisis: "China's shadow banking system has become the main source of financing for the ongoing speculation. Nearly half of the credit growth this year can be classified as that. As such financing is usually short term, the speculative game depends on rollover confidence…"
Xie concludes by observing that China's reform should be about changing the role of government, and "not tinkering with the market system." He contends that while interest rate liberalization sounds good in theory, the vested interests of local governments, property speculators and developers are too strong to permit fundamental reforms.
One year ago, when China's new leader, Xi Jinping, assumed power, the main issue on the minds of China watchers was whether he would rekindle the reform process that had been largely dormant since the middle of the past decade. With the unveiling of the proposals coming out of the third Plenum, President Xi has clearly positioned himself to be a reform minded leader. This is a welcome development as China embarks on a transition to more sustainable growth.
The sequencing of reforms will have an important bearing on the program's overall success. Some reforms such as the change in the "one child" policy and the hokou registration system will bear fruit over a long time frame. Others such as the decision to make interest rates more market-oriented and to reform the financial system and capital controls could play out in the next few years.
From an investor's perspective, one of the key issues is whether China can reform its antiquated financial system without destabilizing it. A move toward market-oriented interest rates is critical, because the current situation where interest rates are set too low has helped to spawn a boom in housing while also giving rise to rapid growth of China's shadow banking system. At the same time, one must acknowledge the risk of financial instability if the reforms are not accompanied with adequate safeguards.
In the end, I believe China's policymakers understand this dilemma and are likely to proceed gradually in overhauling the country's financial system. This, at least, is the lesson I draw from the country's reform process over the past 35 years. Consequently, I view the proposed policy reforms as favorable to China and the global economy.