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IMF Bangs On A Familiar But Necessary Refrain

THE INTERNATIONAL MONETARY Fund has left its growth forecasts for China this year and next unchanged at 6.6% and 6.2%. However, in the newly published edition of its World Economic Outlook, the IMF notes that “China’s growth stability owes much to macroeconomic stimulus measures that slow needed adjustments in both its real economy and financial sector”.

Policy support and opened credit taps stabilised growth in the first half of the year close to the middle of authorities’ target range of 6½% –7% for the full year.

The Fund bangs on a familiar drum when it calls for more decisive action in tackling corporate debt and governance issues in China’s state-owned enterprises (SOEs). Lack of progress on these, it says, raises the risk of a disruptive adjustment from reliance on investment, industry and exports to greater dependence on consumption and services. Rebalancing could become ‘bumpier than expected at times,” the Fund warns. The current short-term stimulus on which China is relying and a still-rising credit-to-GDP ratio exacerbate that concern.

Credit dependency is increasing “at a dangerous pace, intermediated through an increasingly opaque and complex financial sector”. A combination of factors are at work here: “the pursuit of unsustainably high growth targets, efforts to prop up unviable state-owned enterprises to preserve employment and defer loss recognition, and opportunistic lending by financial intermediaries in the belief that all debt is implicitly guaranteed by the government”.

The IMF’s policy prescriptions are similarly familiar:
• address the corporate debt problem by separating viable from unviable state-owned enterprises, harden budget constraints and improve governance in the former while shutting down the latter and absorbing the related welfare costs through targeted funds;
• apportion losses among creditors and recapitalise banks as needed;
• allow credit expansion to slow and accept the associated slower GDP growth;
• strengthen the financial system by closely monitoring credit quality and funding stability, including in the nonbank sector; continue to make progress toward an effectively floating exchange rate regime; and
• further improve data quality and transparency in communications.

The medium-term outlook for China remains clouded by the high stock of corporate debt—a large fraction of which is considered at risk. And vulnerabilities continue to accumulate with the economy’s rising dependence on credit, which complicates the difficult task of rebalancing the economy across multiple fronts:

The medium-term forecast assumes that the economy will continue to rebalance from investment to consumption and from industry to services, on the back of reforms to strengthen the social safety net and deregulation of the service sector. However, non-financial debt is expected to continue rising at an unsustainable pace, which—together with a growing misallocation of resources—casts a shadow over the outlook.

Spillovers from China’s rebalancing and gradual slowdown via global trade and increasingly financial channels continue to concern the Fund. These have been significant, and China’s growing global role, the Fund says,  makes it all the more important for it to address its internal imbalances.

However, it also notes the other side of the coin:

The outlook for emerging market and developing economies will continue to be shaped to a significant extent by market perceptions of China’s prospects for successfully restructuring and rebalancing its economy.

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A Scorecard Of China’s Economic Rebalancing

A NEWLY PUBLISHED IMF Working Paper takes the measure of Beijing’s progress in rebalancing the economy away from investment and export-driven growth to high-value-add innovation-led industry and domestic consumption.

In summary, the paper says:

External rebalancing has advanced well, while progress on internal rebalancing has been mixed, with substantial progress on the supply side, moderate progress on the demand side, and limited progress on the credit side. Rebalancing on income equality and environment has also been mixed, with the energy intensity of growth falling and labor’s share of income rising, but income inequality and local air pollution remaining very high.

The author of the paper has also created a visual traffic-lights type scorecard, with data going back to 2010 and forecast out to 2021.
untitled-2

We have taken the liberty of taking a snapshot of where we are now based on 2015 or most recent available data (see Table 1, left).

The IMF has long been cheerily upbeat about the prospects for China’s economic development — no dramatic headlines generated by dire warnings of the rising risks of a banking crisis, as came from the Bank for International Settlements in its latest quarterly review published this week.

While the paper does acknowledge in this regard that the risk of “a disruptive adjustment” will increase significantly in the medium term, it also says that buffers such as foreign-exchange reserves are still large and able to help absorb potential financial shocks, although they will likely diminish over time, especially if reforms lag.

The paper also notes that demographic and structural changes will provide tailwinds to China’s rebalancing. It is certainly true that the rapid ageing China will experience over the next 15 years will turn the demographic dividend that has helped power growth for the past three decades into a demographic deficit.

The paper underlines that “successful rebalancing requires coordinated progress on various fronts. Going too fast on one area, while too slow on others, may derail the whole process.”

That is also not to say that significant policy efforts are not needed to get there.

Specific recommendations include:

  • continuing to move to an effectively floating exchange rate regime to prevent future foreign-exchange misalignments;
  • raising government health care spending to encourage a lowering of the savings rate (always a treat to see the austere IMF urging a communist country to increase state spending);
  • deregulating services to drive service sector productivity to offset the impact of labour being re-allocated away from the high-productivity industrial sector. This also comes with a warning of the dangers of deindustralising too early and too fast;
  • pushing ahead with the glacial pace of reform of state-owned enterprises to improve the efficiency of credit allocation.  Currently, 40% of industrial assets are managed by SOEs, with asset returns some 7 percentage points lower than their private counterparts, the paper notes; and
  • improving the redistributive role of fiscal policy through a more progressive tax structure, increased transfers and strengthened social safety net.

No surprises in that list. All the prescriptions are out of the IMF’s policy toolkit for China that the Fund has been using to cajole for reform.

 

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State-Owned Enterprise Reform Slogs On Slowly

TWO THINGS WILL emerge — eventually — from China’s reform of its state-owned enterprises (SOEs): the elimination of a lot of redundant capacity in heavy industry and some multinationals that are strategically important domestically and formidably competitive internationally.

China has 111 centrally owned SOEs (those under the State-owned Assets Supervision and Administration Commission), down from 196 in 2004. The goal is to more than halve the number to around 50.

The consolidation of heavy industry, which accounts for more than two-thirds of SOEs, will let that target be attacked forcefully. Capacity reduction, particularly in steel and coal, is a policy priority in the near term.

That will drive consolidations. So, too, with inefficient and unprofitable, or zombie, SOEs in all sectors. Making globally competitive SOEs, particularly those that can underpin and benefit from the ‘One Belt, One Road’ initiative, will also be undertaken by horizontal and vertical merger and acquisition.

Similarly, SOEs that operate in sectors identified as strategically important: vehicle making, ‘green’ industries, information technology, biosciences, advanced engineering (from defence to aerospace, robotics and advanced transport), energy (nuclear and renewables) and new materials. AVIC in aerospace and CRRC in high-speed-rail equipment are examples of merging existing SOEs into huge monopolists that can dominate the domestic market and provide a platform for international sales (just, it seems, the same way Western companies are going).

The intention is to reinforce government control over core industries while opening up some parts to private and, particularly in financial services and telecommunications, to foreign investors. The intention of what is delicately called ‘mixed ownership’ is to drive improvements in governance, competitiveness and efficiency. Wholesale privatisation is not on the cards, though some spin-offs, such as Sinopec’s sale of its retail division, are.

A contradiction in all this is that the current five-year plan, to 2020, calls for its ambitious growth target (average annual GDP growth of 6.5% to vault the ‘middle-income trap‘) to be achieved through innovation based on entrepreneurship and advanced technology, not oligopolistic state capitalism.

Yet economic decision making is being centralised as warp and woof of the Party’s reassertion of its political control.

At the same time, SOE reform is proceeding slowly (too slowly for the IMF) in the face of stiff resistance from long-standing interests that feel endangered and the anti-corruption investigations that are being used by President Xi Jinping to break it. The Maoist tradition of regarding SOEs as economic arms of political institutions (and the politicians that control them) has deep roots.

A similarly live memory is of the social unrest that followed Prime Minister Zhu Rongji’s round of SOE reform in the 1990s. Then, tens of millions of workers lost their jobs and the big state-owned banks carrying the SOEs bad loans had to be bailed out.

Even though SOEs have steadily withdrawn from labour-intensive industries over the past two decades and they no longer get favoured policy loans to the extent they once did, the risk of social unrest remains a significant reason that this latest round of SOE reform will proceed slowly.

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Jobs’ Challenge To Slowing Growth

THE ECONOMY CONTINUES along its glide path to slower growth. Last year’s GDP growth target of ‘about 7%’ has been replaced by 6.5%-7% for this year. Announcing this to the National People’s Congress (NPC), Prime Minister Li Keqiang warned that the rebalancing of the economy towards consumption-driven growth faced challenges and tough times ahead.

One of those will be keeping unemployment ‘within 4%’ – of a workforce of more than 800 million that has been adding 12 million jobs a year for the past five years and faces an unusually high number of 15 million new graduates joining the workforce this year.  A detailed reading of the 13th Five-Year Plan, the economic development blueprint to 2020 due to be approved by the NPC, will provide some insight into how that will be done.

The official unemployment rate was 4.05% in the second half of last year.

Like any economy deindustrialising, China has to bear a heavy burden of workers left without jobs or the skills to get new ones. At least 3 million jobs, or 30% of the workforce, could go from heavy industry as a result of cutting surplus production capacity. The bulk of those redundancies will fall on the coal and steel industry. Human resources minister Yin Weimin says that 1.8 million jobs in those industries, an estimated 10-15% of the workforce, are at risk.

With that comes the possibility of social unrest and thus a threat to Party rule based on the premise of delivering ever higher living standards. The number of strikes and protests by workers, at more than 2,700 last year, was more than double 2014’s number, according to the China Labour Bulletin, a Hong Kong-based civic group.

The response has been carrot and stick — a crackdown on labour activists and non-governmental organization to snuff out any political nexus forming and financial measures such as the 100 billion yuan ($15.3 billion)  to be given to local authorities ‘solve the problem of worker placement’ under the umbrella an industrial enterprise restructuring fund.

The stick, though its use is well practiced, is not without hazard. Overzealous suppression of labour unrest could cause the Party itself to become a target of worker anger, and especially in provinces such as Guangdong, where local officials have traditionally held a relatively tolerant attitude towards labour relations but where several labour activists were arrested in January and put on trial as ‘foreign subversives’.

The only officially sanctioned trade union, the All-China Federation of Trade Unions (ACFTU), has recently reformed itself to stress its role as an instrument of Party and government and to straighten its top-down control over its local unions. This could have the unintended consequence of turning disgruntled workers more towards unofficial channels.

So far, though, labour disputes are overwhelmingly economic, not political, and a Party leadership that puts a premium on maintaining stability will want to keep it that way.

There are risks in the carrot, too. Local governments already have a debt time bomb ticking quietly under them. For all the help they will get from Beijing, they will face immense fiscal pressure as growth slows to pay for dealing with shuttered mines and mills and factories and workers demanding unpaid wages (a chronic problem, particularly in the construction industry), redundancy pay and social security.

The pressures will be particularly acute in those areas where heavy industry is concentrated, notably the rust-belt of the northeast, in the export factories in the Pearl River delta, and where the reforms of state-owned enterprises bite hardest, particularly the proposed rationalization of ‘zombie’ companies hitherto kept afloat by local governments seeking to avoid job losses.

If more and more workers see the Party failing to look after their interests, the overarching risk is that their acceptance of the social compact that underpins the Party’ monopoly on political power will erode, which is what the Party is most set on avoiding.

This Bystander recalls a far more drastic set of state-sector reforms and sharply decelerating growth in the late 1990s.  If there is a ray of hope for the top leadership, it is that the Party got through that when it had fewer carrots and less sophisticated capabilities with its sticks.

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China’s Crashing Stocks And Creaking Politics

THERE WAS A time when even financial markets in China were believed to be responsive to firm instruction and Party discipline. Yet China has become much more market driven in many spheres than it once was, even, incongruously, as President Xi Jinping has sought to exert greater control over every aspect of the body politic.

The trouble with markets, as has been seen in the Shanghai and Shenzhen exchanges in recent weeks, is that they have a mind of their own. Stock markets, in particular, can express it in stark and cantankerous ways.

July’s attempt to prop up stock prices that had started to blow off a lot of excessive froth — by cajoling 21 securities firms to hold stocks — was brushed aside like a mistress’s hair from a jacket; so, too, was the more recent directive to the country’s massive pension funds to act as the buyer of last resort.

This was not markets just thumbing their nose at any old government intervention. This was a direct challenge to the proposition that the Party leadership could be trusted to stop the stock markets fall. By extension, it could also be trusted to keep the real economy from slowing too quickly even while making the transition from the old model of infrastructure investment- and export-led growth to one driven by domestic consumption.

That transformation is a Herculean task of macroeconomic management demanding extensive structural reforms, although a task that both Japan and South Korea have earlier undertaken, if not on the scale required in China. It is one, though, that challenges many vested interests that profited richly from the old ways and stood to lose much from the reforms needed.

One thing that this recent stock market crash has inadvertently advertised is how deep and widespread are the pockets of opposition to reform — a contrast the the narrative of inevitability and Xi’s expanding control portrayed in state media.

The arguments of what countermeasures to take against falling stocks, the currency, and slowing growth have become a proxy battle for the bigger one over reform. Xi has championed reform as necessary to ensure the Party can continue to deliver economic wellbeing for China’s population and thus retain its mandate to rule.

He, correctly in the view of this Bystander and many other outside observers, believes that the old growth model is unsustainable if China is to continue to develop as a wealthy economy. If there turns out to be any substance to the gossip the Prime Minister Li Keqiang is to be a scapegoat for the slowing economy and stock market fall — then that would indicate deep divisions over the path to rebalancing on a scale that would rattle global markets.

The precipitousness of that path, which we have frequently referred to here as a glide path to slower growth, is what is now so concerning. We have always regarded its trajectory as being the object of the leadership’s management, but equally have cautioned that it would not, inevitably, be as smooth as the leadership would like.

There are many potential bumps: property bubble, equities bubble, shadow banking crisis, and local government debt bomb. All remain manageable, but the stock market’s fall raises the risk of a credit crunch.

What is now at stake is trust in the government’s capacity to manage the markets and the economy more broadly.

Ever since Deng Xiaoping started to open up the economy at the end of the 1970s, the government has been able to marshal the capital needed to direct the economy and absorb the external shocks to distorted markets. The assumption that that will continue to be the case is now being tested.

The banking system as a closed conduit of state-disposed capital is under stress. The Catch 22 is that it has to be if the financial system is to be opened — as, in turn, it has to be if rebalancing is to be successful.

All of which brings this Bystander back to a fundamental question: can China do something that no other developing economy has ever achieved, liberalise its financial system without doing the same with its politics.

Last October we said:

The trick for Xi remains to align the political realities he faces with the underlying structural slowing of economic growth, but without getting too close to the feared hard landing of the economy that would undermine his political position. As we have noted before, every mini-stimulus ratchets up a notch the difficulty of introducing the policies needed for rebalancing because they don’t address the underlying causes of unsustainable booms and the vested interests that benefit from them. And that needs a political solution before it can get an economic one.

That remains the case.

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An Architect For A Rich China

RATHER LIKE FINANCIALLY threadbare English nobility marrying American new money in the 19th century China’s Communist Party is embracing the country’s new self-made wealth. Five of the country’s ten richest people will attend the National People’s Congress — China’s parliament — which convenes for its annual showpiece plenary on Thursday. Thirty-six of the country’s 100 richest people will be involved in either the NPC or the meeting of the top political advisory committee that precedes it.

The incongruity is not as pronounced as it might first seem. The trend of the Party co-opting new wealth — and the nascent political interest it represents — is not new, even if it has not been given the same degree of public attention before. Nor are the newly rich necessarily popularly reviled. Many citizens see them as aspiration-worthy models of self-made success, and stark contrasts to the beneficiaries of the corruption and cronyism that has long flourished in the creases where state-owned businesses, government officials and Party elites converge.

Many of these new multibillionaires have made their fortunes in areas such as the internet, e-commerce and telecoms where there were not state vested interests in the first place. As well as having them on the inside of the tent rather than outside it, the new leadership may well find them useful role models in support of President Xi Jinping’s ‘four comprehensives,’ a collection of objectives being bundled up as an ideological foundation for Xi’s vision of the ‘Chinese dream’ — and his contribution to the Party’s theoretical canon.

The quartet of building a moderately prosperous society, deepening (economic) reform, rule by law, and strict party discipline provide plenty of echoes — as does the presence of glorious wealth at the NPC — of Deng Xiaoping’s economic liberalisation of China. That is no accident. Xi continues to establish himself as the country’s paramount leader and take on the Deng-like mantle of being the architect of the country’s future prosperity.

Deng helped a handful of Chinese get rich first, and they they helped a second, if still privileged wave to do so on the back of three decades of helter-skelter growth founded on infrastructure investment and cheap export manufacturing. Xi has to scale that to the mass of Chinese citizens in a more equitable way if the Party is to maintain the legitimacy of its political monopoly. That in turn means making economic growth sustainable by rebalancing the economy on the fulcrum of domestic demand while avoiding the pitfalls of its debt legacy from the old model.

More of his blueprint, in the form of the new five-year plan, will be revealed in more detail over the coming weeks, starting with Prime Minister Li Keqiang’s ‘work report’ to the NPC, which will likely enshrine a new GDP growth target of ‘around 7%’, to replace the existing ’around 7.5%’.

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Take China’s 2014 Annual Growth Rate For What It Is

AN ECONOMY EXPANDING at an annual rate of 7%-7.5% would be a cause for celebration in many economies right now. In China, it is more likely to be a cause of handwringing than bell ringing.

The annual GDP figure for 2014 is due to be announced on Tuesday. The consensus view of economists whose views get polled for these sorts of things is that fourth-quarter growth will come in at 7.2%, which would put the number for the year at 7.4%.

That would be less than the official target of 7.5% although that has been turned into ‘about 7.5%’ over the course of the past year as the economy has slowed. Anything above 7% would be close enough to count as ‘about’. It is inconceivable, to this Bystander at least, that government statisticians won’t deliver a number that doesn’t have a seven to the left of the decimal point.

The sky probably won’t fall when China’s annual GDP growth falls below 7%, as it one day will. The sky didn’t fall when growth fell below 8%, similarly said at the time to be the rate below which only chaos could ensue.

However, to look at the likely performance of the economy in 2014 and only see one of the two slowest growing years of the past quarter of a century, a period that for decades routinely saw double-digit annual growth, is more than looking at the glass half empty. It is looking at the wrong glass.

The pace of growth that China has enjoyed for nigh on 30 years is no longer sustainable. That is partly a consequence of the law of large numbers. Even at current growth rates, China’s economy expanded by an estimated $680 billion last year, which is more than the entirety or Africa’s largest economy, Nigeria, or a European economy like Switzerland.

To move to its next phase of economic development, China’s economy needs to rebalance towards domestic-demand driven growth and away from investment- and export-led growth. A more moderate pace of growth is inevitable, as it was for Japan and South Korea at similar points in their economic trajectories. President Xi Jinxing has repeatedly signaled that. Only last week Prime Minister Li Keqiang called during a highly symbolic ‘Southern Tour’ for growth “within a proper range”.

The leaders’ only concern is that the economy does not slow too rapidly in case job losses or other economic or social dislocations undermine, first support for the measures needed to rebalance, and second, but far more importantly the legitimacy of the Party’s claim to monopoly rule which is based on delivering a rising standard of living. McKinsey, the international management consultancy, forecasts that salary rises this year will be the lowest in a decade. Nor can China’s burgeoning middle-class look to flip real estate now the property market bubble has been deflated.

Authorities took a series of targeted measures to stimulate the economy across the course of last year — a surprise interest rate cut, lower reserve requirements and looser loan restrictions. Such measures have continued into this, such as with the latest wad of loan money being made available to banks to lend to rural and small businesses and the ‘direction’ given to the private sector to invest in infrastructure projects.

The accelerated timetables being given to such projects means capital spending, a reported 7 trillion yuan ($1.1 billion) of projects approved in 2014, is greater than the 4 trillion yuan of stimulus monies that were thrown at the economy in the wake of the 2008 global financial crisis. That underlines the continuing struggle the government has in maintaining a balance between its long-term goals of structural economic reform, its medium-term need for fiscal discipline (there is still a shadow banking and local government debt bomb ticking, if less loudly than before) and its short-term imperative to keep the economy – and Party rule – humming along.

The number to the right of the decimal point that we will learn on Tuesday is relatively immaterial to all that.

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