External events and domestic risks govern speed of economic reform

March 24, 2014 by Ken Davies

This year’s government work report indicates that China’s leadership is aiming at gradual reform of the economic structure rather than at pushing through major changes. This incremental approach may be prudent, considering the challenges China’s economy is facing from domestic strains and an uncertain international environment. Following last year’s promises, this year will provide a test of the government’s seriousness in pursuing economic reforms.

On 5 March 2014 Premier Li Keqiang proclaimed the Chinese government’s annual work report at the opening of the National People’s Congress (NPC). He started by announcing the 2013 statistics: real GDP growth of 7.7% year-on-year, consumer price inflation of 2.6% and a new high of US$4 trillion in combined imports and exports. Real incomes rose appreciably, by 7% in urban areas and 9.3% in the countryside, while the number of rural people living in poverty fell by 16.5m.

Critics of official statistics – including by Mr. Li himself in a former ministerial incarnation – have previously charged that the GDP figures are fiddled and that indicators such as energy and freight transport are more reliable measures of economic growth. Accordingly, the report states that total electricity consumption increased by 7.5% and the volume of freight transport rose by 9.9% in 2013, so that “main real physical indexes matched economic growth”.

Mr. Li also proclaimed progress in restructuring the economy. For the first time, the share of the value-added of the services sector in total GDP, at 46.1%, surpassed that of secondary industry.

Another major aim is to rebalance growth by shifting output from the developed eastern coastal region to China’s hinterland. Progress was also made in this policy area as the proportion of the gross regional product of the central and western regions in the country’s GDP continued to rise. This is, incidentally, probably the main reason that the official Gini coefficient, which measures inequality in an economy, has edged down since 2008 after having risen relentlessly during the reform period.

At the NPC’s March session, Premier Li announced modest targets for 2014: GDP to grow by 7.5%, consumer price inflation to be kept to around 3.5%, 10m more urban jobs to be created and the registered urban unemployment rate not to rise above 4.6%, and increase personal incomes in line with economic growth, budget deficit to be held to 2.1% of GDP, monetary (M2) growth to be about 13%.

The 7.5% GDP growth target is reluctantly supported by the National Development and Reform Commission (NDRC), China’s super-ministry in charge of the economy, which appears to see this as the bare minimum acceptable rate.  By contrast, Lou Jiwei, the finance minister, said at the NPC that 7.2% growth would be acceptable, as long as enough jobs were created. Last year he said that 6.5% was OK, so this is not surprising.

Underlying the difference in target growth rates is disagreement on the desirable pace of reform, with the NDRC seeing GDP growth as top priority. The resulting balance of policies will be affected not only by the balance of forces between contending government bodies but also by events outside the economic ministries’ control.

While China’s leaders strive to increase the weight of domestic demand, particularly consumption, the external sector remains important, with total two-way merchandise trade totalling approximately 45% of nominal GDP last year. In 2013, net exports of goods reached US$259bn as exports rose by 7.6% over 2012, while imports grew 7.3%.

So far this year, net trade has underperformed. Although the authorities let the Chinese yuan depreciate from 6.0541 to the US dollar on 1 January to 6.1449 at the end of February, exports of goods in February were 18.1% lower than in the same month last year, while imports grew by 10.1%, producing a US$23bn trade deficit.

Large rises and falls in year-on-year monthly figures in the first two months of the year are normal in China because Chinese New Year, which lowers most economic variables, is a movable feast in the Western calendar, falling in either January or February. This is not the case this time, because the bulk of the Chinese New Year holiday occurred in February in both years.

With – mostly low-earning – foreign-exchange reserves continuing to pile up to a ridiculous height (US$3.8 trillion at the end of 2013, a rise of 15% over the year), China can afford a few months of trade deficit this year, especially if this is the result (as seems likely) of sharp upturns in imports of fuels and raw materials for industrial expansion, as well as increased consumer demand, desirable as an element of economic restructuring away from dependence on investment. Increased producer inventory, though, will turn into costly stockpiles without steady growth in domestic and export demand for finished products.

Much, then, depends on the external environment, which is difficult to predict. Economic recovery in the US, UK, Japan and Germany may be sufficient to offset the lack of growth in most European markets. Central banks might be sensible about the speed of tapering, so they do not cause too sharp a reversal of the hot money flows that their easy money policy has inflicted on emerging markets like China.

On the other hand, conflicts between major powers are no longer inconceivable. While tensions in Ukraine and the South China Sea remain high, investors, tourists and others may defer big spending decisions. China being one of the powers involved, there is a risk that military conflict with Japan or a South East Asian country could throw reform off course as the country’s leadership focuses on external issues.

The main threat to reform, though, is from domestic economic risks, in particular the shakiness of the financial system caused by the expansion of debt since the onset of the global economic crisis.  Following the unprecedented and unrepeatable stimulus splurge five years ago, the explosion of shadow banking and local government borrowing raise the spectre of a potential financial meltdown, possibly starting with a property crash, as in the US and UK in 2008.

The government will continue to restrain the property market and take whatever other measures it deems necessary to prevent such a crisis. The precedents over the past 35 years of reform are good. The Chinese Communist Party’s record in muddling through in the face of dire predictions, not only from outside economists but from those who are invited into Zhongnanhai to advise it, is impressive. And the muddling has been accompanied by ratcheting reform.

How can we tell if this wave of reform is serious or not? I suggest looking at the China (Shanghai) Pilot Free Trade Zone, launched at the end of September last year, as the unwieldy and unfinished state of this project suggests it has been a bone of contention between reformers and conservatives. The first thing to look for is the depth of reform. Will the closed list (for foreign investment) be pruned? Will the procedures be as simple and transparent as those in Hong Kong? The second thing to look for is how soon the pilot is expanded to other areas and then the whole country. Let’s revisit this in a year’s time to gauge progress.

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