By Houze Song
It’s been two years since Beijing released an impressive 60-point reform agenda at the 3rd Plenum of the 18th Communist Party Congress. But so far, instead of an economic turnaround, what we are witnessing in China is a deteriorating economy and more financial instability (evidenced by the recent stock selloff and continuing capital flight). These problems largely stem from Beijing’s unbalanced reform strategy: financial reform is moving faster than more fundamental reform, and the government is prioritizing emerging industries while ignoring the problems with traditional sectors.
Since the completion date for Beijing’s current reform agenda is 2020, some may suggest it is too early to assess Beijing’s reform effort. However, Beijing has already released a detailed blueprint of how the government will carry out some of the most important reforms. The state-owned enterprise reform document published recently indicates that reform of the state sector will be piecemeal at best. In addition, Beijing’s passive attitude towards real-side economic problems, like debt and overcapacity, has made these problems worse during the last few years. Even if Beijing begins to take some serious actions, it will take much longer than it would have if the government had addressed these issues two years ago. As such, the uneven state of reform is likely to persist for a few more years.
China’s finance minister, Lou Jiwei, pointed out during a speech earlier this year that Beijing lacks the political capital to tolerate mass layoffs, and therefore will not pursue the kind of quick and radical economic adjustment the United States made during the global financial crisis of 2008. Indeed, real economic reform—which would force the state-owned enterprise sector to compete on a level playing field with the private sector—is moving more slowly than financial reform.
But finance and real-side reform are complementary—one cannot yield substantial benefits without the other. Radical financial reform can’t compensate for lackluster real-side reform. Without more fundamental reform, such as allowing private firms to enter sectors that are currently dominated by the state-owned sector, financial reform will not provide a significant boost to economic growth—and might even cause financial instability. In other words, such reform strategies might backfire, creating even worse problems, instead of soothing China’s economic transition pains.
Why is the uneven progress of financial and real-side reform counterproductive?
- First, without real structural reform, China’s economic growth will continue to slow, bringing down domestic investment returns. With limited attractive domestic investment opportunities, Chinese investors already are increasingly looking for overseas investment opportunities and moving to riskier forms of investment.
- Second, to offset the slowing economy, the central bank has to cut interest rates; the People’s Bank of China has already cut interest rates 6 times over the past year. Although low interest rates can be justified in order to bolster the economy, such loose credit can also lead to financial instability. As the return on safe assets is closely linked with nominal interest rates, low interest rates will make safe assets less appealing—which will further exacerbate the search for higher yields. As a result, a low interest rate environment could fuel a financial bubble and instability.
- Third, corporate governance and moral hazard issues are still rampant in the domestic financial system. As domestic financial institutions continue to expect life support from Beijing when crisis strikes, liberalizing the financial sector alone is unlikely to change the behavior of financial institutions much. On the contrary, financial liberalization could result in reckless behavior on the part of financial institutions. The development of China’s “shadow banking” system offers perfect evidence that less regulation does not necessarily lead to good outcomes. When the informal banking practices first emerged, the rapid growth of the “shadow banking” sector was praised for improving the efficiency of capital allocation—and getting funds to borrowers who had been barred from traditional lending before. But it is now clear that “shadow banking” is mostly driven by banks hoping to escape regulation and move to off-balance-sheet lending. What’s more, a significant percentage of the money has been directed to local government financing vehicles and over-capacity sectors like real estate. As a result, Beijing is now tightening its oversight on the “shadow banking” sector and replacing it with traditional bank loans.
Under the above three conditions, easing capital control will only exacerbate domestic problems. Capital will move out of China as overseas investment opportunities offer higher and more stable returns, thus weakening the Chinese yuan (RMB). Up until now, Beijing and private investors have held different views regarding future path of the RMB exchange rate. Such disagreement has led to the mass capital outflow of the past few months. Even if Beijing eventually allows the market to determine the exchange rate of RMB, an idea the government has resisted so far, the adjustment process will be bumpy, as the divergence between official and private views on the RMB is now so large and has lasted for so long.
Beijing likes to portray China’s current economic difficulties as a structural problem, stressing that China needs to develop service sectors and high-tech industries. There is no doubt that such an economic transition is necessary. But such industrial upgrading will be a gradual process. And it will occur as a natural consequence of rising per capita income rather than industrial policy.
Even in the near term, a reform strategy that prioritizes emerging sectors without tackling more fundamental issues can’t truly succeed for two reasons:
- First, the size of China’s emerging sectors remains insignificant compared to the traditional industrial sectors. It is unrealistic to expect that they could pull the lackluster state sectors out of their troubles.
- Second, China’s most acute problems are all concentrated in the traditional sectors. For example, China’s non-financial state-owned enterprises have been accumulating debt at a rate much faster than overall economic growth, and their total debt is now larger than the country’s GDP. If Beijing doesn’t tackle the problems with traditional sectors head-on, these problems will only get worse.
Beijing understandably is concerned that more dramatic economic reforms—particularly affecting the state-owned sector—could trigger job loss, possibly leading to social instability. Such worries are limiting Beijing’s ability to quickly implement necessary restructuring—including bankruptcy processes to get rid of the overcapacity problem in the state-owned sector that has resulted from years of lending and expansion with no accountability.
But here’s the twist: concerns about stability in the short run could lead to even worse problems in the long run, if the economy doesn’t really become more competitive. The net worth of uncompetitive state-owned firms will continue to shrink as they keep losing money while their debt keeps growing. By delaying reform, Beijing will end up holding more debt and less valuable industrial assets. Prolonging the reform process will make China’s economic—and social— predicament more unmanageable, not less.