Economists: China Faces Rough Road to Reform in 2014

By Catherine Matacic

With the Chinese Communist Party’s third plenum and the leadership transition behind it, 2014 is already turning into a busy year for China’s economic reformers.

November’s third plenum and the opening of Shanghai’s free-trade zone injected some optimism into the debate on progress toward economic reform. Policies as diverse as liberalizing interest rates, loosening China’s residency rules, and tightening environmental controls could affect China’s economy in 2014.

But experts are still waiting to see how these policies are implemented and whether China can tackle the long list of challenges that face the country’s economy. We spoke with some of the world’s top economic experts on China to get their predictions for China’s economy in 2014.

David Dollar, senior fellow at the Brookings Institution’s John L. Thornton China Center, says the new reforms proposed by China’s leaders address the unsustainability of the country’s growth model, but real change will depend on the speed and thoroughness of implementation:

The biggest concern for the Chinese economy in 2014 is excess capacity, both in manufacturing and local government infrastructure. It is clear that not all of that excess capacity is being well utilized. That creates a risk going forward. The main concern is in the public sector—infrastructure and SOEs. The reforms [China’s leaders] have announced do address many of the key areas, including [residency] reform and financial reform. If they follow through on liberalizing interest rates, for example, this should lead to more efficient investment. The question is will these reforms be implemented quickly enough? If China is lucky, 2014 will be a year of stable economic growth globally. If they can transform their growth model so they rely less on investment… this will put them in a more stable and less risky situation.

Fan Zhang, associate director of UOB Kay Hian Investment Consulting, says that China’s new leaders will not shy away from making tough decisions in 2014, but will adjust the magnitude of restructuring according to what the economy can bear:

The new reforms will create greater economic volatility and confusion, and will affect business confidence and consumer sentiment. Rising funding costs will be the biggest concern for China in 2014. It is very likely that tight liquidity conditions will continue in coming months and will keep market rates relatively high. Another point is that long-term interest rates, including long-end government bond yields, are going up quickly now compared to the [credit crunch] in June 2013. [This is] mainly due to tight liquidity, the introduction of negotiable certificates of deposit, more regulations against off-balance-sheet lending, as well as expectations of [pending] deposit rate liberalization. Thus, there’s an increasing chance that borrowing costs will stay high in 2014, and will then affect earnings for enterprises.

Patrick Chovanec, managing director and chief strategist at Silvercrest Asset Management, says that China needs to go through a process of “creative destruction” in order to move forward, and that the country’s leaders should be prepared for a painful adjustment:

The main issue is that China faces a real economic adjustment, away from dependence on investment and export growth and towards a greater balance between consumption and investment. This is something that most people realize needs to take place, but doing it is very difficult. Because this investment boom has gone on for so long and because there is such an explosion of credit—from $9 trillion at the end of 2008 to $24 trillion, there’s tremendous debt. We’re not seeing debt because people are declaring it. We’re seeing it because there’s rapid monetary expansion and yet still a need for cash. They need to wean themselves away from that easy investment growth, and the longer the correction is put off, the more difficult it will be. To get on the right track, they’ve got to get off the wrong track. I am not completely bearish on China… there are real productivity gains to be realized. Reform is needed to make that happen.

Shuang Ding, senior China economist for Citigroup, says the Chinese government needs to be willing to sacrifice short-term growth in order “to absorb the excesses” that have built up over the past few years:

My main concern is further expansion of the government’s role in investment, which is the source of the local government debt problem, crowding out private investment and posing risks to the banking system. It also indirectly contributed to property bubbles as local governments have the incentive to keep land and home prices high to boost land sales revenues and tax revenues. The plenum [promised] to let the market play a decisive role in allocating resources. Apart from reforms to improve price signals… the government appears to [have emphasized] encouraging private investment in previously monopolized areas, especially financial services, medical services, upstream energy and telecommunications…. This indicates the government is eager to facilitate self-sustained private investment to substitute government-driven investment that has led to low efficiency, excess capacity, and debt problems.

David Hale, chairman of David Hale Global Economics, says that Chinese policy makers know where they have to go with reform measures in 2014, but they are not exactly certain about how they will get there:

The Chinese economy is now confronting both cyclical and structural challenges. The economy’s growth rate has dipped from over 10 percent four years ago to about 7.6 percent because of weaker exports and the unwinding of the great macro stimulus program which occurred during the global financial crisis in 2007-08…. The great risks in China’s economy center on the large debt increase which occurred after 2007. It rose from 135 percent of GDP to over 225 percent. Some warn this debt could create a financial crisis. It is unlikely that China’s debt expansion will be destabilizing because most of it has occurred in two sectors: state-owned enterprises and local governments. The state-owned enterprises have stable cash flows, and should therefore be able to service the debt. The local governments borrowed to finance infrastructure projects which were mandated by Beijing. The central government will not allow them to default.

Daniel Rosen, founding partner of the Rhodium Group and lead strategist on China, says that Chinese President Xi Jinping has signaled a strong readiness for reform and that “business as usual has already been thrown out the window”:

President Xi has committed to economic reform more decisively than most observers expected. My biggest concern for 2014 is that he fails to live up to the high expectations he has set, by allowing a return to over-investment in heavy industry, overbuilt infrastructure and real estate to avoid adjustment…. The plenum reforms are adequately comprehensive and admirably specific—as these political pronouncements go. Moreover, since the plenum a range of even more concrete implementation plans have been issued for capital markets, foreign exchange loosening, industry consolidation and environmental regulation. The People’s Bank is following through with stated intentions to moderate the growth of liquidity and force riskier channels of credit back into the open. Taken together, this spectrum of actions (and many more) anchored in the plenum decision is changing expectations about the course of reform.

Vikram Nehru, a senior associate at the Carnegie Endowment for International Peace, says that China’s leadership appears serious about implementing the reform program, but the challenge of the task should not be underestimated:

The biggest concern for the Chinese economy is the ability of the leadership—and the newly established leading group on deepening comprehensive reforms—to press ahead with the reforms described in the third plenum document but doing so without slowing economic growth significantly. This will be challenging task for three reasons. If, as the document says, markets and not government are to play a decisive role in allocating resources, then many of the bad debts heretofore masked in bank balance sheets and in the shadow banking system will rise to the surface. These bad debts will need to be financed using fiscal resources, and it is not clear how these resources will be raised and applied. Second, vested interests in the current state enterprise and state banking systems will inevitably oppose fundamental changes, which will test the political will of the new leadership. And third, external factors—a sudden slowdown in China’s main markets, or worse, a ratcheting up of tensions in the East China Sea—could potentially raise market uncertainties and slow growth significantly, forcing the government to retreat on reforms and return to the tried and tested approach of using the state sector to sustain growth by increasing domestic demand through investment expansion.

[author] Catherine Matacic ([email protected]) is associate editor of the China Business Review. [/author]

(Photo by Dai Luo via Flickr)