The tough road ahead for China's reform effort

The systems which so successfully marshalled the capital to drive China’s first phase of growth are being swamped by the more complex economy they helped create.

Despite the challenges, China’s leaders are pushing into the most critical phase of their ambitious reform program, cautiously unleashing the power of private investment and consumption to breathe new life into its slowing economy. But it will be a tough road.

The systems which so successfully marshalled the capital to drive China’s first phase of growth are being swamped by the more complex economy they helped create. The result has been increasing misallocation of resources on the ground and growing imbalances within the financial sector.

The solution is to allow market forces to play a much greater role in the economy, but although that is simple in conception, in execution it is akin to playing three-dimensional chess against the clock.

Shifting China’s enormous economy from a state-controlled, investment-led growth model to a market-led, consumption-heavy model will not – and should not – happen overnight. We don’t underestimate the challenges, but this is not the first time that China has faced both cyclical and structural challenges. The government has the resources to avoid a hard landing, but delaying reforms would in itself pose a risk to the long-term health of the economy.

We expect the time frame for significant reforms will be within one to three years but this year and the next will be vital in pushing forward the reforms. The leadership is committed to reforms and has recognised that the price of inactivity is likely to be much higher than the costs of reform.

The pace of reform this year has slowed, but the government has announced more substantial and challenging reform as simpler changes to the economy -- the low hanging fruit -- were made some time ago. The thorniest decisions -- stripping big state firms of an implicit government guarantee; opening sectors such as banking to competition; and reforming the fiscal system to deal with local government debts -- still lie ahead.

China has set a clear timetable to build a modern fiscal system that will help optimise resource allocation, unify market standards and boost social justice. Major reform tasks concerning the fiscal and tax system will be completed by 2016, before a modern fiscal system will be built by 2020. The key is balancing the interests of central and local government; and business and society, but challenges remain for fiscal progress.

The potential impact of state owned enterprise (SOE) reform on the economy is massive. There were 113 SOEs controlled by the State Council at the end of 2013 and about 145,000 SOEs under local government control. The total assets of non-financial SOEs were worth RMB 91 trillion (US$ 14.6 trillion) at the end of 2013, or 160 per cent of China's GDP.  SOEs absorb a disproportionately large share of bank credit.

Breaking the SOE monopoly and relaxing price controls are a crucial part of opening the door to private capital in industries like finance, oil and gas, telecommunications, railway, natural resources -- all areas where government-owned companies have dominated. This indicates an eagerness to facilitate self-sustained private investment as an alternative to the government-driven investment that has led to low efficiency, excess capacity and debt problems.

We see this as a significant breakthrough that should improve the efficiency of SOEs and capital allocation throughout the economy. But reform of the SOEs will be a long process. These are still at an early stage and much more work is needed to reduce bureaucracy, simplify the investment approval process, further deregulate prices, better protect individual property rights and intellectual property rights and make life easier for small businesses.

The progress with reform at local levels, particularly in terms of asset divestment, could accelerate in 2015 and 2016 given local governments’ deteriorating fiscal position due to the property sector’s current weakness.

Financial reform will be the highlight of this year, especially in the banking sector. Banking reform, such as deregulating interest rates, increasing the limited range of investment products and allowing the entry of new banks, is under consideration.

We think the progress on interest rate liberalisation, the development of the bond market and renminbi capital account convertibility will be faster than many expect. A deposit insurance scheme is in the pipeline and this should pave the way for the next and the most critical step: market-set interest rates. This, plus the recent launch of local government bonds, should accelerate the development of more flexible domestic financial instruments.

There will be some short-term pain during these reforms – jobs will go as overcapacity is cut; local governments will have to surrender some autonomy as they accept the judgement of the markets on the viability of their pet projects; and some investors will lose money as the government allows borrowers to default.

Reform always carries an element of risk, but trying to maintain the status quo with its increasing imbalances and unsustainable future carries a greater threat to China’s enduring prosperity, and the immediate costs will be more than repaid in higher growth. The implementation of planned reforms should help lift China’s potential growth rate in the medium to long term.

David Liao is Head of Global Banking and Markets, HSBC China.

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