Why China is plumping for reform over stimulus

China has been hit with a slew of bad economic data in recent weeks, from the slowest pace of factory output in nearly six years to falling home prices.  

Fixed asset investment, which has been one of the strongest growth engines for decades, declined to 16.5 per cent, its slowest pace since China joined the World Trade Organisation in 2001.

This has prompted some to call for aggressive monetary policy support, such as cutting interest rates or lowering bank reserve ratios in order to achieve the official growth target of 7.5 per cent per year. However, the government has been reluctant to open its wallet to stimulate growth.

“China will not make major policy adjustments due to a change in any economic indicator,” said Chinese Finance Minister Lou Jiwei on Sunday at the G20 meeting of finance ministers.

This statement from the Chinese Finance Minister further supports media reports that say Beijing is prepared to accept that growth could come in below its target of 7.5 per cent, and that reform will be prioritised ahead of stimulus, following a top-level gathering at the beach resort of Beidaihe last month.

This should be greeted as good news, although it will exert further downward pressure on iron ore prices (Australia’s most important export earner) as the Chinese government puts structural reform ahead of the inertial need to grow at the official target of 7.5 per cent.

Why is Beijing more relaxed about the pace of its economic growth this time around?

It's important to understand that the government’s bottom line is stable employment and containment of systemic financial risk, such as widespread debt defaults. China’s official growth target is often linked with its employment numbers.

For years, policymakers believed China needed to grow at eight per cent a year to create 20 million new positions for the country’s new graduates and rural migrants. However, two big structural changes have weakened the relationship between the official growth target and the employment situation.

China has more or less reached the so-called ‘Lewis turning point’, where a developing country runs out of its supply of cheap and surplus labour. Real wages for rural migrants have been increasing at double digits for many years, including during the global financial crisis.

This is reducing the pressure for the government to create more jobs. In fact, some factory owners struggle to find skilled workers to fill vacancies at some coastal provinces.

Another big structural change that is taking place is the gradual but steady transformation of a manufacturing-based economy to a more services-oriented economy. Despite the collective obsession with the manufacturing purchasing index (PMI), manufacturing actually accounts for a smaller portion of the Chinese economy than the services sector.

If you look at China’s GDP data, the services sector now accounts for 49 per cent of the Chinese economy. On the other hand, the much-talked about Chinese manufacturing industry is only 41 per cent of the economy (At the service of China's rebalancing, April 21).

The services sector absorbs more jobseekers than the manufacturing sector. According to Cao Yuanzheng, chief economist of the Bank of China, for every one percentage point growth in the economy, it creates 1.8 million jobs.  However, the same pace of growth only created 1.2 million jobs in the past six years, according to an interview with the Southern Weekend, a respected Chinese-language newspaper.

This means that if Beijing wants to create about 10 million new jobs, it needs less than 6 per cent annualised GDP growth to achieve that.

Cao explains the reason that Beijing needs to maintain around about 7.5 per cent growth in the face of a stable employment situation is to prevent a widespread debt default. The government’s effort to rein in the ballooning debt problem cannot be solved within a short period of time, so Beijing needs more time. This requires maintaining a reasonable growth speed.

He says China’s local government debt problem is largely an issue of taxation. Beijing and local governments need to work out a more sensible tax-sharing agreement that clearly delineates fiscal responsibility.

Since a historic tax sharing agreement in 1993, Beijing is receiving a lion’s share of tax revenue while at the same time delegating fiscal responsibility to local governments.

For example, a decade after the tax-sharing agreement, local government revenue accounted for 45 per cent of tax receipts but it was responsible for 72 per cent of expenditure in the country (What’s behind China’s debt spiral, January 13).

Resilient employment numbers and a growing services sector is providing Beijing with the confidence to take its foot off the accelerator at the time when the economy is facing considerable downward pressure. Beijing’s reluctance to stimulate the economy should be taken as a step in the right direction. It’s not easy to shake off an investment addiction.