China’s leadership continues to demonstrate its commitment to reform, and progress in several key areas is now increasingly visible. While short-term pains may be inevitable, policymakers can, and almost certainly will, adopt the necessary measures to keep the economy afloat amid the uncertainty of reform.
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The Chinese government endorsed a range of reform initiatives that were detailed in the Decision Report published in the wake of last November’s Third Plenum. At the National People’s Congress (NPC) in March this year, the government reiterated that reform remains its top priority. In our view, the commitment of China’s leaders to rebalancing the economy and improving the quality and sustainability of growth is positive. So far, we have witnessed progress in several key areas including i) financial reforms; ii) state-owned enterprises (SOEs) reforms; iii) fiscal/administrative reforms; iv) environmental protection; v) urbanization and Hukou reforms; vi) free-trade zones.
Moving towards interest rate liberalization and a more freely convertible Chinese Yuan
In an NPC press conference, Zhou Xiaochuan – Governor of the People’s Bank of China (PBoC) – surprised markets by stating that, in his personal view, the liberalization of deposit rates could be achieved within the next 1-2 years. While the timeframe is significantly shorter than the market expected, the rapid growth of money-market funds and other internet-related finance products (which offer higher returns to depositors) have already and indirectly accelerated the liberalization process. The effect of achieving this goal sooner than expected could increase funding costs of banks and adversely affect the sector’s earnings in the short term. However, the move is in line with the government’s long-term goal of deregulating the financial sector to reflect the true cost of capital.
Another area of significant progress relates to the PBoC’s widening of the USD/CNY daily trading band to +/-2% (from +/-1%). The move is part of an effort to generate greater exchange-rate flexibility. The move came about as the PBoC reiterated its intention to “exit day-to-day FX intervention, allowing market supply and demand to determine the exchange rate.” The purpose of widening the trading band is two-fold. In the near term, the central bank aims to create two-way expectations on the yuan (CNY) and curb speculative inflows. From a longer-term point of view, the initiative is designed to create a more flexible, market-driven exchange rate. This latter objective is part of a broader process of making the currency more freely convertible, therefore encouraging its international use.
Potential positives from SOE restructuring and opening up to private capital
During the NPC, the government confirmed its intent to open up sectors to private capital investment. These sectors include: finance, petroleum, electricity, railway, telecom, mining and public utilities. Previously, these industries were restricted to state-owned enterprises (SOEs) only. Over recent months, the government has approved the establishment of five new, privately owned banks to encourage greater competition and efficiency in the country’s largely state-operated financial system. One of China’s state-owned oil companies also is planning to divest a 30% share of its retail distribution business to private investors. More recently, a state-owned conglomerate announced its intention to inject a range of businesses (covering financials, resources and industrial construction and manufacturing) into its Hong Kong-listed subsidiary to create a more diverse ownership structure.
Investors have reacted largely positively to the SOE reform plan, in view of its potential benefits. For instance, the railway sector could gain access to additional sources of funding, which would support new investment and development. Having more private sector involvement also could lead to more efficient business management and deployment of capital for the SOEs. Selected local governments also could divest part, or all, of their stakes in local SOEs, and then use the proceeds to repay their surging debt, if necessary. While few details were discussed during the NPC, we may well hear more on this issue in due course, which could lead to acceleration in SOE restructuring activities.
More balanced growth targets for local governments
Fiscal and administrative reforms
Since China’s new leaders took charge last year, they have worked aggressively to improve controls and transparency across public services. Government offices are now required to make their spending and budgets available to the public. Lavish spending and gift-giving also have been prohibited. Meanwhile, a study has been commissioned to examine the inclusion of local government debt in the management of budgets. The central government also is looking at giving local governments the ability to issue new bonds directly as part of measures intended to curb the build up of local government debt. More encouragingly, the evaluation of local government performance is now less focused on economic growth and more concerned with the quality and sustainability of growth: governments are paying attention to debt, overcapacity, the environment, technology innovation and social welfare.
“The way the economy grows must change, and all industries must eliminate waste, reduce consumption of energy and raw and processed materials, and use resources more efficiently, to develop production and consumption patterns that conserve resources and build a conservation-minded society.”
The above quote comes from former Premier Wen Jiabao’s speech to the NPC in March 2004. Today, ten years later, current Premier Li Keqiang’s work report identifies pollution as “nature’s red-light warning against the model of inefficient and blind development”. Various initiatives and targets have been adopted, highlighting the government’s commitment to tackle environmental issues. For instance, the authorities now conduct PM2.51 monitoring in 161 cities to control air pollution. Firm targets for cutting their PM2.5 levels by 2017 also have been given to respective provinces, self-governing municipalities and autonomous regions. (Source: Ministry of Environmental Protection). The government is aiming to reduce its coal usage to <65% of its total energy consumption this year (Source: Bloomberg). It will also continue to invest in environmentally sustainable infrastructure, such as the addition of water treatment capacity.
The fight against pollution is not likely to end overnight
The fight against pollution in China is not new, and the implementation of these particular reforms will be as drawn-out as it will be complex. With the country continuing to balance its need for stable economic growth with environmental protection, it is clear that drastic change on the issue of pollution is unlikely to come about overnight. While the focus on pollution has spurred interest in the environment-related sectors (e.g. clean energy, water treatment), we would caution against blindly investing in “green” companies, particularly those with a poor track record. Instead, fundamentally sound companies that were deemed as contributing to pollution (e.g. coal producers) may be worth revisiting, especially if they had been sold down unjustifiably.
Urbanization and Hukou reforms
China announced its ‘New Style Urbanization Plan’ with the aim of increasing the urbanization rate from 54% (2013) to 60% by 2020 (Source: Xinhuanet). A higher level of urbanization could help raise the average income of the population (rural residents, in particular) and promote consumption growth. It also could bring about demand for public infrastructure, as well as housing investment, to support economic development, especially in smaller cities. To facilitate the urbanization process, the reform of the household registration system (or Hukou) remains critical. With its new urbanization plan, the government aims to make it easier for rural migrants to obtain residency status in urban cities and so enjoy the basic services and benefits afforded to existing urban residents. The unification of pension schemes for urban and rural residents is a good start – and we expect there will be further initiatives aimed at enabling China to achieve its urbanization objectives.
Free Trade Zones
Proposals for establishing FTZs in other provinces – including Guangdong, Zhejiang and Fujian – also have been floated, although no clear timeline for approval has been indicated. As highlighted in our article It’s another FTZ? No, it’s SFTZ! (published in our Asia Compass, November 2013), the FTZ concept may be a good testing ground for major reforms as well as for innovative investment and services-trade liberalization. The jury is still out on the effectiveness of FTZs, but we remain cautiously optimistic that something good will emerge. A summary of the key reform developments discussed can be found in Figure 1.
Managing the credit situation
While China is making steady progress with its reforms, investors are becoming increasingly nervous about the country’s rising leverage. Shanghai Chaori Solar Energy’s failure to meet interest payments on its debt made it China’s first onshore corporate bond default, and prompted fears of further defaults across the country. The near-default of troubled trust products, such as China Credit Trust, raised further concerns about potential liquidity pressure. Unsurprisingly, policymakers are paying very close attention to financial and debt risk. Trust products running into trouble are not new; there have been at least 22 cases reported since 2012. However, compared to previous years, the sector is witnessing a significant increase in the number of trust products maturing in 2014.
That said, it is premature to conclude that China is in line to experience a “Lehman moment”. During the NPC, Premier Li acknowledged that some defaults are probably unavoidable, but these are unlikely to present systemic risks. Arguably, some defaults could be positive, as they would relieve the government of the burden of implicitly guaranteeing trust products. Over time, this would lead to more disciplined pricing and greater differentiation. At the same time, it is unlikely that the government would allow a default that could give rise to systemic risks, and we believe it has the ability to prevent that situation from occurring.
Growth expected to be slower…but not much
Apart from credit default risks, growth concerns have been raised by softer macro data such as the manufacturing PMI (Figure 2). Our economists expect growth to slow from 7% in 4Q13 to 4.9% in 1Q14 (on a q/q seasonally adjusted annual rate). Premier Li’s comment that the 2014 GDP growth target of 7.5% remains “flexible” reflected the government’s tolerance of slower growth if it means longer-term reforms can be implemented.
Premier Li also indicated that the government has the capability to keep growth within a reasonable range, and has, in hand, policies to counter any volatility this year. While we do not expect any large-scale stimulus, we do believe the government will introduce fiscal and/or monetary measures to support growth when necessary. Our economists maintain their growth forecast of 7.2% for 2014 – which they believe is the bottom of the range for policymakers – with an expectation for growth to pick up in 2H14.