The new nor­mal in China’s ci­ties

Financial Mirror (Cyprus) - - FRONT PAGE -

For decades, rapid ur­ban­i­sa­tion in China cre­ated clus­ters of knowl­edge, man­u­fac­tur­ing, and dis­tri­bu­tion in ar­eas that ben­e­fited from well-es­tab­lished con­nec­tions to the global econ­omy. But that growth model has reached its end. With the share of peo­ple liv­ing in ci­ties ris­ing to 53% in 2013, from 20% in 1981, China is shift­ing to a “new nor­mal.” Ac­cord­ing to Pres­i­dent Xi Jin­ping, the aim is to en­sure an­nual eco­nomic growth of around 7%, driven by new op­por­tu­ni­ties in val­ueadded man­u­fac­tur­ing, in­for­ma­tion tech­nolo­gies, and mod­ernised agri­cul­tural pro­duc­tion.

In mov­ing to­ward this goal, how­ever, China will face dif­fi­cult bal­ance-sheet ad­just­ments that can­not eas­ily be man­aged by con­ven­tional fis­cal and mon­e­tary poli­cies. A new Deutsche Bank study re­ports that, last year, China’s 300 ci­ties faced a 37% drop in their land-sale rev­enues – a ma­jor set­back, given that land sales ac­counted for 35% of to­tal lo­cal­go­v­ern­ment rev­enues. Such rev­enues had risen at an av­er­age an­nual rate of 24% from 2009 to 2013.

More­over, an­nual con­sumer and pro­ducer in­fla­tion dropped to 1.5% and -3.3%, re­spec­tively, last De­cem­ber, owing partly to the sharp de­cline in world oil prices. China now faces de­fla­tion and an in­hos­pitable ex­ter­nal eco­nomic en­vi­ron­ment, and its ur­ban cen­ters are strug­gling with the com­plex in­ter­ac­tion of sol­vency, liq­uid­ity, and struc­tural is­sues.

But some ci­ties are bet­ter equipped than oth­ers to weather th­ese chal­lenges. China’s first- and sec­ond-tier ci­ties are very wealthy, ben­e­fit­ing from high prop­erty val­ues and the con­tin­u­ous in­flow of tal­ent, cap­i­tal, com­pa­nies, and in­vest­ment projects. De­spite a prop­erty-mar­ket slow­down, Beijing’s re­cent land auc­tion con­cluded with record-break­ing prices of about CNY 38,000 ($6,200) per square me­ter.

Third- and fourth-tier Chi­nese ci­ties, how­ever, face more chal­leng­ing bal­ance-sheet ad­just­ments, owing to fall­ing as­set prices, out­flows of labour, and the need to de­fine new growth mod­els. In the af­ter­math of the post-2008 debt-fu­eled in­fra­struc­ture-in­vest­ment boom, th­ese ci­ties need to re­form how rev­enue is shared with the cen­tral gov­ern­ment, in­crease the trans­parency and ac­count­abil­ity of lo­cal bud­gets, and over­haul the use of mu­nic­i­pal-bond and pub­lic-pri­vate part­ner­ship mod­els for lo­cal in­fra­struc­ture projects.

But, be­fore such changes can be im­ple­mented, th­ese ci­ties must ad­dress the over­hang of poorly per­form­ing projects and loss-mak­ing state-owned en­ter­prises (SOEs). In fact, Chi­nese ci­ties and lo­cal en­ter­prises will need even more liq­uid­ity than would be re­quired in a clas­sic case of de­fla­tion, credit tight­en­ing, and fall­ing prices, be­cause in­fra­struc­ture and prop­erty in­vest­ments by lo­cal gov­ern­ments and SOEs are still con­sum­ing funds. And, given state in­ter­ven­tion, in­ter­est rates do not ad­just quickly enough to al­lo­cate re­sources ef­fi­ciently.

Of course, the Peo­ple’s Bank of China could lower the in­ter­est rate and re­lax its liq­uid­ity pol­icy. But it re­mains con­cerned that do­ing so would spark in­fla­tion and fuel waste­ful in­vest­ment – and greater ex­cess ca­pac­ity – in the real-es­tate sec­tor.

Main­tain­ing rel­a­tively tight liq­uid­ity, how­ever, also has se­ri­ous con­se­quences. For starters, as long as ex­ter­nal con­di­tions re­main rel­a­tively liq­uid, tighter con­di­tions in China put up­ward pres­sure on in­ter­est rates in the shadow-bank­ing sec­tor. To­gether with the growth of the ren­minbi carry trade, this has pushed up the ex­change rate at a time when non-US dol­lar-linked cur­ren­cies are largely de­pre­ci­at­ing.

De­spite slow­ing growth, China’s A-share mar­ket has risen by nearly 50% since last July, and the bank­ing sec­tor’s mar­gins re­main ex­cep­tion­ally large. Mean­while, con­fi­dence in the non­fi­nan­cial pri­vate sec­tor re­mains de­pressed, as di­min­ished de­mand leads to in­creased pro­duc­tion costs.

China’s growth model hinges on a gov­er­nance sys­tem in which re­gions, ci­ties, com­pa­nies, and in­di­vid­u­als com­pete within an in­creas­ingly mar­ket-ori­ented, but still cen­trally reg­u­lated, econ­omy. But, in a coun­try as large and di­verse as China, a one-size-fits-all ap­proach will not en­sure that the mar­ket func­tions ef­fec­tively.

The best way to sus­tain China’s eco­nomic tran­si­tion and pre­vent a hard land­ing is to im­ple­ment looser mon­e­tary and credit poli­cies that en­able the most pro­duc­tive ci­ties, com­pa­nies, and in­dus­tries to gen­er­ate new added value. With the risks of in­fla­tion and as­set bub­bles be­ing mit­i­gated by lower oil prices and ex­cess ca­pac­ity, now is a good time to ini­ti­ate this pol­icy shift.

Of course, China will prob­a­bly face some short-term head­winds, so the pos­i­tive ef­fects of this shift will take some time to emerge. As the cen­tral gov­ern­ment con­sol­i­dates its power through fis­cal re­form and an anti-cor­rup­tion cam­paign, or­ches­trat­ing the next phase of struc­tural re­forms at the lo­cal level will re­quire deft co­or­di­na­tion.

After decades of high-speed growth and pol­icy ex­per­i­men­ta­tion, cycli­cal over­shoots – re­flected in ex­cess ca­pac­ity, ghost towns, and lo­cal-debt over­hangs – are no sur­prise. Now it is time to ad­dress them. Only by con­fronting th­ese struc­tural is­sues can China com­plete its shift to its new, more de­vel­oped, and more eq­ui­table “nor­mal.”

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