China’s dual-track chal­lenge

Financial Mirror (Cyprus) - - FRONT PAGE -

With China’s eco­nomic slow­down more ap­par­ent than ever, its prospects of avoid­ing a hard land­ing are weak­en­ing. Whether pol­i­cy­mak­ers suc­ceed will de­pend on whether they can nav­i­gate the chal­lenges stem­ming from an in­creas­ingly di­vided dual-track econ­omy.

The lat­est year-on-year data, from Jan­uary, high­light the dan­ger. The con­sumer price in­dex dropped to 0.8%; the pro­ducer price in­dex fell by 4.3%; ex­ports con­tracted by 3.3%; im­ports were down by 19.9%; and growth of broad money (M2) slowed by 1.4%.

More­over, the ren­minbi has come un­der down­ward pres­sure, ow­ing partly to eco­nomic re­cov­ery in the United States, which has fu­eled cap­i­tal out­flows. Given huge de­clines in industrial profit growth (from 12.2% in 2013 to 3.3% last year) and in lo­cal-gov­ern­ment rev­enues from land sales (which fell by 37% in 2014), there is con­sid­er­able anx­i­ety that to­day’s de­fla­tion­ary cy­cle could trig­ger cor­po­rate and lo­cal-gov­ern­ment debt crises. China hopes to se­cure its long-term eco­nomic devel­op­ment by shift­ing from a state-di­rected to a mar­ket-led econ­omy. But the process has cre­ated sig­nif­i­cant dis­crep­an­cies in eco­nomic per­for­mance, with state-owned en­ter­prises (SOEs) per­form­ing sig­nif­i­cantly worse than their pri­vate-sec­tor coun­ter­parts, de­spite hav­ing bet­ter ac­cess to credit. And there is a widen­ing dis­par­ity be­tween real-es­tate prices in China’s thriv­ing first- and sec­ond-tier cities and its lag­ging third- and fourth-tier cities (though higher house­hold in­comes in the for­mer make hous­ing there more af­ford­able).

The au­thor­i­ties’ task now is to de­ter­mine how to sup­port con­tin­ued growth on the bet­ter per­form­ing track (the pri­vate sec­tor and the first- and sec­ond-tier cities), while elim­i­nat­ing over­ca­pac­ity and boost­ing pro­duc­tiv­ity on the weaker track (SOEs and third- and fourth-tier cities). To suc­ceed, they must ad­dress the fall­out of the pre­vi­ous ap­proach, which, by pro­vid­ing more money and pref­er­en­tial poli­cies to the lag­ging track, ended up fu­el­ing over­ca­pac­ity and un­sus­tain­able lo­cal debts.

In other words, China must con­front the sunk costs of bad lo­cal-plan­ning de­ci­sions. In­stead of con­tin­u­ing to hope that bu­reau­cratic in­ter­ven­tion can re­pair flawed projects, of­fi­cials should take a mar­ket-based ap­proach, al­low­ing losses to be al­lo­cated through the bank­ruptcy process, thereby en­abling all stake­hold­ers to move on to more pro­duc­tive ac­tiv­i­ties.

The Chi­nese econ­omy’s dual-track struc­ture also presents unique chal­lenges for macro-fi­nan­cial man­age­ment. As the fast-grow­ing sec­tors ab­sorb an in­creas­ing amount of re­sources, a shift to­ward more mar­ket-ori­ented in­ter­est rates is needed to en­sure ef­fi­cient al­lo­ca­tion. Mean­while, the slow-grow­ing sec­tors risk fall­ing into a “bal­ance-sheet re­ces­sion,” with highly in­debted SOEs and lo­cal gov­ern­ments be­com­ing so fo­cused on pay­ing down their debts that they stop in­vest­ing in needed in­fra­struc­ture, even when in­ter­est rates fall. As a re­sult, con­ven­tional mon­e­tary and macro-pru­den­tial poli­cies are caught be­tween com­pet­ing de­mands for credit, with one track need­ing to sup­port pro­duc­tive growth and the other at­tempt­ing to buy time for re­struc­tur­ing.

The Peo­ple’s Bank of China (PBOC) has at­tempted to con­front this dilemma by dif­fer­en­ti­at­ing re­serve re­quire­ments ac­cord­ing to sec­tor or type of fi­nan­cial in­sti­tu­tion. The re­sults have not been en­cour­ag­ing.

For ex­am­ple, when the PBOC cut its bench­mark in­ter­est rate last Novem­ber, in or­der to help re­duce pri­vate-sec­tor bor­row­ing costs, it trig­gered a spec­u­la­tive stock-mar­ket boom. Fol­low­ing Jan­uary’s dis­ap­point­ing macroe­co­nomic data, the PBOC acted again, by low­er­ing the re­serve ra­tio for banks by 50 ba­sis points, with ad­di­tional cuts for banks fo­cused on small and medium-size en­ter­prises (50 ba­sis points) and for the Agri­cul­tural Devel­op­ment Bank of China (400 ba­sis points). De­spite th­ese ef­forts, nei­ther track seems sat­is­fied that their credit de­mands are be­ing met.

Ef­forts to ad­dress th­ese struc­tural chal­lenges are be­ing frus­trated not just by in­sti­tu­tional bar­ri­ers, but also by en­trenched of­fi­cial cor­rup­tion. The prob­lem is that an­ti­cor­rup­tion mea­sures, de­spite en­joy­ing broad public sup­port, un­der­mine bu­reau­cratic ef­fec­tive­ness in the short term – a sig­nif­i­cant is­sue in a crit­i­cal re­form year, es­pe­cially given slow­ing growth.

In­sti­tu­tional re­forms aimed at com­bat­ing cor­rup­tion, re­duc­ing over­ca­pac­ity, and deal­ing with un­sus­tain­able lo­cal debts will gen­er­ate long-term div­i­dends and sus­tain­able pay­offs. But short-term stim­u­lus mea­sures, such as tax cuts and higher fis­cal deficits, will be needed to min­imise growth dis­rup­tions. This would mean re­vers­ing the re­cent decline in the gov­ern­ment bud­get deficit, which nar­rowed to 1.8% last year, from 2% of GDP in 2013.

The tran­si­tion from a dual-track econ­omy to a mar­ket-based econ­omy will not be easy. The Chi­nese econ­omy is clearly in ur­gent need of re­pair. But the news is not all bad: a sub­stan­tial por­tion of the econ­omy con­tin­ues to ex­pand, underpinning much higher over­all growth rates than in most other economies. More­over, de­spite some con­cerns about cap­i­tal out­flows, China’s con­sol­i­dated net for­eign-as­set po­si­tion, which stands at $1.7 trln (17.6% of GDP), re­mains suf­fi­cient to sus­tain China through this tough tran­si­tion.

China’s lead­ers recog­nise the long-term im­per­a­tive of se­ri­ous in­sti­tu­tional re­form, even as con­cerns about slow­ing growth heighten the temp­ta­tion to em­brace short-term fixes. The au­thor­i­ties are tak­ing strong ac­tion to curb pol­lu­tion, im­prove en­ergy ef­fi­ciency, im­ple­ment pen­sion re­form, and ex­pand ac­cess to health care and low-cost hous­ing.

More im­me­di­ately, China’s lead­er­ship is com­mit­ted to ex­cis­ing the can­cer of cor­rup­tion. The key, as with any crit­i­cal surgery, is to en­sure that the nec­es­sary life-sup­port sys­tems are in place. In China’s case, that means main­tain­ing ad­e­quate liq­uid­ity.

In the end, sus­tain­able devel­op­ment will re­quire that China’s two eco­nomic tracks merge. With the right ap­proach, rel­a­tively sta­ble and rapid growth can be main­tained through­out the re­form process. Avoid­ing a hard land­ing would be good not only for China; it would en­sure much-needed growth and sta­bil­ity for the global econ­omy.

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