At first glance, China’s new lineup of top leaders doesn’t look like a reform dream team. But let’s not jump to conclusions just yet.
While the omission of two widely touted reform-minded candidates, Wang Yang and Li Yuanchao, came as a surprise, China watchers are optimistic that the freshly chosen seven-member Politburo Standing Committee (PSC) will push ahead with critical private sector and consumer growth policies essential to the future of the world’s second largest economy.
Some of this confidence comes from the words used by the Chinese communist party itself. Capping an orderly transition of power, the party released a political report that hit all the right notes about the country’s direction in the next five years: "Reform" was mentioned 84 times, “scientific development" was mentioned 17 times and "the People" 141 times.
And on Nov. 15, in his first public speech as head of China’s Communist Party -- and, thus, the de facto leader of the country -- 59-year-old Xi Jinping pledged to "carry out reform and opening up" of the economy. He promised to “further release and develop the productive forces, work hard to resolve the difficulties the people face in both work and life, and unwaveringly pursue common prosperity.”
Xi and his team have inherited an economy that will this year record its slowest rate of annual economic growth since the late 1990s -- only about 7.5 percent compared with about 10 percent in recent twelve-month periods. The World Bank warns that without quick action, growth may slip further to 5 percent by 2015 -- probably too low to create the levels of employment and fund the social programs Beijing holds as key to keeping a lid on political unrest.
China’s primary challenge, if it hopes to meet its pledge of doubling incomes by 2020, is to unlock consumption as a bigger driver of growth. This is particularly crucial to balance out declines in the country’s export competitiveness and the fallout from China’s excessive investment in infrastructure, which has reduced capital available for small- and medium-size businesses and created levels of overcapacity that are constraining wage growth.
At the top level, restructuring the economy has been a stated priority for nearly 10 years, as emphasized by both the 11th and 12th five-year plans. However, few changes have been pushed through. This time, though, there is a general belief that the new leadership will back up its words with action -- if for no other reason than that China has no choice but to restructure the economy if it hopes to return to anywhere near the GDP heights it once routinely enjoyed.
“I think rebalancing is happening and [China’s top leaders] are beginning to take it more seriously,” said Steve Blitz, chief economist at ITG Investment Research.
An Appetite For Reform
Of the three “reformist” candidates thought to have had a chance of joining the Communist Party’s main decision-making body, only one was promoted. What’s more, Wang Qishan, who was elevated, has been shunted into a role that gives him oversight of Party discipline rather than economic policy. Wang is currently vice premier with responsibility for economic and financial affairs and is widely seen as a supporter of liberalization.
“This is not the Standing Committee that reformers might have hoped for but neither should it be a cause for despair,” writes Mark Williams, an economist at Capital Economics. “Our forecasts assume that the new leadership will push through significant changes to economic policy.”
Potential reforms are likely to include further interest rate liberalization, weakening the ties between state-owned banks and state-owned enterprises, and fostering an environment more conducive to the growth of smaller, privately-owned firms.
Analysts attributed their optimism to a handful of observations:
1. China’s new leaders are the first ones not appointed by the old revolutionary cadre and should thus prove more pragmatic and ideologically flexible.
2. The new leaders were educated in the 1960s and 1970s; because they experienced the traumatic upheaval of the Cultural Revolution first-hand -- when millions of people were persecuted in violent factional struggles and young intellectuals living in cities were "sent down" to the countryside to work as peasants or on assembly lines while the Chinese economy nosedived –- they will surely see social stability as a key responsibility.
3. Having witnessed China’s semi-capitalist-based economic transformation in the 1980s, they are probably believers in the market economy.
4. The decision by Hu Jintao, Xi’s predecessor, to relinquish control over the military should make it easier for Xi and his team to break with policies of the past because they will not have former leaders, still holding the edges of power, looking over their shoulders. Hu's graceful exit was different from that of his predecessor Jiang Zemin, who continued as chairman of the Military Commission for two years, even after retirement.
5. By reducing the size of the Standing Committee to 7 members from 9, more cohesive decision-making is possible and policy changes can be implemented faster.
6. Most senior officials in China now seem to agree on the need for economic policy reform. Incoming premier Li Keqiang is believed to have facilitated February’s joint publication of the 468-page “China 2030” report by the World Bank and a think tank linked to China’s government. The report proposed wide-ranging policy reforms to secure sustained, rapid growth.
A Bigger Bond Market Needed To Finance Urbanization
China has witnessed the largest and fastest migration from the countryside to the cities in its history, and the lure of urban life also has major implications for the bond market, as China’s cities and towns require more financing.
For the first time in the country’s history, a greater number of people live in urban areas than in rural regions. At the end of last year, 51.3 percent of the population lived in the cities, up from 20 percent in the early 1980s, when China was just starting to open up its economy.
This implies that an average of 10 million people have left the countryside each year, a trend that is likely to keep accelerating as China catches up with developed countries. By 2030, China's urban population is expected to reach 70 percent of the country’s total, World Bank President Robert Zoellick said in April.
This means there will be a huge demand for investment in railways, roads, bridges and other infrastructure projects. According to the China Development Research Foundation, a Chinese government think tank close to the country's central leadership, each city dweller will spur at least 100,000 yuan ($16,036) in infrastructure investment.
But this time, the Chinese leadership says that it will not fall prey to the mistakes it made in the past when overheated infrastructure investment was primarily funded by relatively short-term lending by banks, which continue to have a cozy relationship with the government. Absent long-term financing instruments, there was a big mismatch between the decades it can take for these projects to show a return on investment and their short-term loan maturity dates.
To address this problem, Beijing is speeding up the development of bond markets and “significantly (lifting) the share of direct financing,” according to the 12th five-year plan.
HSBC economists Qu Hongbin, Sun Junwei and Ma Xiaoping expect the expansion of Chinese municipal and corporate bonds to double the size of the domestic bond market in the next five years, lifting it into the world’s top three.
“International experience shows that overreliance on bank credit in a financial system can, under certain circumstances, lead to systemic risk,” Guo Shuqing, the head of the China Securities Regulatory Commission, told the official People’s Daily newspaper in March, saying that the bond market, which provides 13 percent of China’s debt, “seriously” lags behind the demands of the real economy and needs to develop.
A bigger, deeper bond market will give banks more incentive to finance small and medium-size enterprises and consumers, according to HSBC. Such companies account for 65 percent of GDP, 50 percent of taxes and eight out of 10 jobs in China.
Liberalizing Interest Rates
Interest rate liberalization also appears to be slowly inching along in China, a potentially valuable economic tool for the new leadership. Under the current system, the People’s Bank of China sets a ceiling for deposit rates and a floor for lending rates, creating a high spread that generates fat bank profits. It also means that the returns that savers earn on their deposits are below the level of inflation, so they are effectively losing money.
This, in turn, works against the government’s policy to make consumption a bigger driver of economic growth. Consumption in China was 51.6 percent of GDP in 2011, compared with about 70 percent in the U.S.
Economists see the latest move by the People’s Bank of China to widen the floating band of deposit rates while trimming lending rates as an indication of Beijing’s determination to push forward interest rate liberalization in the coming years.
On June 8, China cut borrowing costs for the first time since 2008, lowering the one-year rate by 0.25 percent to 6.31 percent, and banks could offer a 20 percent discount to the key lending rate as well, up from 10 percent previously. Moreover, for the first time, lenders will be able to offer savers deposit rates that are up to 10 percent higher than the benchmark-lending rate.
Wang Tao, chief China economist at UBS in Hong Kong, who previously worked at the International Monetary Fund, described this move as "unprecedented" and a "milestone for interest-rate liberalization," according to Bloomberg.
The move to liberalize interest rates is intended to boost the private sector by making capital allocation more efficient and provide the middle class with more choice about where to put their money. That would enable households to earn a higher return and, hopefully, spend more.
But there are also questions about how smartly Chinese banks and the country’s leadership will implement these new interest rate rules and whether they will be able to navigate a sharp shift in fiscal priorities that could hurt the economy and the country’s overly prominent state-run companies if not done properly.
“The real risk to me in the banking system is that the banks are clearly skewed to help the state-run enterprises, and as such, they’ve created a misallocation of capital within China,” ITG’s Blitz said. “But in (changing the rules), a lot of these state-run enterprises could become losers and could just simply go, in Western terms, bankrupt as a result of it.”
Internationalization Of The Yuan
A number of empirical studies conclude that the international acceptance of a currency goes hand in hand with the rise of a country’s economic power. That was true of the British pound in the 19th century and the dollar in the 20th century. Consequently, as important as China already is to global economic fortunes, the internationalization of the yuan -- which is rarely used outside of the country -- is long overdue.
Nonetheless, there are encouraging signs. The use of yuan as a trade settlement currency has accelerated since the currency was introduced in 2009. Trade volumes surged to 227 billion yuan in the first quarter of 2012, from just 18 billion in the first three months of 2010.
Making the yuan a more global currency became a major consideration for China during the financial crisis in 2008 when the value of the dollar tumbled, putting the Chinese yuan, which was pegged closely to the dollar, as well as the country’s dollar-denominated assets, at risk.
The U.S. Federal Reserve’s decision to rely on quantitative easing as a response to the country’s economic woes -- which involved essentially acquiring a lot of government bonds to flood the market with dollars -- caused more consternation in Beijing. This policy was intended to keep the dollar fluid and relatively inexpensive; in turn, however, China faces a period of growing inflation as the cost of dollar-denominated products, whether they be American-made products or global commodities like oil, would go up in the country.
In an interview with Caixing magazine in 2010, Yi Gang, a deputy governor for China's central bank, said: “A convertible yuan remains the ultimate goal for the nation's currency exchange-rate reform.”
According to HSBC estimates, the yuan will likely become a fully convertible currency within five years.
Come Back In 5 Years?
Although the number of Chinese observers who believe that economic liberalization has already begun and will speed up in the coming years outweigh those who are more pessimistic about the country’s immediate future, one potential obstacle to economic liberalization emerged from the National Congress last week. Jiang Zemin, who led China until 2002, appears to have had an outsize influence on the appointments made at these sessions.
As many as five of the seven members chosen for Communist party leadership are Jiang’s allies. Among them is Zhang Dejiang, who is No. 3 in the Politburo Standing Committee and expected to head the largely rubber-stamp parliament, the National People's Congress, when it holds its annual meeting in March.
Like his mentor, Zhang is known for supporting China’s state-owned enterprises and a state-centric model of economic growth. In the early 2000s, Zhang was opposed to even allowing private entrepreneurs into the Communist Party.
“Having him in such a powerful role, will have a dampening effect on the liberalization discussion,” said Victoria Lai, China Analyst at the Economist Intelligence Unit (EIU). “Now that the standing committee has been clipped down to seven members, each person has more weight than before.”
Indeed, for Lai, the bright spot is that the majority of seats on the PSC went to officials who will reach the retirement age of 68 within five years, when the next party congress is held.
“There’s the possibility that in five years, some of the more liberal elements may be able to come into power,” Lai said.
For China’s sake, hopefully better judgment will prevail over dustbin ideology, because in the fast-paced, globalized business environment of today, five years is too long a time.