Sunday, Apr 30, 2017, 3:08 PM CST – China

Economy

Commentary

Down to Business

China needs new perspectives and new actions to convince the market and alleviate fears that the world’s second-largest economy is spiraling

People walk past a billboard advertising a planned upscale shopping and office complex in Beijing, October 19, 2015 Photo by IC

Ms Zou, a housewife in Wuhan, Hubei Province, becomes a parttime courier with e-commerce platform JD.com in July. More than 100,000 people in 21 cities have done the same Photo by CNS

It has been a tumultuous few months for the world economy.

In September 2015, the market watched nervously as the US Federal Reserve considered raising interest rates and Chinese leaders explained their plans to mitigate the impact of China’s current growth slowdown and build new economic engines.

The sweeping stock sell-off in late August brought the world price-earnings ratio, a share valuation measure, down to its 1987 median value by the start of September, according to the Bank of International Settlement (BIS). Commodity prices on the international market continued to dip, reaching a 16-year low as measured by the Bloomberg Commodity Index at the end of August, reducing profits in commodity-producing economies. Major emerging economies, including Russia, Brazil, Turkey, Malaysia and South Africa, have been regarded as a significant source of risk for the global economy after their currencies suffered significant depreciation during the same month, greatly increasing their foreign debt burden.

Market observers worried that if the Fed raised interest rates in September, the first such action in nearly a decade, it would trigger capital flight from other parts of the world, particularly from emerging economies whose currencies had been weakening against the strengthening US dollar since the second half of 2014.

In August, the stock market in China struggled to recover from its mid-June chaos, and real estate investment declined. The sudden yuan depreciation that resulted from a foreign exchange rate policy change was interpreted as an official confirmation of the country’s economic deterioration. Meanwhile, new growth engines have yet to gain enough strength. These have fueled already pervasive fears that if China runs out of steam, commodity prices and the global economy could be dragged into a deeper downturn. The market needs to be reassured that China’s growing pains today are both tolerable and worthwhile.

Discouraging Data

China’s Producer Price Index fell in August for the 44th month in a row. As a result, profitability for such industries as mining, manufacturing and utilities was well below the interest rate on their loans. The Consumer Price Index remained below target. Chinese Academy of Social Sciences (CASS) professor Yu Yongding noted at an August 30 forum in Beijing that these indicators show China had already been trapped in deflation, which could exacerbate China’s debt-to-GDP ratio, the highest in the world, and threaten the potential for growth. Many Chinese and international economists share this opinion. Also in August, the Caixin Purchasing Managers’ Index recorded a six-year low, reflecting business contraction in the private manufacturing sector.

On August 11, the People’s Bank of China (PBoC), China’s central bank, announced a sudden change in the foreign exchange rate system. The yuan’s interbank benchmark value set by the central bank would be influenced more by the closing price of the previous trading day than by the central bank’s daily whims. The main purpose is to make the exchange rate more market-oriented. As the yuan’s price on the interbank market had already been much lower than the parity price for some time, reflecting the buildup of devaluation pressure, the new policy immediately led to a nearly 3 percent slump in the parity price within three trading days. This was a minor correction from the yuan’s 15 percent rise in real effective terms over the previous year as measured in July, according to the IMF.

However, market watchers did not believe the PBoC’s reform rhetoric, and interpreted the step as the Chinese government’s tacit recognition that the country’s economy had deteriorated to such an extent that a drastic currency depreciation was necessary to save the country’s exports, which experienced a 7.3 percent year-on-year fall during the first seven months of 2015. Worse still, the market pessimism over China’s economy has led to the assumption that the depreciation may become so intense in the future that it will force China to burn through its foreign exchange reserves to prop up the yuan.

Overreaction

During their international visits and meetings this September, Chinese leaders took advantage of every opportunity to try to ease the market jitters. At this year’s World Economic Forum held on September 10 in Dalian, Liaoning Province, Chinese Premier Li Keqiang highlighted the country’s low unemployment rate, rising service sector, growing consumption, faster growth in residents’ incomes compared to that of the GDP, as well as signs of strong movement in tech-oriented industries and business startups.

Indeed, China’s growth targets over the decades have always been closely linked with the unemployment rate. In addition, the targeted growth rate set for the year is now “about 7 percent.” As Li reiterated in Dalian, something either a bit above or below the line is acceptable. Revised forecasts for China’s growth in 2015 by major international institutions, including the IMF, the World Bank, Goldman Sachs, JP Morgan, the BIS and the OECD, stand between 6.8 and 7 percent, falling comfortably into the “about 7 percent” range. Some Chinese economists, including Yu Yongding and Professor Cai Fang, deputy head of CASS, believe that even an average growth rate of 6 to 6.2 percent for the next five to 10 years would be sufficient, taking into account the labor and capital supply. Since the end of August, international investment banks and analysts have recognized that the market overreacted to China’s short-term stock market chaos and growth figures as well.

However, these facts are often simply ignored by the market, as investors, particularly those in the stock market, tend to overreact to short-term changes. No one can change that. This is why managing market expectations is always so difficult and important. At the end of September, China declared that there was further decline in industrial profitability in August, and the Fed hinted that an interest rate hike was coming soon. The equity markets in China and the rest of the world, along with international commodity prices, plummeted at this news.

There are other reasons for this persistent and sometimes excessive reaction to China’s changing growth figures. Although everyone has been talking about the “new normal” ever since last year, when Chinese leaders highlighted the idea of slower growth now for better growth in the future, it is still taking time for investors to accept the reality in practice. Professor Nouriel Roubini of New York University is known as Dr Doom for his predictions of the 2008 global financial crisis and early warnings of China’s economic crash, yet even he recently told international media that investors were switching from exuberance over China’s two-digit growth rates to excessive pessimism too quickly. “China is not in free-fall,” he said at a recent forum in Italy.

This is largely attributed to China’s GDP-centered growth model and politics, which have guided the market focus since the late 1970s. There have already been calls from some analysts that it is time for China to officially make other signposts just as important as the GDP in economic policies, such as the unemployment rate, which is used by the Fed. This is particularly important at a time when China is trying to shift its growth model from being quantity-based to being quality-based. Using indicators other than the GDP will send a much stronger, more direct signal to the market that China is serious about the shift.

Past problems also affect today’s confidence. Professor Lu Feng of Peking University’s National School of Development has studied deflation in recent years. He thinks it is necessary to rethink what he terms “deflation panic syndrome” in international analysts, an affliction rooted in the memory of the Great Depression of the 1930s.

Fresh Perspective

Certain voices in the market are urging bigger monetary and fiscal stimulus. Catering to this pressure may not be a good idea. It may not be a good idea, either, to wait for investors to calm down, as their panic could lead to a self-fulfilling crisis. Instead, fresh perspectives could be useful both for investors and policy makers.

Professor Lu Feng describes China’s current deflation as “neutral,” with some positive aspects. According to data from the National Bureau of Statistics, China’s most serious price slump now is in upstream sectors that expanded too fast during the 2003-2008 boom, as well as in 2010, such as coal, steel and oil production. In Lu’s view, while this has worsened corporate balance sheets in those sectors, it also shows the market is successfully squeezing the bubble, something the government has tried to do in vain for years.

Similar things, he added, can be said about the fact that individual incomes are now growing faster than the GDP, a long-expected change that will help boost consumption and social equality. Indeed, the rise of retail sales has been so stable that those numbers were rarely a part of the debate over China’s economic downturn. It has proven to be the most reliable buffer amid the downward pressure felt by the whole economy. This buffer would not be possible without consistent income growth and low prices.

In the first eight months of the year, the value of China’s imports plunged by 14 percent, according to the General Administration of Customs of China. This figure has also been used by analysts as proof that demand in China has shrunk significantly. However, a closer look at the details would find that the decline is mainly due to the commodities’ lower prices rather than lower quantities. For example, as a major buyer in the world market, China imported 0.2 percent less iron ore in 2015 than recorded over the same period last year, yet the amount spent was down by 43 percent. While resource-intensive areas in China have felt the pinch of cheaper commodity prices, Lu said, less developed midwestern provinces have benefited from the reduced production costs and reported higher growth in the first half of the year.

New Moves

While a closer look at past records can help unfold more truth into the present, it is much more difficult to read the future in the rubric of current policy. A major concern of the market is the uncertainty of whether China’s troubles today can be taken care of by installing a market-oriented economy tomorrow. In this regard, the whole world is watching for China to give the market “a decisive role,” a goal enshrined in China’s reform agenda in November 2013.

The government is trying to renovate both the private and State-owned sectors. Much of the red tape blocking entrepreneurs from starting up and running their own businesses has been reduced. The number of companies in China has increased more quickly since 2013 than the average from the previous decade. This fact, along with the wide use of the Internet, has made Internet-based services a part of daily life for Chinese consumers. This has boosted China’s low-end, labor-intensive services market, such as catering, which had previously been regarded as saturated. New services related to the tech industry, from entertainment to professional consultancy, are emerging all the time.

 However, these services are all adjacent to markets that already exist. Some innovative projects that create cutting-edge solutions aren’t seeing the light of day. Mao Xiao, a Tsinghua University graduate, has had little luck in the past few years getting her new smart household power meter off the ground. She faces two problems. One is insufficient intellectual property rights protection. Under the existing rules, she cannot apply to protect her method of data collection and analysis. The other is the existing electricity industry. Mao is missing out on many potential partners, as retail power companies simply will not exist until reforms open up the market. She has to wait for the State grid monopoly to break up and loosen the whole power supply chain. A lot of other innovators in this industry, she said, are in the same situation.

In mid-September, long-anticipated guidelines on State-owned enterprise (SOE) reform were unveiled. They focused on improving the efficiency of SOEs by lessening administrative intervention into their business decisions, a concept that has been hailed by the market. However, onlookers are disappointed that crucial reforms have yet to be enacted, such as removing the exclusive business licenses or privileged access to production resources, including land, capital energy and telecoms services, that SOEs enjoy. Without these reforms, the commitment to equal access to production factors and a level playing field for all companies, regardless of ownership, can hardly be realized.

Rules on mixing private investment into SOEs were specified at the end of September. These policy changes, however, have not fully dismissed the lingering controversy over pricing of State-owned assets, which brought the previous round of SOE reforms to a halt in the early 2000s.

Unlike central SOEs, local SOEs today are mostly fundraising platforms for local governments, so their reform is linked with the issue of massive local government debts, noted Zhao Changwen of the Development Research Center of the State Council at a recent meeting at Peking University. The solution proposed so far is also inviting private investment in public projects.

Indeed, many government documents have been issued over recent years to encourage private engagement with State-dominated sectors, projects or companies, but private investors remain hesitant. They are afraid of being accused of buying State assets at a discount, or facing contract breaches by the government. Consumers are frustrated with high prices caused by SOE monopolies on the one hand, yet on the other hand, they are concerned that the services provided by private operators, once they are introduced into the utility market, will be even worse.

No government document can deliver true confidence and fair practices in the economic world, no matter how complete its provision. The only thing that can accomplish this is the law, when it adequately defines and protects fair economic practices. The role of the law has been mentioned, but not highlighted, in these documents. It appears that the reform progress will depend on good officials, rather than a mechanism that encourages and imposes good conduct. Chinese laws to be followed, such as the Corporate Law, the Bankruptcy Law and the Contract Law, have to be specified in all reform documents. More importantly, the market needs to see at least one or two cases in which contract disputes between governments and private companies are brought to court, and do not merely appear in media, academic or official reports. The best way to manage market expectations is to provide more progress on the rule of law, something that is beyond the scope of the marketplace.

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