From UBS today comes a note on what expect from China’s upcoming plenary session of the 18th Party Congress:
All eyes are on the upcoming November third plenary session of the 18th Party Congress, where a set of far-reaching economic reforms is expected to be unveiled. For many China observers and market participants, this is the “make or break” moment. After three decades of rapid growth, the economy is running out of steam. More importantly, there are deep rooted structural issues that threaten sustainable growth and even social stability. If the new government does not launch sweeping reforms now, many people believe, China’s economy is heading for the ruins.
What are the biggest issues to be addressed?
Almost everyone agrees that China’s growth overly relies on investment while consumption has lagged (Chart 1), the government is still dominant in controlling and allocating key productive resources and this has stifled innovation and private sector development, inequality has worsened to a dangerously high level, and the environment is under severe strain. For many economists and the market, the high and rapidly increasing leverage (Chart 2), the ballooning shadow banking system, diminishing returns to investment, and a property bubble are also pressing worries. We think the government perhaps shares many of the market concerns but the big rural-urban and regional income gap (Chart 3), the need to provide jobs for the millions of migrants every year (Chart 4) and establishing better social protection are also very high on the agenda.What should we expect from the 3rd Plenary Meeting? How will the reforms impact on the economy and the market? Will the economy crash soon and should investors run for the exit if there is no major breakthrough in the key reform areas in November?
We think the November meeting will set a comprehensive framework for reforms in the next few years, but will unlikely announce a lot of details, a sweeping overhaul of local government finance or the tax system, or major breakthrough in land and SOE reforms. However, this is no cause for panic. We do expect many reform measures to be initiated gradually over the next couple of years, including financial sector reform and service sector deregulation, while the more difficult ones may follow. In the next 1-2 years, the economy can still grow at 7%+ even without major reforms, with the help of a recovering global economy, the domestic urbanization push and the still abundant domestic liquidity. Of course, the sustainability of growth is questionable without necessary and proper sequencing of reforms.
If the 3rd Plenum does not announce a grand reform plan or major breakthroughs in key reform areas, does that mean China is headed for a big crisis and investors should immediately head for the exit?
We do not think so, at least not yet.
First, we think it is very likely that additional reforms will follow in the next few years, as consensus builds or
when the first stage of reforms lead or force the way. As and when structural problems reach a new level, the Chinese government will likely adapt and take actions, as it has shown time and time again in the past.Second, reforms take time and should take time to be implemented. Sweeping reforms may not be universally positive for the short term – they could unlock future growth potential but also bring dislocation. For example, higher energy prices are bad news for heavy industry users; allowing farmers to sell land directly will hit local government revenues and may bring down land and property prices; dealing with pollution and environmental damage will raise companies’ costs; developing better social safety net may increase labour cost… Therefore, reforms will have to be pursued steadily but gradually.
Third, we have to remember some good conditions/advantages that China still has:
- An aging population notwithstanding, China still has millions of excess labour that can be transferred to the manufacturing and services sectors (Chart 8), and the labour force is increasingly better educated;
- There is still plenty of scope for capital deepening given the relatively low level of development (Chart 9) – to increase productivity in manufacturing and services, to equip the excess labour with machines in productive sectors, and to link the vast inland regions to the coastal market and global economy with better infrastructure;
- China has a national saving rate of almost 50%, which can provide abundant funding for domestic leverage
- and investment for the time being (Chart 10);
- The government has plenty of assets and a relatively strong balance sheet, notwithstanding the sizable local
- government debt;
- At least in the next couple of years, China will still have a relatively closed capital account to help keep most of the national saving at home to provide liquidity for the domestic financial sector.
To the last point, again, it would be important to monitor the progress of China’s capital account opening, especially relative to the progress of other reforms in the next few years.
This sounds about right to me. China must signal its intention to reform, reinforce the narrative as it were, but will no doubt move at its own pace. The real question is: will the politics of interests slow reform so much that stagnation overtakes the economy?
