26 Jun 2014
China must risk higher growth to implement needed reforms
The Chinese government must navigate the implementation of economic reforms while maintaining growth at a pace sufficient to keep unemployment steady. This is a difficult task for any government, and particularly so for the Chinese government right now, as many critical reforms to the economy will be potentially disruptive to growth. This is happening while many analysts and markets are worried about a loss of momentum in the Chinese economy.
To delay reforms is in itself a risk to growth, albeit over the medium-term. China’s financial system presents a number of problems for its government. It is not allocating capital effectively, unregulated elements are growing rapidly and the monetary policy transmission mechanism is under question.
Most of the immediate concerns around China focus on a collapse in property prices and construction activity. ANZ does not believe China’s property market is a macroeconomic bubble waiting to burst. House prices have been volatile in recent years and there is nothing to say that the recent softening is any different to recent cyclical slowdowns. Furthermore, there have been major constraints on the market including tight lending conditions and a variety of ‘curbs’ such as restrictive loan-to-value ratio targets for borrowers.
The major concern around the residential property market is construction activity, which looks to be more vulnerable to a slowdown than at any time since the global financial crisis. Developers are pulling back on land purchases and building commencements are slowing. As a result, construction is expected to slow down and help the market re-balance as demand softens. With this slowing comes the risk of a significant retrenchment which will require monitoring.
Despite these challenges, it should be clear that there is no disaster scenario on the horizon for China. There is no ’Lehman moment’ just around the corner. China is, if anything, over-insured. It currently runs a savings rate of almost 50 per cent of GDP and has about $US4 trillion in foreign exchange reserves.
China can bail itself out of any financial mess that comes its way and has been doing so for decades. That doesn’t mean there won’t be hiccups and volatility – because there will be. Indeed, the noise around the Chinese financial system is likely to pick up as reform efforts continue.
What we do know is that from a policy perspective reform momentum has taken a back seat to growth momentum in recent months. Premier Li has targeted growth of 7.5 per cent. He sees it as critical to ‘hit the target’ early in his term of government for his own credibility, arguably in order to push forward with key reforms. If this is the case, the current hiatus in reforms is not a significant issue.
For China and Premier Li, a desired slowing in property activity risks not achieving the growth target this year. Ideally, this would be offset by stronger activity from private sector SMEs and households. Easier monetary conditions, which have been kept quite tight in recent years, would help. The problem is the complexity of monetary policy operations at this point. It’s not as simple as just reducing the Reserve Ratio Requirement (RRR). Indeed, there have been two RRR cuts in recent weeks, but these have been targeted at small and medium sized banks in an effort to increase the flow of credit to SMEs. In any case, the bulk of bank funding costs are determined by the deposit rate. To effect a genuine easing in domestic monetary conditions, this must be cut as well.
Finally, the authorities want to make sure any new credit goes to the right sectors, as evidenced by the selective RRR cuts. This would require some diligent administrative guidelines for the banks as well. All of this makes one wonder how effective domestic monetary easing would ultimately be. It also does not factor in the possibility that lower interest rates in the core banking system might also add to growth in the ‘shadow’ system.
While delaying these reforms will allow Premier Li to hit his desired 7.5 per cent growth target for this year, it risks exacerbating any imbalances currently building in the finance and property sectors. This will only make the task harder in the years to come.
This is an edited excerpt from the ‘The Global Recovery Muddles Through’, ANZ Research Quarterly, Q3 2014. The full article is available on ANZ Live.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.