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China Unleashes New Economic Reform

Posted in Finance Articles, Total Reads: 5545 , Published on May 09, 2014

China unveiled its boldest set of economic and social reforms since 1978 on November 15, by relaxing its one-child policy and further open up markets to stabilize the world's second-largest economy. It took about seven months to prepare a draft of the 60 point blueprint which is planned to be implemented by 2020.

The blueprint included measures such as increasing the contribution of State owned enterprises to the profits, by bringing corporate governance. Emphasis will be laid on increasing the efficiency and focussing more on profits rather than trying to eliminate them by privatization. Steps will be undertaken to convert China from an investment driven economy into healthier consumption driven economy. China which is riding high on debt-plans to deleverage by 2015-16.Investment on huge infrastructure projects to be replaced by improvement in standard of living, focusing on making people happy, a cleaner environment and improved health care.

Image Courtesy: freedigitalphotos.net, Feelart

Some of the other key points were:

• To open up sectors such as banking as regular people will be able to save more, to keep up with inflation; new private banks may offer more competitive financing to the small and medium-sized private companies.

• Other sectors included rail, health care and telecommunications which would be opened up thereby encouraging private competition.

• To tighten the control over local finances and allowing new channels for funding to limit the risk of a debt crisis hobbling the world’s second-biggest economy.

• To reduce the government influence on IPOs. Listing in china is an tedious process, and requires long waiting time by the securities regulator.

• Introduction of Land reforms- which would allow farmers to sell their land freely.

• Encouragement of private players to set up financial institutions such as small and medium-sized banks subject to certain criteria that needs to be fulfilled.

• Development of market that encourages technological innovation and strengthening of intellectual property application and protection.

• It plans to allow couples to have a second child. Under the one-child policy, China’s population was projected to shrink by about 30 percent before the end of the century at the same time as it is ageing. By 2050 there would be more people in the age group 65 and above and in 2100 there would be one working person for every 2 non working persons if the same rate of population growth is continued.

• Another reason for scrapping the one child policy could be identifying the need to boost the value of its excessive infrastructure by making sure there were more Chinese people around to use it. However it is still a question mark considering the increasing costs of raising a child in China.

Figure 1

Source:Vienna Yearbook of population research,2007

Its a good thing that China is moving in the right direction by bringing new structural reforms and liberalization of interest rates. Economic data shows that china was able to recover well after a slowdown in the previous two quarters. The manufacturing PMI rose to its highest level since last May, along with increase in exports and industrial output. The 60 point blueprint was introduced to avoid ‘Hard Landing’–a phase in which the economy slows from a double digit growth to a low single digit caused by the tightening of monetary policies from the Central bank to keep the inflation under control. The Chinese economy is unlikely to undergo hard landing, sustaining a growth of 7 percent or above. Premier Li Kequiang revised the rate to 7.2 which according to him would be necessary to maintain a stable rate of unemployment and create 10 million jobs per year. China’s working age population has started to decline. It will shed about 70 million workers by 2030.

The world’s largest economy has slowed down considerably from 14 percent in 2007 to 7.6 % in 2013.Shrinking workforce and diminishing returns on investment raise concern of further slowdown. The policy shift is considered as the next best thing after Den Xiaoping kick-started market opening in 1978.There is divergence of outlooks and prevalence of uncertainty questioning the growth once the reforms are in place. Deutsche Bank has given the most optimistic growth rate of 8.6 percent while Society Generale has predicted 6.9 percent growth.


Source: Bloomberg

The hike in the money market rates made the investors nervous, instilling a fear among them with the recent liquidity crunch crisis that China witnessed in June. But there is another dimension to it. China is a closed economy and it uses the models that are used by developed nations that are more open which may not give accurate results. The People’s Bank Of China can have a control over the interest rates for Money Market Operations. However it is not exercising its rights as it prioritizes control on inflation over focusing on reforms. There are very slight chances of a liquidity crunch affecting the economy.

The policy makers prepared the 60 point blueprint with emphasis on qualitative stable growth rather than pace. With stable growth there would be less room for unnecessary infrastructure, that requires high investment and also the wastage of resources could be eliminated. It has taken the measures to save itself from a potential credit crisis. Fiscal reform was cited as one of the main priorities in a document released after the plenum by China’s Communist Party leadership.

The reform included points such as ruling out the one child policy, permit private investment in state businesses and extension of land rights to farmers. The Asian stocks rallied after the details of the plan were unveiled. The Australian dollar outperformed better than its peers with some of the points such as the Hukou reform benefitting the Australian economy. The Hukou reform relaxes the permissions needed to relocate from villages to cities for employment that would boost the Construction industry as Australia’s largest contributor to exports is iron ore .The opening up of the financial markets focuses to improve the completion between the SOEs which are making huge losses and the private firms. Non Performing loans are a reason to worry for most of the State Owned Banks. Shadow Banking, which has become a reason to worry for the Government could be curtailed by bringing in the private players.

Figure 3

Source: Bloomberg

China’s commitment to to bringing the new reforms and the positive economic data for the latest quarter has managed to gain investor confidence .The reform path however has a difficult goal to achieve . Investment has a share of 50% in Chinese GDP. South Korea and Japan have these numbers as 45% and 36% respectively.

Figure 4

Source: Bloomberg

The investment had managed to provide double digit growth to the economy, but the excess investment has brought the law of diminishing returns into the picture. Pushing in of resources to maintain the growth rate is not sustainable which is evident from the chart depicted below.

Figure 5

Source: Bloomberg

There have been evidences that unwinding imbalances comes at a cost for the short term growth. Japan’s growth decreased by 75 percent in 10 years post peak investment, while that of South Korea decreased by 50 percent. China would face greater problems as investment share is greater than its Asian peers.

Corporate and Household debt in China has ballooned to 200 % of GDP in 2013 versus 130% in 2008.There have been attempts made by the policy makers to control this flood, with short term interest rates at elevated levels in November and December. This has affected the Equity market in China with the CSI 300 index falling by 1000 points in a timeframe of 3 years.

Figure 6

Source: Bloomberg

Deleveraging will have a negative impact on the growth looking at the past of developed economies. Output in the US and UK fell as the debt to GDP ratios dropped in the early 1990s.China’s leaders are taking steps to convert China, an investment driven economy to a consumption led economy. It is essential that the consumers to have the required purchasing power .However, the growth in income has reduced from 15.4 percent in 2011 to 10.2 percent in 2013.Deleveraging might bring down the asset prices, thereby hitting consumer confidence. Households are lightly leveraged and could take on more debt to provide some cushion to corporate deleveraging.

The fundamental purpose of the reform is to make China prosperous and improve the standard and quality of life of the people. It was in 2013 that Xi Jinpeng with his team laid the path to make China reach greater heights. 2014 would be the year in which they have to take new strides across the path that they have laid.

This article has been authored by Hrishikesh Rahatal from SIMSREE



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