To tinker or to reform: that’s the financial dilemma facing China’s new political masters.
Once every 10 years the country’s Communist Party convenes to affirm its next generation of leaders. The latest transition began with its 18th Party Congress on the week of November 19, marking the beginning of the end of the 10-year reign of president Hu Jintao and premier Wen Jiabao in favour of a regime led by upcoming president Xi Jinping.
As Xi and his fellow officials ease into the seats of power, they will have to consider some big questions about China’s economic and financial future. In particular they must decide whether to embark on a far grander economic and financial vision than Hu and Wen managed to deliver.
National pundits have already dubbed the past 10 years a “lost decade”, characterised by missed growth opportunities.
In some ways it seems a harsh judgement. After all, during Hu’s time at the helm China’s industries grew quickly, its capital markets enjoyed early innovation including internationalisation of the renminbi, and during the pre-global financial crisis years the country routinely enjoyed economic growth of more than 10% per annum.
Yet the two are poised to leave office on a stagnant note, with the economy experiencing its slowest expansion since 2009.
“A lot of stuff needs to be finished from the last administration – the most important thing to focus on is making the changes,” says one economist.
Critics accuse Hu and Wen, the economic face of his administration, of failing to move the engine of China’s economy away from investment to consumption; of not encouraging more private enterprise; of failing to diversify corporate financing channels; and most damningly of not equipping the economy to withstand global economic volatility.
The upcoming administration, which includes key players such as Xi, Li Keqiang and Zhang Gaoli, will have its hands full making up ground [see respective boxes].
Economists believe that China needs genuine reform in many sensitive areas if it is to maximise its potential. These include interest- and exchange-rate liberalisation, an overhaul of accountability measures, and an industrial system not dominated by state-owned monopolies.
Additionally, the country needs major refinement of its existing infrastructure to distribute money to those companies and people that most need it.
Fail to tackle these problems fully and the country’s capital markets will have difficulty supporting its companies, which could lead the nation to another decade of lost potential. The challenge is how best to begin.
Personality politics
One thing is definite – bold new policies are unlikely to occur at the outset of a fresh administration.
China’s economic policy is overseen by collective party decision-making, spearheaded by the Politburo Standing Committee. This seven-person group of the Communist Party’s top leadership – which includes Xi and Li – makes decisions by consensus on the economy, legislation, security and propaganda.
But economic interests within the Standing Committee vary, while the new leaders have not had a chance to develop much personal authority. That means they will have little initial ability to stray from the chosen Communist Party message.
“The economy will continue to grow and the next administration will implement measures to further promote development. As for reforms, the key directions have already been outlined in the 12th five year plan and I don’t think the new administration or leadership will deviate much from those.” says Tao Wang, China economist at UBS. “I don’t think we can conclude yet that they are more progressive. They will still toe the Party’s line, but rising pressure and changed circumstances will likely push for more reforms.”
Despite this, gifted individual leaders can influence the direction and speed of reform in the system.
Deng Xiaoping, China’s enterprise-focused leader in the late 1980s and early 1990s, wasn’t wary of extending a hand to the West. He surrounded himself with like-minded military and political allies who gave him the bandwidth to modernise the country’s agriculture and manufacturing system, reversing Maoist order.
Likewise Jiang Zemin, president from March 1993 to March 2003, did not personally excel in economics so he selected Zhu Rongji to spearhead policy as premier. A confidant of Deng, Zhu helped lead China to achieve years of sustained 8%-plus gross domestic product (GDP) growth.
It needn’t be the very topmost officials that make the difference, either. While Hu and Wen get lukewarm marks for their oversight of China’s economy, individual agency leaders under them are far more warmly viewed.
Among them is Zhou Xiaochuan, the governor of the People’s Bank of China (PBoC). The 64-year-old, who is expected to leave his post at year-end due to retirement protocol, is praised by economists for his commitment to modernising the financial sector. He presided over events such as the gradual rise of the renminbi relative to the US dollar.
Likewise, Guo Shuqing is credited for progressive measures during his one-year stint as the chairman of the China Securities Regulatory Commission (CSRC), China’s capital markets regulator. These include spearheading efforts to open the country’s underdeveloped debt market, such as introducing a high yield bond market to let small- to medium-sized enterprises (SMEs) issue bonds.
Zhang Ping, chairman of the National Development and Reform Commission (NDRC), China’s socioeconomic development agency, is also viewed as a moderniser. During the 18th Party Congress, he spoke out about the need to promote research and technology to advance China’s industrial model.
But each of these individuals is likely to either retire or be moved into new roles when the new Xi-led administration assumes its role in March. Speculation within China is already flying about who will replace them.
Interest in rate reform?
Whoever ends up taking the reins of China’s central bank, CSRC and NDRC in 2013 will oversee areas in sore need of reform.
The consensus among China economists is that interest rate liberalisation is most essential. With this, Chinese lenders and borrowers can determine their own costs and better weigh funding opportunities.
China’s central bank has historically kept both lending and deposit rates low to support GDP growth. That allowed big-time industrial borrowers to access capital cheaply, which helped them fuel economic growth between 2003 and 2008.
But the situation has changed as China’s economy slowed. The central bank maintains stringent interest rate parameters that prevent corporate and commercial banks from reducing lending rates for borrowers, or raising them for depositors, beyond official limits. That stymies the ability of banks to attract new business or liquidity, crimping fair competition in the banking sector. This especially hurts smaller banks.
Interest rate reform is required to deal with the country’s new economic paradigm. And on June 8 the PBoC made an encouraging step when it announced a systematic cut of both one-year benchmark lending and deposit rates by 25 basis points (bp) to 6.31% and 3.25%, respectively – the first time it lowered its rates since 2008. The PBoC replicated the move a month later on July 5, lowering one-year lending and deposit rates by 31bp and 25bp, respectively, to 6% and 3%.
Economists agree that this was a breakthrough. But they insist the reforms are not enough.
“The expansion of the floating range for lending and deposit rates done in June...was a historic step taken already by the PBoC,” says Jun Ma, chief economist for Greater China at Deutsche Bank. “In the next few years we’re hoping to see more steps.”
The next would be for China to establish a deposit insurance system, so that further interest-rate liberalisation does not lead to runs at smaller banks. Next, the PBoC should expand the floating range for lending and deposit rates, followed by entirely abolishing regulated lending and deposit rates.
Lastly, the PBoC should switch its intermediate target for monetary policy to a policy rate.
“This means that there will no longer be benchmark lending and deposit rates but the policy rate will be the overnight rate or the seven-day repo rate,” says Ma.
Private sector pains
Interest rate reform would also be an initial step towards solving a larger problem: giving China’s smaller companies better and cheaper access to capital.
The country’s financial landscape poorly reflects its corporate sector. SMEs provide 80% of new jobs in the country, yet they have traditionally had more difficulty accessing bank loans than their well-capitalised state-owned peers, according to the Ministry of Finance.
This has especially been the case in recent years, when banks have come under pressure to control their lending lines and have responded by cutting lending to smaller companies first.
To add insult to injury, SMEs have found it almost impossible to tap China’s onshore bond market and far from easy to issue stock either.
In 2012, private companies accounted for just 1.68% of China’s Rmb1.09 trillion (US$174.64 billion) bond sales, according to financial analytics provider ChinaScope Financial. And while Beijing did open a new onshore high-yield market, which was touted as a key funding channel for cash-strapped SMEs, less than 30 companies received licences to issue debt during the launch.
SMEs are a small part of stock markets too. China’s state-owned enterprises (SOEs) comprised more than 73.44% of the country’s stock market capitalisation in 2011, up from 69.4% in 1999, according to ChinaScope.
“The Chinese stock market needs to better reflect the Chinese economy; that means seeing more small companies listed, rather than the state-backed enterprises that make up most of the market,” says the economist. “The stock market is still very underrepresented.”
Giving SMEs and private institutions greater access to financing opportunities will not be easy, particularly given the relationship between the country’s politicians and its SOEs. State-owned giants slowly contracted in the late 1990s and early 2000s, but the global financial crisis of 2008-2009 led a panicking Beijing to throw vast amounts of cheap money behind them in an attempt to maintain economic growth.
As a result they have become effective national champions in industries such as agriculture, financial services, power and transportation. They wield enormous financial and political power, which raises the dangers of cronyism and misallocation of capital, while preventing nimbler private sector rivals from flourishing.
“The economy is very dominated by very big and powerful SOEs and smaller players are having trouble competing with them – it’s a system that needs reform,” says Francis Cheung, head of China-Hong Kong strategy at CLSA.
Beijing should encourage the competitiveness of private enterprises by only investing in those SOEs based in select industries deemed critical to China’s security, rather than the widespread-funding it currently provides. Later on it should actively consider privatising non-core SOEs.
The government should also encourage banks and property officials to fairly consider private enterprises’ applications and contracts, rather than favouring SOEs. Giving private companies more access to bank loans, public debt and equities would offer them the necessary resources to compete against SOEs and promote innovation.
Growth beyond borders
The upcoming administration also needs to begin opening China’s economy to greater international participation.
Today foreign investors have very limited access to China’s capital markets. Only select fund management companies are allowed to enter its markets through the qualified foreign institutional investor (QFII) programme.
Beijing is slowly letting more foreign capital in. It raised the ceiling of investments allowed under QFII licences from US$30 billion to US$80 billion in April. Additionally it expanded its renminbi QFII programmes (or funds raised by the offshore divisions of mainland financial institutions in offshore renminbi for investment into the onshore markets) by Rmb200 billion from Rmb70 billion in November.
Yet both programmes severely restrict investment and dictate the specific areas in which they can invest. Likewise, local investors and companies face heavy restrictions from participating in overseas capital market activities, even the offshore renminbi bond market.
Additionally, while the Chinese renminbi exists onshore and offshore it is not freely transferrable between the two versions, which has resulted in lopsided exchange rates between the two and other currencies. On December 14 one US dollar was worth Rmb6.2439 of the onshore currency, while if fetched Rmb6.2198 of the offshore version of the renminbi.
These limitations are particularly ironic given China’s stated plan to make its currency fully convertible by 2015 and its capital account fully open by 2020 in advance of Shanghai becoming a global capital markets centre.
“What the new administration can improve on versus the outgoing one is to work on patching holes before the next issue comes up – it’s a Whack-A-Mole approach to the economy where the market has to ask itself where is the next mole going to pop up,” says Jason Mortimer, a rates strategist at J.P. Morgan.
China’s new administration needs to liberalise if it intends to make the renminbi a truly global currency.
While the ultimate goal should be full convertibility, it will take time for the Communist Party to be convinced that it is in the country’s interests to surrender its iron control of the currency’s value. But Beijing’s new leaders can begin easing their hold on the renminbi through smaller movements.
Approximately 1% of renminbi money supply is held offshore, in contrast to 30% of US dollars, according to Deutsche Bank. China could easily triple its current supply within a short period if it desires, which would help to mitigate the price differential between onshore and offshore money.
Following that, China must allow its currency to naturally appreciate or depreciate against other currencies. This means widening the daily renminbi trading band against the US dollar –
a move that it has slowly adopted within the past year.
In April, the PBoC expanded the daily renminbi trading band from 0.5% against the US dollar to 1% to cool appreciation pressures. But again, many foreign observers think the move was too cautious.
“Regulators need to continuously widen the band until we have a freely floating currency – or at least a lightly managed one – that is subject to more volatility,” says Mitul Kotecha, head of global foreign exchange strategy at Crédit Agricole. “Then it will have greater ability to be used for trade and convertibility.”
To facilitate the renminbi’s use internationally, Beijing should be more lenient to offshore banks that are already central players in its daily usage, for example by letting them clear renminbi trades. That would help them encourage their corporate clients to settle trades in the currency.
Additionally, global banks could be given greater access to the interbank bond market and multinational corporates using the renminbi offshore should be offered the ability to set up onshore bond programmes.
As China looks to play a more primary role in the global capital markets, it would make sense to nurture relationships with the players that are already diligently participating in its offshore renminbi market. It is something that financial regulators in Beijing could enact with the swish of a pen.
Finding solutions
These are important but surmountable challenges for China’s new rulers. They should tackle them head-on with confident market reforms rather than tweaking stagnant policies, as per the previous administration.
For example, Xi and Li should extend existing capital-market pilot programmes for select investors, issuers, companies and citizens to the market as a whole.
The caution of China’s outgoing leaders led the country to miss several opportunities. Its new heads must be bolder if its financial markets are to progress enough to sustain continued economic development.
Doing so is hard, but not impossible. Former leaders Deng and Jiang demonstrated what is achievable with enough will.
Deng clawed the country away from the commune mentality set in place by Mao, incentivising farmers to work for riches rather than community and designating special economic zones across the country. And Jiang unveiled a sweeping gambit to privatise China’s monster SOEs at a time when the Party adored its comfy positions.
China’s new leaders must draw inspiration from such bold predecessors to get the country moving from a lost decade into a defining one.
