China reforms – too little, too late

In the three critical areas, China’s new reform package has been remarkably brief and vague. 

Too much paeans have been sung in praise of the Chinese government’s new reform initiatives unveiled in November after the Chinese Communist Party Plenum. The government released a brief initial statement of reforms. It did not set create much excitement. The government was anxious to send the right signals to financial markets. Hence, two days later, it released a detailed list of reform guidelines with some specific measures. Quite why China was keen to impress international financial markets of its reform intentions is interesting in itself. Justified or not, China sees an opportunity in the policy fuddle in the United States. It sees the US dollar as a currency that is in an inevitable decline.


Internationalisation of the Renminbi is firmly on the agenda. China has been striking swap agreements with many Asian countries. It has allowed two-way direct quote on the Renminbi against the Australian dollar, the British pound and the Singapore dollar. Hitherto, that honour was reserved for the US dollar and the Japanese yen. But, these are baby steps. Much more has to happen before the Renminbi can mount a challenge to the US dollar as a global reserve currency, if at all is able to. Many reckon and Baretalk concurs that the Renminbi might become an international currency as several other currencies – the Swiss franc, the Canadian dollar, the Australian dollar, etc. – have become but it might not become a global reserve currency. That requires far more than economic heft and clout. But, that is not going to stop China from trying. That is what separates China from India. The former is ambitious, focused and never loses sight of the ultimate goal even if the progress is halting and slow. Further, no opportunity is too small to press ahead. That is the stuff of winners.

Capital account liberalisation is an important milestone in this journey. China has been liberalising its capital account rather slowly and correctly so, given the huge domestic credit bubble that it has yet to confront. Worse, China keeps resorting to pumping up credit to address even minor economic slackening. But, we will come to that in a while. China has created specific quotas for qualified international investors to invest into China stocks. That is a neat psychological ploy. It makes those investors and countries feel special. In reality, given China’s corporate fundamentals, it is not a privilege but a cross to carry. China’s stocks before the global crisis of 2008 were stark underperformers. Only in 2006, did they begin to generate investment returns only to slip into bubble territory quickly and burst shortly thereafter. Its recovery since 2009 was tepid to start with and has mostly evaporated. China’s stock markets remain the most severe indictment of the Communist Party’s model of capitalism with Chinese characteristics. However, this is not going to prevent international investors from investing on hope as they have been doing in other markets and stocks in recent years and decades.

As China contemplates more significant capital account liberalisation measures than these stock quotas, it has to ensure that there is international interest in the currency and that liberalisation does not lead to a one-way movement in the Renminbi with money flowing out. Smart Chinese residents taking money out must be met by inflows from naïve international investors led by Western investment banks. Hence, all the “song and dance” about the new round of China economic reforms as these banks are only too happy to oblige and humour the Chinese government.

Three main areas for reforms in China are excess capacity in several sectors, excessive borrowing by local governments and the persistent bubble in the property sector. In March 2007, former China Premier Wen Jiabao had gone on record calling the Chinese economy unstable, unbalanced, uncoordinated and ultimately unsustainable. In the six plus years that have gone by since then, the problems have become bigger. The perception and fear of a rising China, apparently strong Central government finances, capital account restrictions and the West’ economic hara-kiri have kept China afloat. One should not fail to mention the huge bargaining chip that China has. It has vast holdings of US Treasuries. It can hurt the United States (as much as it would hurt itself) if it began to offload them in the market. That threat has kept American money centre banks from precipitating a China crisis as they usually do in less important and less cooperative countries.

In the three critical areas that we mentioned earlier, China’s new reform package has been remarkably brief and vague. Local governments will not get any taxation rights and no new property sector bubble-control measures have been announced. The fountainhead of excess credit creation, misallocation and excess capacity is the mispricing of capital and the State (read ‘Party’) dominance of the financial sector. Banks do not have the freedom to price capital correctly – either when they lend it out or when they accept deposits. There is no time line on that reform. Even if there had been one, it might not happen because it would strike at the very heart of the control of the Communist Party over China’s economy and finances.

The reform package proposes introduction of competition in the banking sector, appointment of non-party talent in the management of state-owned enterprises, allowing markets a decisive role in the pricing of several other essential services and liberalisation of interest rates. The problem is that most of these have been proposed on several occasions in the last decade with precious little follow-through. There is no reason to believe that it would be different this time. If anything, entrenched interests might be more difficult to dislodge. The Party has gorged on the gravy train too long to let go of its control over the commanding heights of the economy.

In 2007 in the wake of the Wen Jiabao remarks on the China economy, Morgan Stanley’s Stephen Roach, a long-time China watcher and admirer, wrote thus on the firm’s research pages: For those of us in the West, this is a strong signal we need to update our perceptions of China. Think less of open-ended unbalanced growth and more of a somewhat slower and better balanced expansion.  Think less of an industrial-production dominated model with destabilising implications for natural resource consumption and the environment. Think more of a shift to consumption and ‘greener’ growth. Think also of macro stabilisation policies – not just those of central bank but especially those of the central planners at the NDRC – that will be used increasingly to up the ante on the tightening required to achieve these objectives. But don’t think for a moment that China will back down on the reforms that have driven nearly three decades of its extraordinary transformation. Time and again, China has used the reform process to spark key transitions in its development journey.  I suspect a similar transition is now at hand. 

Six and half years later, the ratio of Credit/GDP in China is more than 200 percent and the imbalance between investment (more) and consumption (less) has worsened further and changes have been pledged and proposed again. In the opinion of this columnist, China might have left its reforms a little too late. The path of least resistance for the Chinese currency is down, once the reform euphoria (resistance to reality) fades.

Indeed, the two behemoths of the world – the United States of America and China – are perched atop fragile and shaky foundations. They need nothing more than a small accident to collapse. Policymakers, with their unprecedented and untested experiments are working overtime to create such an accident. The world is on course to experience the chaos and vacuum of the interregnum between the two Wars. You heard it here first.

Photo: Wolfgang Staudt