Economic Research:

China: Our Post-Plenum Prognosis

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Table Of Contents
Reality Check: This Is A Political As Well As An Economic Exercise We See Several Major Reform Areas Decoding The Implications For The Role Of The Market Notes

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China: Our Post-Plenum Prognosis

The Chinese government has recently completed its much anticipated Third Plenum (of the 18th Central Committee of the Chinese Communist Party) under new President Xi Jinping. Expectations were high, with some analysts calling this the most important plenum since Deng Xiao Ping's Third Plenum in the late 1970s. The official post-event communiqu was seen insipid and fell well short of expectations. However, the government's subsequent clarifications have, on balance, not disappointed in the scope and breadth of the proposed reforms. (1) Reading through the proverbial tea leaves, one can even see emerging the meaning of the "decisive role" for the market. As ever, implementation will be critical. Overview Following the flop of the communiqu following China's Third Plenum, subsequent details provided by the government suggest that the reforms under consideration could be quite significant in reorienting the economy, once implemented. Most importantly, a series of microeconomic reforms seek to rationalize prices of inputs and financing, and increase competition. These should lead to better resource allocation and efficiency. However, the likely effect on rebalancing would appear to be modest. In keeping with the past, the pace of reforms is likely to be incremental, with initial measures being targeted and heavily monitored before allowing for broader application.

Reality Check: This Is A Political As Well As An Economic Exercise

Before identifying what we see as the key economic reform measures coming out of the Plenum, it is perhaps useful to put the event in context. It is much more than a discussion about economic and social policy, although the English translation of the title of the detailed statement was called "The Decisions On Major Issues Concerning Comprehensively Deepening Reform." As an example, the second paragraph of the resolution is as follows: "To comprehensively deepen reform, we must hold high the magnificent banner of Socialism with Chinese characteristics, take Marxism-Leninism, Mao Zedong Thought, Deng Xiaoping Theory, the important "Three Represents" thought and the scientific development view as guidance, strengthen self-confidence, concentrate a consensus, comprehensively plan matters, move forward in a coordinated manner, persist in the reform orientation of the Socialist market economy, stimulate social fairness and justice, and enhancing the people's welfare as starting point and stopover point, further liberate thoughts, liberate and develop social productive forces, liberate and strengthen social vitality, resolutely eliminate systemic and mechanistic abuses in all areas, and strive to open an even broader prospect for the undertaking of Socialism with Chinese characteristics." Needless to say, some of the reform measures have to be teased out of the text. Nonetheless, taken as a whole, we see the proposed reforms as quite significant. And the expectation, based on past plena, is that measures will continue to

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Economic Research: China: Our Post-Plenum Prognosis

be rolled out in the months ahead.

We See Several Major Reform Areas

We expect that the list of reforms coming out of the Plenum will grow. At this juncture, we can group the measures into a number of key areas. We note that a new body reporting directly to President Xi will be responsible for seeing through the reform process. While some commentators see the formation of this new body as a potentially dangerous concentration of power, it will supersede the authority of the National Development Reform Commission, which is widely seen as a conservative, slow-moving body that oversaw the reform process in the past. Also, the government has for the first time set a target date for implementing some key reforms.

Land rights and local government financing

The confiscation of, or underpayment for, land by local governments as part of their urbanization and industrialization process has been a socially contentious issue in China. An outcome of the Plenum was the introduction of tradable land usage rights. The creation of these rights should result in a market that will allow citizens to sell usage rights to local governments or anyone else, thereby forcing the buyer to pay market rates. This reform will have several implications. It will raise the income (and wealth) of local citizens, raise costs for local governments, and improve resource allocation since purchasers of land will now pay market prices. As a way to at least partly offset higher costs for local governments, the current sharing arrangement for the value-added tax (75% for the central government, 25% for the local government) will be revisited. Also under consideration is allowing some local governments to directly issue bonds, although market participants think that this will be on a limited basis and gradual.

Liberalization of deposit interest rates

Another key distortion in the Chinese economy has been the mispricing of funding, in particular deposit rates. Real deposit interest rates have been negative for most of the past decade--in contrast to the preceding decade. This amounts to a tax on savers and a subsidy to banks and, to the extent it is passed onto borrowers, a subsidy on credit. While language in the Plenum resolution was somewhat vague, the view in the market is that measures regarding liberalization of deposit (and funding) interest rates will move further ahead in 2014. An early key measure would be introduction of certificates of deposit (CDs). Importantly, there is no interest-rate cap on CDs, so issuers can offer higher rates to attract funds. In opening up this market, a logical and often-mentioned sequence begins with banks, then moves to other financial institutions, and then to corporates and households. Another measure would be to lift the cap on interest rates on longer-term deposits to introduce competition in that market, and then gradually move down the yield curve. Finally, to protect smaller banks from a migration of deposits, a deposit insurance scheme could be introduced, protecting all bank deposits below a certain threshold. A deposit insurance scheme would also serve to reduce "moral hazard," a term used to describe "excessive" risk taking and an increase in financial sector vulnerability as a result of implicit or explicit government guarantees. As we noted

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in our commentary on the Chinese interbank market (see "Credit FAQ: Top-10 Investor Questions On The Chinese Interbank Market And Financial Stability," published July 4, 2013, on RatingsDirect), the general perception is that the government virtually guarantees in some form all financial instruments in China. This leads to an underpricing and oversupply of risk in the system. Deposit insurance can help mitigate this moral hazard by moving toward a system where the types of assets that are guaranteed are made explicit.

Other financial sector measures

The Plenum also included a number of other measures to liberalize the financial sector, most notably allowing private companies to start new banks. The intent is to allow banks funded by private capital entry into the market. While implementation is likely be to gradual and the initial entrants will be symbolic, private banks will serve two key roles: First, they will likely cater to small and midsize enterprises (SMEs), which are often crowded out of credit markets by state-owned enterprises (SOEs) that have strong relationships with state banks (which are also SOEs) as well as implicit state backing. Second, privately funded banks will likely be run more on a commercial basis. Their behavior could have "demonstration effects" that could, over time, influence behavior of the state-owned and joint venture banks. The Plenum also proposed a significant change in the investment regime. This relates to a change from "positive lists" to "negative lists." In essence, the government will now inform investors--both foreign and domestic--what they cannot invest in. Anything not on the list will be allowed. Many have advocated this measure for some time, and its announcement was received quite favorably by various business groups. The negative list will not apply everywhere; however, it will not necessary be limited to the recently created Shanghai Free Trade Zone, as was previously thought. Some other financial sector measures mentioned in the document include: Increasing the quotas for qualified foreign and domestic institutional investors (QFIIs and QDIIs), a form of capital account liberalization. Exchange rate liberalization, likely through gradually widening the trading band for the Chinese renminbi. Encouraging the establishment of a securitization market. This will allow banks and other entities to bundle and sell assets, thus freeing up their balance sheets. Encouraging the development of direct financing through stocks and bonds.

Labor market and population measures

The "hukou" system constrains labor market mobility in China. In this system, social benefits are closely related to a person's registered locality. While workers can migrate to try to find work elsewhere, they would find it more difficult to claim social benefits, a significant disincentive. With the labor market getting tighter in recent years, this system was seen as overly restrictive. The Plenum proposes to ease controls over access to local registration, helping to increase labor mobility. As with other measures, the rollout will be measured, and initially the restrictions will be eased for workers in second- and third-tier cities. The Plenum proposes to relax China's widely known (globally), and quite unpopular (domestically), one child policy. As with the hukou reform, the reason for this proposed relaxation is the tightening labor market. Indeed, by some measures, Chinese labor force growth has already peaked and will contract at an accelerating pace as the one child policy works its way through the demographic structure. The reform seeks to loosen the policy for couples where one

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of the parents does not have a sibling (the current one child policy has some exemptions, including for rural families). We expect any further measures to be gradual. And any effect on the demographic structure, the workforce in particular, will take time to manifest.

Reform of state-owned enterprises

The final set of key reforms relate to SOEs, which dominate China's key industries. While SOE reforms were mentioned upfront in the communiqu and the subsequent resolutions surrounding the Plenum, these strike us as rather modest. The state will maintain its dominant role in the SOEs, and we expect only limited private competition in these markets. Nonetheless, some measures came out of the Plenum that will lower the perception (and reality) that SOEs receive preferential treatment. The first is an increase in the profit surrender ratio to the central government to 30% from 15%. The second is that prices for industrial inputs such as coal and water will be more market-based to reflect social, including environmental costs. (Improving the environment through more rational growth policies received substantial coverage in Plenum documents.) Related to these measures, both of which will have a negative impact on profitability, more SOEs will be allowed to issue equity to broaden their funding. Using the state banks as a model, the thinking is that equity issuance would be in the range of 15%-20%. Aside from easing funding conditions, the equity issuance would help transparency, given disclosure requirements in capital markets.

Decoding The Implications For The Role Of The Market

In our view, the meaning of the Chinese authorities' pronouncement of a "decisive role" (as opposed to a "basic role") for the market is emerging. This has several dimensions. Foremost, input costs are moving toward market prices. This includes land, labor, and financing, which have all been underpriced. The higher input costs will reduce overuse of these factors of production. This will have consequences for investment growth, as well as the physical environment. Relatedly, various subsidies, both implicit and explicit, are being reduced. These microeconomic reforms should together improve resource allocation. Considering the transitional costs of moving toward market-related input prices, the government is proposing several ways to soften the blow. The sharing of more central government revenues with local governments will partly compensate for the higher costs. And at least some entities at both the government and SOE level will be allowed to tap the capital markets for new funding. Finally, how do all of these reforms relate to rebalancing the economy? In our view, they would appear to have transitory benefits at best. While resource allocation and efficiency and productivity growth will improve, the main drivers of China's low private consumption ratio--the desire for fast growth and the desire to run an external surplus--remain. The government is committed to doubling GDP by 2020, implying growth of about 7% in real GDP, roughly the current level. It has also shown no evidence of a desire to avoid running external deficits, except on a temporary basis. As our research shows, China faces a trilemma. (See "The Unpleasant Math of Raising China's Consumption-To-GDP Ratio, published Nov. 21, 2013.) It cannot have fast GDP growth, a rising ratio of private consumption to GDP, and an

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external surplus at the same time; it must choose two of these three objectives. So while microeconomic reforms are welcome, and can improve efficiency and productivity growth, and thereby create space for higher consumption over the medium term, they cannot be a long-term solution to China's rebalancing challenge.

Notes
(1) The official text in Chinese can be found in http://www.gov.cn/jrzg/2013-11/15/content_2528179.htm while an unofficial English translation can be found in http://chinacopyrightandmedia.wordpress.com/2013/11/15/ccp-central-committee-resolution-concerningsome-major-issues-in-comprehensively-deepening-reform/)

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