The Challenges of Moving to a Market-driven Economy
Average annual GDP (gross domestic product) growth of 9.3 per cent since 1990, rapid opening up of the economy, which has seen exports and imports combined rise to 67 per cent of GDP from 30 per cent in the early 1990s, sharp increases in penetration of world export markets and the expansion of the non-state sector testify to the success of China’s development and reform model. A high savings rate and FDI (foreign direct investment) inflows of 3-4 per cent a year have allowed China to finance growth without building up external debt obligations, which remain low at 14 per cent of GDP. Robust external finances have provided an important cushion against external shocks and underpin China’s A- sovereign rating.
The structural transformation of the economy continues, with the latest phase being the emergence of the urban household consumer as a driver of growth. Urban household income levels in the richer provinces have reached thresholds where demand for consumer durables is starting to emerge rapidly. In addition, the sale of most state housing assets in recent years has spurred the development of the housing market and mortgage lending. Economic reform continues to progress, underpinned by China’s commitments under WTO membership to further liberalisation and in many areas based on a pilot-scheme model that has a good track record.
Operational restructuring of state-owned enterprises (SOEs) has been quite impressive with large-scale employment reductions, major divestment of smaller SOEs and improved profitability for the sector overall. And while the institutional framework for market based economic activity remains weak, efforts have been stepped up in recent years to strengthen property rights, enhance the legal status of private business and improve the regulatory framework. The recent acceleration in banking sector reform has been a notable achievement here, with the establishment of a specialised financial supervisory authority and advanced plans to introduce an element of foreign ownership into two of the large state-owned commercial banks.
Yet major challenges remain as China moves further along the transition from a centrally planned to market based economy. While the SOE sector has seen significant operational restructuring, balance sheet adjustment has advanced much less rapidly and SOE assets and liabilities have actually grown as a share of GDP. The latter remain over 100 per cent of GDP. This illustrates that the SOE sector, while of diminishing importance in economic activity, remains the dominant user of capital resources in the economy. Moreover SOE liabilities are concentrated in the poorer performing local government-owned SOEs. Despite banks having diversified their loan base significantly in recent years through the expansion of mortgage lending, SOEs remain their largest borrowing customers, absorbing the majority of credit. The exposure to SOEs forms a considerable chunk of Chinese banks’ non-performing loans (NPLs), which were RMB2.4 trillion at the end of 2003, equivalent to 20 per cent of GDP.
Concerns about banking sector weaknesses are amplified by unsustainably rapid credit and investment growth in the past couple of years. Bank lending has outstripped its long-run trend rate by about five percentage points over the past two years, taking the ratio of domestic credit to GDP to elevated levels of 150 per cent. With declining rates of return on investment and reports of heavy local government direction in the recent lending boom, it seems likely that the rate of NPLs on recent lending will be much higher than official figures suggest. Recent improving trends in asset quality are likely to have been flattered by the benign macroeconomic environment of rapid growth and low real interest rates. Even a soft landing scenario could see the overall NPL ratio increase significantly – a hard landing would be a major blow.
The recent investment boom has pushed the investment to GDP ratio to 44 per cent, a record high and nearly 10 percentage points above the average for the past 15 years. Part of the macroeconomic adjustment that is required over the medium term will entail reducing this ratio, with investment growing less rapidly than GDP for some time. But it will only be possible to achieve this while simultaneously keeping GDP growth around 7-8 per cent if other elements of demand – namely consumer spending – accelerate above 7-8 per cent. It remains to be seen whether macroeconomic policies can help achieve this or whether expenditure switching will have to occur at a lower overall GDP growth rate.
Policy adjustment has commenced and recent indicators have raised hopes of a soft landing with most forecasts seeing GDP growth slowing to around 7 per cent in 2005, from rates of 9-10 per cent recorded recently. But such expectations belie the extent of current macroeconomic policy challenges. With sterilisation of foreign exchange reserve purchases of over 10 per cent of GDP a year proving difficult and some reluctance to raise interest rates, the authorities have leant heavily on prudential and administrative measures to rein in credit growth. These have proved rather blunt instruments – threatening to transform a smooth deceleration in credit and activity into a more dramatic slowdown – and their initial application has been subsequently reversed.
At the same time, the political consensus behind tightening appears to be wavering somewhat. In the face of base money growth remaining close to 20 per cent a year and real interest rates that are turning negative, there is a risk of a premature pause in policy adjustment. In view of the inevitability of a policy-induced slowdown, this would only increase the chances of a more severe austerity programme – with bigger effects on growth – being required further down the track.