China’s macroeconomy in the ‘new era’ of politics and power
Changes in annual economic indicators are better than expected
All major economic indicators in 2017 are at least acceptable, with some exceeding expectations.1 China’s GDP reached RMB82.7 trillion, an increase of 6.9% that has reversed a downward growth trend for the first time since 2011, contributing more than 30% of total global growth. As for economic activity, 13.51 million new jobs were created in 2017, maintaining the record of more than 13 million for five consecutive years. The number of newly registered enterprises amounted to 6.07 million, up by 9.9%. Regarding economic structure, the dominance of the services industry became more prominent. The proportion of tertiary industry in GDP was 51.6% – 11.1 percentage points higher than that of secondary industry. The services industry contributed 58.8% to economic growth, an increase of 1.3 percentage points over the previous year. Consumption continued to be the driving force behind economic growth, totalling 58.8% – 26.7 percentage points higher than the gross capital formation.
Regarding economic quality, energy consumption per RMB10,000 GDP dropped by 3.7% compared with 2016; and the author believes that most people will have personal experience of environmental improvement and more effective pollution control. The increase in residential consumption is apparent: the Engel coefficient was 29.3%, down 0.8 percentage points over the previous year. Per capita expenditure in 2017 was 11% on healthcare and 8.9% on education, culture and entertainment. With the further concentration on the ethos of ‘manufacturing, service plus internet’ and accelerated online and offline integration, high-end consumption began spreading further into middle-income groups.
In conclusion, the macroeconomy grew steadily in 2017, manifesting generally benign changes. Supply-side structural reform is gradually taking effect. Since the 18th National Congress of the Communist Party of China (CPC) in 2012, a roll-out of crucial reform measures has improved the efficiency of resource allocation, total factor productivity and advanced macroeconomic development. For instance, there was strong support for reforms prioritising the household registration system; the policy encouraging rural migrant populations to relocate to cities was fully implemented nationwide2; endowment and medical insurance were enacted in urban and rural areas3; and a unified fund was established to ensure resources for compulsory education in all regions.4
China also pushed ahead with market-based reform in the exchange and use of land: rural collective construction land will now, like urban land, enter the market under new land-use regulation5; rural rights on ownership, contract and management have been separated and the exchange of land has been enabled6; and agricultural product price reform7 has optimised the allocation of land use.
China has accelerated the pace of ‘opening‑up’ to the outside world by introducing a management model of pre-establishment national treatment with a negative list, in accordance with the principle that such a model can be copied and with the expectation that the model can be applied to other areas. It has also implemented a high-level trade and investment liberalisation facilitation policy to reduce import tariffs and cut trade barriers. China’s business reform focused on removing inappropriate administrative controls and drastically lowering the threshold for access to the free market. Meanwhile, China has implemented judicial reform: the Supreme Court set up six circuit courts to achieve full coverage and carry out more contracts; and trials in cross-regional civil litigation cases have been made fairer. In addition, China has set up intellectual property courts in Beijing, Shanghai and Guangzhou to strengthen the protection of property rights. All of these measures have markedly improved the business environment in China – it now ranks 78th out of 190 economies, 18 places higher than in 2013.8
Demand management and supply-side structural reform
No target for GDP growth was proposed at the 19th CPC National Congress, but China must continue to maintain an appropriate economic growth rate to turn the ‘two-step’ blueprint for development – China realising socialist modernisation by 2035, and becoming a modern, prosperous nation by the middle of the century – into a reality. Realism is required to maintain economic growth within the correct parameters and achieve high-quality development. China’s macro policy must focus on supply-side structural reform as there is only limited policy scope for implementing demand management in the coming period.
1. Fiscal and monetary aggregate policies are limited. On the part of fiscal policy, there is little scope for large-scale, concentrated infrastructure development after so many previous rounds of stimulation. On the one hand, the local debt risks proliferate, and infrastructure debt should not be increased further. On the other, it is quite reasonable to carry out infrastructure development such as transportation in accordance with the principle of advancement. A balance should be struck: with the development of a metropolitan-centred urban belt and a people-oriented urbanisation process, ample and sustained latitude exists for economically viable investment in infrastructure.
In terms of monetary policy, China’s monetary multiplier has risen rapidly, from 3.86 in 2012 to 5.02 in 2016, while the ratio of M2 to GDP has increased from 180.3% to 208.3% over the same period,9 indicating rapid economic monetisation. The GDP growth rate has, however, been declining simultaneously, indicating that the expansion of the money supply is impacting less on the economy. To this end, stimulus through monetary policy will only aggravate over-monetisation and further amplify the shift from a real to a virtual economy while playing a limited role in stimulating economic growth.
2. Greater latitude is needed for fiscal policy to focus on structural adjustment in line with supply-side structural reform. Tax relief can help enterprises increase investment in research and development (R&D), as well as enhance economic vitality through innovation. Efforts can be made to cut overcapacity in expenditure, reduce excess inventory, deleverage, lower costs and strengthen areas of weakness through readjustment of expenditure. Resources can also be guided to industries more in line with macro-control measures to improve the diversity and quality of supply. Fiscal policy has much to offer in these areas. Monetary policy, in principle, has all the attributes required without the need to adjust the structure. Against the backdrop of a ‘new normal’ in the economy, save for major external shocks or internal systemic risks, the adoption of monetary distortions similar to US monetary policy or European Central Bank structural policy instruments will be unnecessary. The European Union has a single currency, but no unified finance, so must adopt monetary policy tools to achieve structural adjustment.
3. Supply-side structural reform should be problem-conscious and focused on long-term goals and dedicated effort. A report from the 19th CPC National Congress states that: “As China’s socialism with Chinese characteristics has entered a new era, the principal contradiction facing Chinese society has evolved. What China now faces is the contradiction between unbalanced and inadequate development and people’s ever-growing needs for a better life.” The report records the unwavering national reality that China is, and will in the long term remain, at the primary stage of socialism. Its international status as the largest developing country has not changed. Supply-side structural reform must, on the one hand, adapt to the change in social contradictions, be problem-aware and serve high-quality economic development; and, on the other hand, emphasise long-term goals and institution-building and continue to introduce reform measures to increase effectiveness year-on-year.
Key issues regarding supply-side structural reform
China’s economic development is still confronted by two deep-rooted contradictions. One is the reality that economic and social development cannot be advanced merely by will alone. The other is efficiency loss, caused by the distortion of institutional mechanisms, which can be corrected through reforms that aim to improve the efficiency of resource allocation and further boost economic growth.
With regard to objective reality, improvements can be made in advancing economic and social development with the aid of supply-side structural reform, but fundamental change is not possible. For example, China has experienced a decrease in its workforce since 2015, and this trend is accelerating. In 2017, the working population aged between 16 and 59 years was 902 million, a decrease of 5.48 million on the previous year. The population over the age of 60 years reached 241 million, an increase of 10 million on 2016, and accounts for 17.3% of the total population.10 The two-child policy, introduced in 2015, has helped increase the population and the supply of future labour, but the recent drop in labour force participation has become a risk factor and has made the future unpredictable.
A roll-out of crucial reform measures has improved the efficiency of resource allocation, total factor productivity and advanced macroeconomic development
China has stepped up efforts in environmental protection and pollution control to meet the public’s need for a better life. But there may be some trade-off, as development that caused increased pollution also resulted in GDP growth. In addition, the external environment is tumultuous – trade protectionism is on the rise. Supply-side structural reform must be concentrated on improving the identification of problems or making appropriate delays. China must, while boosting high-quality economic development, avoid major fluctuations and maintain growth.
Supply-side structural reform must contend with the distortion of institutional mechanisms and prioritise the following
1. Promoting the free flow of factors. The pace of urbanisation has accelerated; the reform of the household registration system has been comprehensively carried out; rural land transfer has been piloted; market-orientated allocation of land-use patterns has also made remarkable progress; some inefficient planting areas have been gradually withdrawn, and thus the agricultural production structure has been improved. The area allocated for the production of maize, with a high inventory in 2017, was reduced by 3.6%, while the allocated area for bean sowing was increased by 6.7%.12
Many obstacles stand in the way of the free flow of factors. Labour mobility, restricting people’s ability to obtain cars and houses and enrol in higher education, through permanent resident permits, is still relatively common in some cities, which is not only a hindrance to the free movement of workers, but also to the improvement of income distribution as, according to the theory of development economics, the transfer of citizens living in agricultural regions to non-agricultural sectors improves income distribution. China’s Gini coefficient was 0.467 in 2017, having risen for two consecutive years. Although this magnitude is small, it highlights that, despite accelerated urbanisation, barriers to the free flow of population widens the gap in income distribution. Efforts must be made to remove all benefits attached to household registration, advancing ‘equal rights for tenants and homeowners’,11 providing both with access to basic public services and promoting the free movement of the labour force. This will help improve total factor productivity, advance income distribution and reduce labour costs.
2. Streamlining administration and cutting taxes and administrative fees. Since the 18th CPC National Congress, strenuous efforts have been made towards reforming business, streamlining administration and delegating government powers. The next step is to reinforce institutional reform. In terms of tax cuts, annual revenue for 2017 was RMB17.3 trillion, an increase of 7.4%. This growth rate shows the effectiveness of tax cuts – if fiscal revenue is synchronised with a nominal GDP growth rate of 10.5% (6.9% plus 3.6% deflator), the fiscal revenue for the full year should be RMB17.8 trillion, and the RMB500 billion increase on actual income shows the effects of tax relief. Given better connectivity between fiscal income and the producer price index (PPI), estimated tax cuts would be even greater if calculated with 6.3% of PPI in 2016.12 This highlights the obvious effect of China’s tax reduction. In 2017, raw material prices rose by more than 8%, PPI by 6.3% and consumer price index by 1.6%, indicating that pressure is moving to the middle- and low-income groups. More taxes apply to high-income groups, but a limited adjustment to income distribution is effected. Further analysis reveals that there remains scope for additional tax cuts: the push for income tax reform, increasing deductions from corporate income tax in R&D, transferring personal income tax to comprehensive collection, reducing the tax burden on low-income groups, avoiding personal tax’s evolution into payroll tax, and forming reverse regulation. Additionally, administrative fee cuts and charges for non-administrative licensing projects lacking a statutory legal basis of the higher authorities have been cleared at central government level. However, a persistently large number of fee-charging items not covered by local government laws should now be the focus of the next step toward lowering costs.
3. Enhancing protection on private investment. Since 2010, China’s consumption has exceeded its investment. It is widely believed that economic growth has reached a turning point towards being primarily driven by consumption and supplemented by investment. In fact, investment – especially private investment – still has great potential for growth. Internationally, both Japan and the Republic of Korea have experienced high investment and high growth for a significant amount of time. Domestically, despite the rapid increase of resident leverage in recent years, the upturn in residents’ disposable income is still higher than that of consumption, which means savings are still rising. Eventually, residents’ leverage ratios will steadily decline, and the savings rate can be maintained at a certain level, which can lay a foundation for substantial investment growth. Moving forward, under the context of a limited space for concentrated governmental investment, China will focus on strengthening the effective protection of property rights and contracts and improving legal justice to provide a guaranteed external environment for the survival and development of enterprises – especially privately-owned enterprises – and fully mobilise the enthusiasm for private investment.
4. Continuing opening‑up to the outside world and advocating globalisation. China will firmly safeguard multilateralism, support the multilateral trade system, oppose various kinds of protectionism and build an open world economy. It will strengthen its involvement with international economic and trade rules, implement more active import policies, ease market access in the financial services industry and continue to expand market access in other fields. China will establish international advanced rules as the standard, give free-trade zones greater reform autonomy and improve their quality. Based on the lessons of free-trade zone pilots, China will implement pre-established national treatment with negative lists to create a fair, transparent and predictable market environment under the rule of law. If the flow of elements, the streamlining of administration and delegation of powers, the protection of private investment, and the continued and reinforced opening‑up are in place, the business environment in China will further improve. There is also reason to believe that the economic growth in the next period will be maintained at a high level of greater than 6%.
5. Preventing and resolving financial risks. Failure to achieve this could lead to subversive consequences. Currently, the ratio of M2 to GDP in China exceeds 200% – roughly equal to that of Japan and more than double the US’s 91%. However, the average one-month Shanghai Interbank Offer Rate (Shibor) in 2017 in China was 4.09%. In the same period, the comparable interest rate in Japan was –0.01%, and that of the US was 1.1%.13 China’s monetary environment is more relaxed while the cost of capital is even higher, indicating a serious distortion of the financial system. Overmixed operation – ‘comprehensive management’ – has caused financial chaos; there is a wide variety of derivatives with Chinese characteristics: peer, channel, nesting, capital pool, universal insurance of Ponzi financing, peer-to-peer, non-standard and payday loans superimpose on one other, resulting in the cost of capital constantly rising and the real economy becoming exacerbated. Simultaneously, channels of risk transmission are extremely opaque. Compared with the US financial market a decade ago – where the characteristics of risk and reward for various derivatives, such as mortgaged-backed securities (MBSs) and collateral debt obligations, were not fully understood although they are now fully recorded – China is even more chaotic and needs to scrutinise the underlyings of the products to identify the true risks and benefits. In addition to conventional banking, securities, insurance and funds, new and innovative financial and quasi-financial institutions with Chinese characteristics and regional exchange markets have been created. In this way, it is very likely that there are systemic financial risks in China. The immediate task is now to win the battle of risk prevention and control.
China can overcome this difficult challenge with hard work. First, senior leaders must understand the situation. President Xi Jinping advised at the 2015 Economic Work Conference that China “must step up the special rectification of financial risks and resolutely reject systematic regional risks”. Taking the US scenario a decade ago as an example, Hank Paulson, former US Treasury secretary, explained to the author that shortly after he had taken office in 2006 he felt financial risks were swirling like a brewing storm, but there was no consensus in society and no means of preventing the outbreak of risks.
Second is an understanding of the situation by governments and financial institutions. Following President Xi’s instructions, governments, and regulatory agencies in particular, have already taken actions to request the return of assets, tighten their trade contracts and strictly control disguised bonds issued by local governments. Financial institutions are also stepping up their efforts to control risks. This highlights that society has recognised the occurrence of a ‘grey rhino’ incident. At that time, there was no consensus in the US financial community except for warnings from a handful of people such as Paulson, economist Ben Bernanke and former president of the Federal Reserve Bank of New York and Secretary of the Treasury Tim Geithner. At that time, the grey rhino was merely a possibility and there was no expectation that the grey rhino would turn into a ‘black swan’. Crisis accumulation is competing with consensus on remediation formation – the former has been running in front, and there was no remediation of chaos or consensus on rescuing a systematic outbreak of risk until the downfall of Lehman Brothers and the emergence of black swan incidents.
China has stepped up efforts in environmental protection and pollution control to meet the public’s need for a better life
Third, awareness of the key risks is essential. President Xi once said: “We must not forget that housing is for living in, not for speculation”, and “Finance should return to its origin and serve the real economy”. This emphasises that the major risk points are financialised real estate and unanchored finance. Before the outbreak of the financial crisis in the US, the American Dream of owning a home was embraced by all US citizens, regardless of how implausible it was to achieve. Financial markets were subsequently flooded with MBSs, with mortgages as underlying assets and derivatives. Eventually, these became intertwined, giving rise to risks.
Fourth, the overall environment must be considered. After the outbreak of the financial crisis, the Group of 20 summit and a series of financial channel meetings saved the global economy with joint efforts, and aided the prompt formation of consensus on strengthening financial supervision and helped to roll out concrete measures. There is reason for confidence, as China’s supervision of major financial institutions is now effectively in line with international standards, and major financial institutions are relatively healthy. In the US, where the environment was not so good when the crisis broke out, risks were concentrated in seven major financial institutions.
The comparison drawn between the US and China during the financial crisis offers a number of lessons – many of which are unique to China. These include the proliferation of transactional derivatives with Chinese characteristics, and the establishment of new and innovative financial and quasi-financial institutions and regional exchange markets with Chinese features, as well as difficulty in regulation. Combating financial risks is a long-term prospect, as Liu He, vice premier of the People’s Republic of China, said earlier this year at the World Economic Forum Annual Meeting in Davos: “We will strive to win the battle against financial risks in the next three years or so.”14 If the problem can be resolved in around three years, so too can the problem of high nominal interest rates.
Fifth, China’s introspection towards its future financial model must be considered. It is interesting that China is a global financial market, while mixed operations are rapidly developing with high risks. In the past, some local leaders have been keen on developing local trading markets, but found it too difficult to exercise regulation. Risks in regional markets will inevitably face spillovers that can be very tricky to handle, which is why these leaders are carefully reviewing these issues.
As making qualitative judgements on future patterns becomes increasingly challenging, the author posits the following:
President Xi emphasised that “finance should return to its origin and serve the real economy”. Should we adhere to the mode of mixed operation to have finance return to its origins? Are we capable of confronting complicated challenges on financial regulation brought by mixed operations? Is it necessary for financial institutions to bear high compliance costs once mixed supervision is implemented? Is it necessary for the real economy to pay excessive nominal interests? Is this due to high compliance cost spillovers or high-risk pricing brought by overmixed operation or multiple derivatives. In the 1990s, then-Premier of China Zhu Rongji insisted on separate management, knowing that mixed operation was destined to fail at that particular stage, as citizens were neither well disciplined nor law-abiding enough, and institutions lacked the capabilities of regulation.
Under his insistence, The segregation supervision pattern of the China Banking Regulatory Commission, the China Securities Regulatory Commission and the China Insurance Regulatory Commission was established, meaning financial institutions would be split according to their main businesses.15
In January 2010 – in the wake of the financial crisis – Nobel Prize winner and economist Paul Krugman wrote: “The US must learn from its neighbour, Canada. More specifically, Canada places more stringent restrictions on the leverage of the banking sector and limits the securitisation process. These constraints in Canada in recent years, undoubtedly, have made bankers lose many opportunities to come up with so-called clever ideas, but these restrictions have all proved to be correct.”16 Observations of financial markets worldwide often find that those in Canada are considered the most ‘boring’ as financial authorities strictly regulate and control mixed operation, limit the appearance and trading of derivatives, prevent infection of financial risks and make every effort to enable financial consumers to achieve the co-ordinated development of finance with the real economy. However, even after the global financial crisis, Canada’s banking system was still rated by Standard & Poor’s and the International Monetary Fund as the healthiest banking system in the world. Its experience therefore deserves our attention and reflection.
The report of the 19th CPC National Congress reminds us that the great rejuvenation of the Chinese nation can by no means be easily achieved and the endeavour to accomplish the two centenary goals will not always be smooth. President Xi’s remarks in January 2018 implore China to ramp up its vigilance towards danger and perservere in preventing risks.
As long as China conscientiously implements the spirit of the 19th CPC National Congress, persists in deepening supply-side structural reform and resolutely guards against risks and challenges – particularly keeping away from global risks that may delay or interrupt the great rejuvenation process and high-quality economic development – we will certainly be able to fulfil the Chinese Dream of rejuvenating the Chinese nation.
1. Data in this paragraph comes from National Bureau of Statistics of the People’s Republic of China, Steady and excellent economic performance in 2017, Better than expected 2018, http://bit.ly/2prfCPH
2. Notice of the General Office of the State Council on issuing a plan to promote the settlement of 100 million non-permanent registered population in cities (promulgated by the general office of the State Council  no. 72).
3. Opinions of the State Council on establishing a unified system of basic endowment insurance for urban and rural residents (promulgated by the State Council  no. 8).
4. Notice of the State Council on further improving the funding mechanism for compulsory education in urban and rural areas (promulgated by the State Council  no. 67).
5. Decision of the CPC Central Committee on several important issues of comprehensively deepening reform.
6. The General Office of the CPC Central Committee and the General Office of the State Council opinions on improving methods of separation of ownership, contracting and management in rural areas.
7. The price reform of agricultural products mainly includes the pilot projects of price reform of cotton in Xinjiang, soybeans in northeast China and Inner Mongolia, as well as subsidy system for corn producers in northeastern China and the Inner Mongolia Autonomous Region.
8. The World Bank, Doing Business 2018: Reform and employment creation.
10. National Bureau of Statistics of the People’s Republic of China, op cit.
11. Several opinions of the general office of the State Council on accelerating the cultivation and development of the housing leasing market (promulgated by the General Office of the State Council  no. 39) stipulates: “(7) To improve housing lease support policies… lessees without local household registration may apply for interim residence permits and enjoy basic public services such as compulsory education, medical treatment and other state-specified services in line with regulations of provisional regulations on residence permit.
12. China’s fiscal revenue mainly comes from indirect taxes such as value-added tax, consumption tax and import taxation, which are greatly influenced by prices. Therefore, it is closely related to the growth of nominal GDP and PPI.
14. Liu He’s speech boosting high-quality development and promoting global economic prosperity and stability together, January 24, 2018, Davos, Switzerland.
15. “Thirteen measures to strengthen macro-control”, record of Zhu Rongji speech (vol. 1). At that time, splitting according to the main business meant the bank’s policy businesses must be divided between insurance, securities and trusts, and made them independent financial institutions and sold the commercial and industrial companies they run.
21. Paul Krugman’s articles for The New York Times in January 2010.
This article is part of The IFF China Report 2018, which draws mainly on content provided by China-headquartered think tank, the International Finance Forum, and is published in association with Central Banking.
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