A year of progress for Chinese reforms, but there is much still to do

Pan Gongsheng, deputy governor of the People’s Bank of China, writes about China’s growth prospects, RMB exchange rate reform and the past years’ stock market fluctuations
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People’s Bank of China headquarters, Beijing

China's economy continues to grow at a reasonable pace, despite recent headwinds. Maintaining a 7% growth rate is difficult under any circumstances, and especially so for a country with a $10 trillion GDP. From a global perspective, China's growth rate is remarkable. Employment remains stable, household income is growing steadily and progress in the transformation of economic structure continues. Nevertheless, China must remain highly alert to any downside risks. To understand our current situation, we must first look backwards.

Global growth has been slower than expected. Growth remains below target in the eurozone and Japan. Emerging markets are also experiencing difficulties. Global financial markets, meanwhile, remain turbulent.

In China, the traditional growth model is losing steam. After many years of investment-driven growth, the economy is suffering from industrial overcapacity and high levels of debt. Government, corporate and household debt currently exceeds 200% of GDP. Leverage is a particular issue in the corporate sector, with corporate debt at 120% of GDP. Debt deleveraging and capacity lowering will likely result in a drag on growth in the short term.

The Chinese government sees slower growth as necessary in facilitating the country's economic transition. The traditional growth model, while highly successful, also caused some problems. Increasingly, the focus in China will be on the quality and sustainability of economic growth. This is positive both for China and the rest of the world.

The record growth rates in China and other emerging markets during the past three decades came at a price. Depletion of natural resources, environmental damage and growing income inequality are some notable side effects, as are the global economic imbalances that helped fuel the global financial crisis.

In recent years, China has contributed to global economic stability by mitigating financial balances both home and abroad. The country's current account surplus fell from 10% in 2007 to 2.1% in 2014. Net exports fell from 7.5% of GDP to 3.7% in the same period. Moreover, in the first three quarters of 2015, services accounted for 51.4% of GDP growth – 2.3 percentage points higher than in the previous year and 10.8 percentage points higher than manufacturing. These achievements contribute directly to improving global financial imbalances.

pan-gongshengPan Gongsheng

What about China's future growth trajectory? Despite recent downward pressure, there are a number of positive near-term developments. Home sales are bouncing back. A 3.2 trillion yuan government debt swap programme has reduced the funding costs of local infrastructure projects as well as the risk of large-scale maturity mismatches. Finally, since the beginning of 2015 fiscal policy has been loosened and the People's Bank of China has cut benchmark interest rates several times. The effects of fiscal and monetary easing will likely become visible in the coming quarters – our estimates indicate a five- to nine-month time lag.

Over the medium term, China's growth potential in services, agriculture, advanced manufacturing and information technology is substantial. A rapidly growing middle-class, meanwhile, will drive greater demand for consumer products. We can also expect healthcare, tourism, entertainment and e-commerce to significantly outperform the overall economy. The huge disparity across regions also means there is still a vast potential for investment linked to urbanisation. Most importantly, the market-oriented reform will likely boost the vitality of the economy, particularly in the service and technology sectors.

The main challenge facing China today is how to strike a balance between maintaining reasonable growth on one hand and promoting structural adjustment while controlling risks on the other. Launching a major stimulus program would boost GDP in the short term but only at the cost of more debt, heightened financial risks and a slower reform tempo. If we allow a sharp slowdown in growth, on the other hand, it will spur unemployment, financial stress, and make it more difficult to implement structural reforms. Managing this balancing act will require a steady hand. I am confident it can be achieved.

Renminbi exchange rate reform

Last August, the Chinese government reformed the daily fixing of the renminbi against the US dollar, allowing market forces to play a greater role in determining the exchange rate. This was ultimately in line with reforms first formulated in 2005 and the currency's trading band has widened gradually since then, from 0.3% to 2.2% today.

What does the future hold for the renmibi? Since the August decision, the currency has depreciated modestly. This follows continued appreciation against most leading currencies in the preceding years. Since the current government took office in 2012, the real effective RMB exchange rate has gone up 17%. Moreover, the US Federal Reserve's expected tightening cycle is intensifying international capital flows.

In light of domestic and international economic and financial conditions, there is no reason to expect further depreciation of the renminbi
Pan Gongsheng, People’s Bank of China

The market is expecting a correction in the value of the renminbi as a result of market forces and the currency's return to its long-term equilibrium level.

In light of domestic and international economic and financial conditions, there is no reason to expect further depreciation of the renminbi. China's economy continues to grow at a reasonable rate and the country still has a current account surplus. The trade surplus also remains strong – a fundamental factor in determining supply and demand for foreign exchange. Finally, China maintains abundant foreign exchange reserve.

According to Swift, the renminbi now ranks as the world's fifth most used currency and the second most used for trade financing. It has also been accepted for inclusion in the IMF's special drawing rights basket. The US Treasury issued a report in 2015 stating that the renminbi remains below an appropriate medium-term evaluation. China's government will continue to pursue reforms aimed at expanding and deepening the market's role in determining the exchange rate.

China's stock market fluctuation

Unlike the mature financial markets in developed countries, which have developed over centuries, China's stock market is still very young, only 25 years old. Its investment structure and regulatory regime are still evolving. Several factors contributed to turmoil in the market during the past year. Investors resorted to high leverage margin trading, often using informal, unregulated margin facilities, stoking a bubble. The subsequent correction prompted large losses and triggered a downward spiral, raising the spectre of systemic risk. The Chinese government responded with a series of robust policy measures.

While such dangers were fended off successfully, there are lessons from this episode. We could have done better. Nonetheless, market risk has decreased since the worst turbulence. Valuations of blue-chip stocks have reached reasonable levels and leverage ratios have come down dramatically, even if the valuation of smaller stocks remains high. There are also concerns that market reforms in China may slow down as a result of this episode.

China is committed to the reform agenda, including the opening up of financial markets. In the short term, we need to strengthen investor confidence in the stock market. In the medium and long term, we must enhance the effectiveness of regulation and supervision, implement macro-prudential policy and further promote the opening up of China's capital market. We also need to reform IPO registration and grow the institutional investor base. There is still a lot to do.

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