• Fri
  • Dec 26, 2014
  • Updated: 11:28pm
PUBLISHED : Monday, 29 July, 2013, 12:00am
UPDATED : Monday, 29 July, 2013, 3:56am

Remember what's at stake in China's reform debate

To achieve sustainable growth, Beijing needs to rein in investment and encourage consumption despite resistance from corporates and banks

In recent weeks, the volume of commentary about the mainland's economic reform has reached a fevered pitch.

Every official pronouncement is scoured either for evidence that the country's new leadership is pressing ahead with difficult deregulation or for signs that Beijing's bigwigs are reformers in word only, not in deed.

Given the lack of clinching proof either way, the debate can get a little theoretical. Sometimes, it is so blinkered it is almost reminiscent of medieval European philosophers arguing about how many angels can dance on the head of a pin.

So in the interests of perspective, it is worth taking a step back and reminding ourselves just why economic and financial reform is regarded as so important and what is at stake any way.

Over the past couple of decades, the economic path the mainland has followed has been broadly the same as Japan's during its high-growth phase of the 1960s.

The government has relied on high domestic savings rates to fund an investment-led model, retaining control of the domestic financial system to keep interest rates low and direct cheap capital to favoured sectors of the economy.

The result has been phenomenal growth in output. But the model has run into problems. Keeping interest rates artificially low transfers wealth from the country's savers - mostly ordinary households - to its borrowers, which are primarily big state-owned firms.

That's had three effects. First, it's kept households' share of national income down, which has held back their ability to consume.

Second, the easy availability of capital has encouraged state-linked companies to keep investing, even as overcapacity has whittled away the returns they earn on those investments.

Third, with returns on productive investments declining while capital remains plentiful, financial institutions and companies have turned to property speculation, inflating an enormous real estate bubble.

In short, with consumption suppressed, the mainland has developed a dangerous addiction to investment, requiring ever-bigger injections of cheap capital to drive diminishing rates of growth.

If the mainland continues on this trajectory, at some point growth will fall below the minimum level needed to service outstanding debts, and a financial crisis will force an abrupt and extremely painful adjustment.

The obvious alternative is to change course now, reining in investment and promoting private consumption to steer growth towards a more sustainable path.

The trouble is that is more easily said than done. To achieve the desired rebalancing, inflation-adjusted interest rates have to rise, partly to push up the real cost of capital to deter reckless investors and partly to ensure savers can earn a decent real return on their money, which will encourage them to consume.

In other words, the mainland's longstanding transfer of wealth from households to the corporate sector must now be reversed.

For that to happen, however, mainland savers and financial institutions need to be able to direct their capital to wherever it can earn the most competitive risk-adjusted returns, including in markets offshore.

And that's the real reason why Beijing needs to scrap its remaining restrictions on cross-border capital flows; not because doing so will promote the yuan as an international reserve currency, but because without capital-account liberalisation it will be almost impossible to effect the financial reforms needed to achieve economic rebalancing.

Unfortunately, there is fierce resistance to reform from those in the corporate and banking systems that benefit from the current model.

But for China as a whole, the economic cost, if that resistance is not overcome, will be ruinous.



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This article is now closed to comments

A poll on what readers think China will do would be interesting. Will China introduce real economic reform or will the economic reform announced be mostly window dressing. I would vote for window dressing. The history of regimes like this is that entrenched interests trump, long-term regime interests. We can see a myriad of examples where regime policy continues long past it's usefulness. A case in point would be the one-child per family policy. Change has been rumoured for at least 10 years, yet the policy is still mostly in tact. Another example would be pollution measures. China has been making statements about moving to reduce air pollution for 10 years, but when you look closely has achieved relatively little. The increasingly poor air quality throughout China is a testament to these failures. Why should one be optimistic about China's economic reform prospects?
It is a tough situation for china to reform. As SOE are the channel for corruption and officials are benefiting from. Even interest rate up for savings, people still need to save money for expensive housing thanks the fact that china is following the Hk path of expensive housing. With china low GDP per capita, it really doesn't make sense that tier 3 cities are more expensive than US most cities. Just because of land speculation and wealth was diverted to developers rather than industries. That means people are spending too much money on housing with little to consume.
Plus people are saving up for sending their kids to study overseas. For their medical and retirement. So even interest rate on saving jump 100% it won't really help that much.
For many years I suspected Tom Holland was the pen name of Michael Pettis when he wrote for SCMP because TH used all of MP's arguments and examples while never once mentioned him. Today's article confirms that I was right. MP has been saying exactly the same thing as this piece for a years, even though there is not a single reference to him in the article. Even the writing and phrasings are straight from MP. The phrase "in other words" is one of MP's most overused phrases, for example, as is the use of hyphens to set off clauses, and the sentence "Keeping interest rates artificially low transfers wealth from the country's savers - mostly ordinary households - to its borrowers, which are primarily big state-owned firms," has been said so many times by MP in nearly identical formulations that it is almost certainly straight MP.
I have exposed you, right?
Thanks Tom! You have made this confusion much easier to understand. I reckon Chien Hai and Shanghai Free Trade Zone are 2 new examples from the corporate and the banking sectors to cling to even more economic benefits- easy money and fake dreams. This is ominous as again more resources will be shifting away from the most needed sectors. The rebalancing is becoming even harder and harder. This situation reminds me of the "Golden 10 Years" of the KMT Era during the 1920's when bad investment went rampant and citizens were suffering from hyper-inflation. History is repeating itself and when new economic opportunities are beginning to dry up, more investments are going abroad and the mainland will soon become a dry well and Hong Kong will be too close for comfort.


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