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China needs another path for growth.

Reform, not monetary stimulus, is China's only choice to revive growth

Andy Xie says to revive growth, China must step up market reforms to tap its inherent competitiveness, while shutting out calls from vested interests for more monetary stimulus

China's economy continues on a downward trend. The main reason is the lack of significant reforms to implement the decision of the party Central Committee's third plenum. Sentiment, both at home and abroad, is at the lowest point in a quarter of a century. If reforms remain just talk, not action, the downward spiral could trigger a financial crisis.

To stabilise the economy, China must cut taxes by 1 trillion yuan (HK$1.26 trillion) or more. Value-added tax should be cut to 13 per cent, from 17 per cent, the top personal income tax rate slashed from 45 per cent to 25 per cent, and contributions to social funds halved for three years.

The central government should issue fiscal bonds to plug the resulting shortfall. To ensure the fiscal deficit is temporary, it should cap spending by local governments and the companies under their control.

Since the last quarter of 2011, China's economy has been deflating, a consequence of irresponsible, illogical and massive monetary stimulus in response to the 2008 global financial crisis. China has wasted tens of trillions of yuan on image projects and property speculation, all in the name of preserving its gross domestic product growth rate. The resulting bad assets are now weighing down the financial system.

The periodic injection of liquidity merely allows troubled financial institutions to delay reporting bad loans. They don't have the capital or ability to finance China's economic transformation.

International experiences of coping with numerous crises since 2008 show that injections of liquidity have a limited and diminishing effect. Fiscal stimulus is a much more potent tool to stabilise a declining economy. And, most of all, only structural reforms can revive a troubled economy on a sustainable basis.

China needs to cope with the consequences of the misguided stimulus in the past and restructure the economy to create another growth cycle. If attention is all focused on covering up past mistakes, it merely delays the inevitable, increases the bill for the eventual tidy up, and delays the beginning of a new growth cycle. As China's population profile ages, the delay may see the middle-income trap become a self-fulfilling prophecy.

There are three paths awaiting China within two years: stagnate, blow up, or break out. The current decisions of the leadership appear to be guiding the country towards the first scenario.

China has a large trade surplus. It should have control of domestic liquidity. Hence, a periodic injection of liquidity, for whatever claimed purpose, is actually to prop up troubled financial institutions and their troubled borrowers. Capital and elite attention are all focused on rearranging the tables and chairs to keep a leaking boat afloat.

The first scenario is similar to Japan's experience after its property bubble began to deflate in 1992. But, China isn't Japan. A trade surplus doesn't guarantee total control of domestic liquidity. The Japanese have an extremely strong domestic bias when it comes to storing their savings. Rich Chinese, by contrast, have a tendency to take their money offshore.

Another volatile element is the large share of wealth in China's deposit base. If the government was unable to prevent such money from leaving the country in a run, similar to what happened to Indonesia after 1997, a full-blown financial crisis could occur.

China is in a unique position to break out from the current paralysis and jump-start a new growth cycle to turn the country into a high-income economy before 2030. Chinese people remain highly competitive in the global economy. This is the most powerful engine for the economy.

Reforms are necessary to turn that competitiveness into world-beating products on the supply side and middle-class consumption on the demand side. All it takes is to shrink the size of government and give the market more room.

Fiscal stimulus can stabilise the economy. Financial reforms must then follow. Too many financial institutions, even some large ones, are merely Ponzi schemes.

A popular saying is that the financing chain must be kept intact. When a business goes bust, a break in the chain usually gets the blame. But that ignores the fact that such businesses were not solvent to begin with. To keep all the Ponzi schemes afloat, the central bank will be forced to inject liquidity again and again.

China's problems are mostly self- inflicted. The elite usually support monetary expansion, which powers asset inflation and fixed-asset investment that enrich insiders. This is why today's dominant opinion on curing the economic ills is still to increase the money supply.

China's internal debt load is already massive. If it continues to grow like before, people will be too frightened to hold more currency.

This is why a new theory on renminbi internalisation is gaining popularity. Instead of 1.4 billion people, some argue, 7 billion people in the world could hold up China's printing press, and, hence, there are no limits to how much yuan can be printed.

That such a fantastical theory is gaining popularity shows how wedded the vested interests are to monetary inflation.

It is puzzling and painful to see inaction on the reform front. Waiting won't bring a miracle. The prevailing theory is to maintain the growth rate with stimulus for the sake of social stability. When everyone throws in the towel for the future, there won't be any stability left to preserve.

This article appeared in the South China Morning Post print edition as: This way up
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