Market rout will strengthen China's resolve to implement long awaited reform
Fred Hu believes market turbulence, painful as it is, will spur the fundamental reforms China needs
The rout in China's stock markets has sent shockwaves across the world, dragging global equities, currencies, bonds and commodities into the worst tailspin since 2008. Both domestic and international investors seemed to have lost faith in China's once-fabled ability to manage its economy, hence the deepening gloom and spreading panic everywhere. While there are very valid concerns about China's economy and financial system, market reactions are vastly exaggerated.
To start with, China's falling domestic equities do not necessarily herald a sharp contraction in its broader economy. Historically, the country's immature and extremely volatile stock market has been a poor predictor of gross domestic product growth. With retail trading dominating the market place, share prices are mostly driven by short-term sentiments, not by any rational expectations of economic fundamentals.
Since mid-2014, the Chinese equity market had been gripped by sudden spikes of speculative frenzies, in part fanned by the official party media, and started a stunning rally. As valuation quickly soared to astronomical levels, a sharp correction just seemed inevitable. That is exactly what has happened over the past few months.
With Shanghai now down by more than 42 per cent from its peak, the current stock valuation has factored in most of the bad news - manufacturing malaise, weakening exports and capital outflows. The risks of further sharp declines in China equities appear limited.
Unfortunately, the Chinese authorities' market interventions have done more harm than good.
Far from stabilising the markets, massive stock-buying by state-owned institutions has distorted the functioning of the stock market, caused widespread confusion and aggravated the risk of moral hazard, further undermining investor confidence at home and abroad. The unprecedented stock market interventions, many pundits speculate, must have revealed the Chinese government's deep worries about the rapid deterioration of the underlying economy. Yet the Chinese stock market, though second only to the US by market capitalisation, remains a sideshow as far as China's Main Street is concerned.
So what has happened to China's economy? Accustomed to growing at a double-digit pace, it is now struggling to reach the official target growth rate of 7 per cent. But the GDP growth slowdown has been both gradual and moderate, far from being the disaster that has so spooked global investors.
Even at 5 per cent, China would generate more growth than any other country.
Partly to address the longstanding concern about China's over-dependence on investment and export-led growth, the leadership has vowed to transform China into a more consumer-centric and innovation-led economy.
Recent data shows that such a shift is under way, with consumption accounting for over half of overall GDP growth last year and 60 per cent in the first half of this year. Though headline GDP growth has been trending down, the growth is now broader-based and more balanced.
Moderating growth rates in the range of 5-7 per cent per annum reflect the changing growth paradigm in China. A modest slowdown is a necessary and healthy adjustment for the country to transition to a new trajectory of more efficient and sustainable growth. But instead of greeting such a positive "new normal" with enthusiasm, the naysayers have reacted with dismay as though they would prefer the old growth model.
To be sure, the shift to a new economic model is always fraught with uncertainty and risks, let alone for a country of China's size and scale. Compounding the challenges is the mess the old growth model has left China with - a manufacturing glut, an excess real estate inventory, heavily indebted local governments and a severely damaged environment. To manage such a transition successfully, China must implement broad structural reforms while maintaining macroeconomic and financial stability.
Except the stock market interventions, the authorities have so far avoided costly policy mistakes, and China's track record of deft economic management remains remarkable. In response to the latest economic and market headwinds, the People's Bank of China has already lowered interest rates and reserve requirement ratios. While China does not need a new credit boom, there is still a scope for additional monetary easing, to ensure adequate liquidity in the financial system, ease the debt service burden of heavily indebted corporates and local governments, and forestall a possible debt deflation vicious cycle.
On the fiscal front, the leadership has taken a more cautious stance, in recognition of past fiscal profligacy and local debt build-up. Even so, there is room for significant fiscal actions. China should follow on recent tax cuts for small and medium-sized enterprises with carefully targeted public spending increases.
Unsold housing inventory across China remains at elevated levels, especially in the so-called third- and fourth-tier cities. The central government should provide significant tax and credit incentives for first-time buyers, especially rural migrants and low-income families, to spread affordable home ownership and broaden the urban middle-class base, while redressing the overhang of past real estate excesses.
China should significantly increase transfer payments to the elderly to raise their retirement income, improve health and medical benefits coverage for both urban and rural populations, and provide more generous financial aid for secondary, vocational and university students with less income means.
While China is right about resisting the European-style social welfare state, it is imperative to reform and strengthen the country's basic social security system. Academic studies have identified inadequate social protection as a key factor for extraordinarily high household savings. Improved pension, health and education benefits for China's rapidly growing urban population would weaken the incentive for precautionary savings and boost personal consumption.
While past overinvestment has led to excess industrial capacity, China's environmental infrastructure, a vital public good, is woefully underinvested. Though China has made encouraging initial efforts, it should launch and can afford a far more ambitious public investment programme to promote clean energy and control pollution. Public investment in clean technology is essential for China to meet its climate change targets. It is also likely to spur a new growth industry that could establish China's global leadership in renewable energy and clean technology.
Contrary to prevalent market fears, China retains a broad range of monetary and fiscal policy options to cope with its stock market woes and economic downward pressures.
But perhaps the most powerful weapon of all in China's policy arsenal is the opportunity to pursue sweeping economic reforms.
Indeed, ever since the inauguration of the Xi Jinping leadership, investors have been expecting the so-called "reform dividends", because robust reforms promised by President Xi will correct structural imbalances, curb intrusive and arbitrary powers of the state bureaucracy, stamp out endemic corruption and level the playing field for the private sector and small and medium-sized enterprises.
In other words, Xi's reform agenda, if fully implemented, should allow the market forces to play a decisive role in resource allocation - promoting open competition, increasing market transparency, boosting efficiency and productivity gains, and stimulating entrepreneurship and innovation.
Perhaps nothing is more disappointing than the lack of progress to date on reform of state-owned enterprises.
Despite early achievements of these reforms initiated by former premier Zhu Rongji , there has been little new progress and possibly backtracking in recent years. It is plainly clear that the state sector has impeded competition from the private sector and dragged down economic efficiency. Privatisation, restructuring, better corporate governance, strong market-based incentives and professional management are required, among other measures, to turn state-owned enterprises into productive enterprises.
As shown by the case of PetroChina, there is a close linkage between political patronage, abuse of state assets and corruption. Hence, a complete overhaul of China's large state-owned enterprises should also bolster the effectiveness of Xi's popular anti-corruption campaign.
China has the capacity to contain the near-term economic and financial pressures, through a judicious combination of strong monetary and fiscal stimulus measures. More importantly, the recent market gyrations have sent a loud and clear message to the Chinese policymakers and are likely to prompt the top leadership to embark on fundamental reforms as pledged at the Communist Party's third plenary two years ago. Bold reform actions can restore investor confidence that the stock market interventions could not.
For several decades, China has been a major engine of global growth and a strong anchor of global stability. Now China is being tested again on whether it can weather the current market turbulence. The short-term challenges are real and the transition will be bumpy. However, China is likely to manage its current financial and economic problems far better than expected. China has the financial resources, the policy tools and, crucially, the political will to meet its challenges.
Past reforms have laid a solid foundation and expected new reforms will significantly improve the outlook for growth. China's accelerating urbanisation, rapidly expanding middle class, a strong human capital base, tremendous entrepreneurial energy and innovative potential portend an attractive prospect ahead. It is a loser's game to bet against China's reformist leadership.
Fred Hu is an economist and chairman of Beijing-based Primavera Capital Group