by Tom Holland
by Tom Holland

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.

This article appeared in the South China Morning Post print edition as: Remember what's at stake in China's reform debate