China: The Key to Sustainable Growth

More than a year and a half has passed since the Chinese Communist Party's leaders last published a detailed blue print for overhauling the country’s economic model. Xi Jinping and Li Keqiang emphasized that China had to transition from an economic system, mostly based on investment, manufacturing and exports, to a model centered on consumption and services. The ultimate goal of the Xi-Li administration was to rebalance the economy toward a more sustainable long-term growth trajectory.

Although the reforms comprised a wide range of sectors, perhaps one of the most relevant initiatives was the reform of the financial system. This is an opportunity to assess the state of the economic reforms in the financial sector now that China and the International Monetary Fund are in talks to include the yuan in the Special Drawing Rights (SDR) basket and since the recent turmoil in the stock markets has raised doubts over the situation of the financial sector.

The World Bank indicated last month in its 37-page “China Economic Update” that China’s economic reforms should focus more on the financial sector to avoid further problems with growth:

“Without fundamental reforms, the current financial system will be unable to support any substantial reallocation of credit to support productive growth.”

With the new Xi-Li administration, China has finally entered into a phase of a steady and solid progress in economic reforms. That said, as stated by the World Bank, the financial sector is one of the key sectors in which the government should put special emphasis if it wants to succeed in its intentions to rebalance the country’s growth model.

The financial sector reform is crucial to boost efficiency, improve resource allocation and enhance the access to financing, particularly to households and small- and medium-sized enterprises. However, a more comprehensive view is necessary and helps to understand that the financial sector reform has to be accompanied by other initiatives such as the overhaul of the state-owned enterprise system and a further opening of the capital account, for example.

While China has begun financial sector reforms, these initiatives may not be enough and the implementation of deeper, speedier reform measures may be necessary. However, Chinese authorities are true to their style of implementing reforms in a gradual manner. So far this year, authorities have made some announcements confirming the government’s commitment to move reforms forward. The new measures include the long-awaited deposit insurance scheme, the certificate of deposits for individual investors, an increase in the ceiling for deposit rates, a massive debt swap program to reduce financing costs for cash-strapped local governments and initiatives to regulate the shadow banking, among others.

Despite some progress and acknowledging authorities’ preference for a gradual approach to reforms, there is still room to enhance the scope and pace of reforms in the financial system, particularly in interest rates liberalization and FX flexibility.

China is already delivering on its promise to accelerate and deepen economic reforms in many areas. That said, in the short term, FocusEconomics economists consider that authorities should persevere in their efforts to further promote capital account convertibility, complete interest rate liberalization and loosen FX rules. Expanding and accelerating the current pilot reform programs for state-owned enterprises should be a priority. In order to shift consumption and saving patterns, the government should also strengthen the social safety net. On the fiscal side, the central government has to provide a clear scheme for local government financing to avoid them to tap into off-balance-sheet entities to raise funds.

Along with the significant moves made in the past few years, the Chinese government should embark on reforms affecting the core of the country’s economic system. Rather than implementing partial reforms to tackle specific issues, the government should initiate a complete overhaul of the economic framework in order to create a more competitive, independent and dynamic business environment. It is now time to put into effect the famous sentence enshrined in the Third Plenum of the Chinese Communist Party's 18th Central Committee held in 2013 of, “giving the market a decisive role in resource allocation.”

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinion of FocusEconomics S.L.U. Views, forecasts or estimates are as of the date of the publication and are subject to change without notice. This report may provide addresses of, or contain hyperlinks to, other internet websites. FocusEconomics S.L.U. takes no responsibility for the contents of third party internet websites.

Author: Ricard Torné, Head of Data Analysis

Date: July 14, 2015

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