Highs And Lows From China's Third Plenum

by: Junheng Li

On November 15, the Chinese Communist Party released "A Decision on Major Issues Concerning Comprehensive and Far-Reaching Reforms," a document detailing the party's reform plan. Accompanying the release, Mr. Xi wrote a letter highlighting 11 key features of the plan, generally viewed as the party's priorities. The biggest surprise among the announcements was the prominent position given to SOE reform.

The market was apparently pleased. It rallied across the sectors, including bank stocks. The plan appears to be a crowd pleaser, possibly because it appeared to be detailed enough to be credible.

The 11 key features of the plan are: a new role for the government and market-driven resource allocation; SOE reform; fiscal reform; integrated rural-urban development (with land reform being the key); democratic consultation; judiciary reform; anti-corruption; social media and internet management; a new State Security Committee; environmental protection (assigning custodian rights for natural resources to responsible parties being the key); and a new small leading group to coordinate reforms.

The Highs

The most encouraging reform seems to be the decision by policymakers to allow the market to play a decisive role in resource allocation. The decision to let the market play a decisive role could also be interpreted as an acknowledgment that the existing growth model has reached the end of its life.

The old model refers to the high-volume manufacturing of low-margin products for export. As I have discussed at length in my new business memoir, Tiger Woman on Wall Street, that old growth model has stalled - and not just for cyclical or near-team transitory reasons. That is evidenced by the excess capacity that has built up in nearly all sectors that the government had subsidized and interfered in, in the rising cost structure, declining global competitiveness, and shrinking corporate profitability of many Chinese companies and in the unprecedented environmental degradation through health-threatening air pollution, health-and-enterprise threatening water and soil contamination, erosion, de-forestation and desertification...

According to a study by brokerage CLSA on 428 publicly-traded (A and H shares) Chinese companies (excluding banks) published this May, corporate margins have declined from approximately 30% in 1997 (before the Asian Financial Crisis) to 10.5% currently. Many state-owned enterprises (SOEs), including state-owned banks, are kept afloat by taking on increasingly more debt from banks or from each other. Excluding banks, Chinese companies' return on equity has declined by approximately 35%, while corporate leverage has increased approximately 33% since 1997.

As economies become richer, more complex and more diversified, administrative discretion and connections become less effective means of allocating resources. The rule of law, markets and arm's-length regulation are critical. China is at the point in its development that it has to move swiftly towards a rules-bound market economy and away from the state capitalism - official discretion-driven, connections-constrained, top-down micro-management - that served the country rather well these past 33 years.

The Lows: No Word on Local Government Financing Vehicles (LGFVs) or Details on Banking Sector Reform

In the short run, the banking system (and the shadow banking system that has grown up around it) is the most likely source of a financial crisis that could cause a sharp recession in China. Following the stimulus of 2009 and 2010 and a somewhat smaller stimulus in 2012, in which banks were pressured by the central government authorities to extend loans, mainly to special purpose vehicles created by local governments and to SOEs, regardless of the financial viability of the project and the creditworthiness of the counterparty, the Chinese system may have as much as 25-30% of GDP worth of bad loans. The banks will in due course be bailed out and recapitalized by the Chinese government. In the meantime "lender forbearance," more accurately nicknamed "pretend and extend," or "delay and pray" keeps non-performing loan ratios near zero. This can go on for another year or two as the authorities try to find out who owes what and to whom. It is unclear whether authorities have figured out the direct and indirect exposures created by and through the shadow banking sector. If the restructuring of the Chinese banking sector and shadow banking sector is mismanaged, there could be a deep recession.

From a longer-run growth perspective, the allocation of credit is as important for capital formation and the evolution of the real economy, as regards sectoral composition and productivity growth, as the total amount of credit. At the moment, SOEs and manufacturing/industrial sectors are being favored. Services and the truly private sector are starved of credit. The fact that individuals and SMEs cannot collateralize land effectively is a further obstacle to SME start-ups and to their subsequent growth.

The government certainly has several urgent tasks ahead of it: breaking the links between the banks (especially the largest banks which are all state-owned) and the other SOEs, stop guaranteeing the debt of any large enterprise (whether explicitly or implicitly), encouraging lending to SMEs by allowing banks to repo individual SME loans with the central bank without incurring horrendous haircuts, encouraging the securitization of SME loans, moving towards full private land ownership to encourage the use of land as collateral, creating a land registry, improving contract enforceability and the ability to use other assets than land as collateral.

Just as Schumpeter's "creative destruction" applies to the formation, growth and collapse of corporations, it also has broad implication for entire national economies in today's intensifying global competition. "Creative destruction" can come from within, resulting from a country's commitment to reform, brave leadership and a realization that continuing to yield to vested interests could lead to a quick collapse of an increasingly inappropriate and inefficient growth model and long-term sub-par growth. China need not fall victim to the "middle-income trap". With the right, market-friendly reforms it has decades of robust growth ahead of it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.