China's Reforms And Local Debt: Don't Mistake Short-Term Fluctuations With Structural Trends

by: Dan Steinbock


Recently, many investors have been spooked by China’s decelerating growth.

In reality, the slowdown was engineered in Beijing; not to harm growth, but to sustain it.

The approach to local debt is a case in point.

The challenge is to sustain the current growth amid weak global demand, huge economic transition, deleveraging, and struggle against corruption.

In the first quarter of 2014, much data from China have been disappointing. As a result of analysts' jaded observations, investors have revised their picture of China and its potential.

What used to be seen as a booming economy driven by double-digit growth is now perceived as a slowing economy with further deceleration ahead.

In reality, recent headlines fail to capture what's going on in China's economy. The slowdown is fairly typical to the first quarter in the mainland (Chinese New Year). The perceived shifts can be attributed to downward revisions to past data. They do not suggest that Beijing's growth target is threatened. Rather, they reflect how Beijing seeks to achieve its target.

Too many investors are mistaking transient, short-term fluctuations with structural trends. China's slowdown did not happen out of the blue. It was engineered in Beijing. China's new growth model, which has been developed in cooperation with the World Bank, will support more sustained, coordinated and balanced growth in the medium term.

But what is Beijing's reform agenda and can it overcome the challenge of rising local debt?

"Balanced" reforms, "flexible" targets

In 2014, China's growth target will remain around 7.5% to ensure adequate employment, whereas the 3.5% inflation target is paving way to further liberalization of energy and resource prices.

Before the two recent high-profile summits in Beijing, China's Premier Li Keqiang had opted for no stimulus, no leverage and economic reforms. After the summits, he re-characterized the current growth target as "flexible," calling for a "balanced" rather than "prudent" monetary policy. That does not mean a new stimulus package, but new fine-tuning measures and possibly the kind of mini-stimulus measures we have seen in the past.

In other words, the government is prepared to loosen credit, but only if necessary. Li knows only too well that a short-term boost to the economy can contribute to local governments' added credit challenges.

In practice, Li hopes to create 10 million new urban jobs this year, while keeping urban unemployment rate at 4.6%. Amid its new urbanization drive, the government completed 5.4 million subsidized houses last year, while 7 million more will follow in 2014.

As a result, the government must increase social financing, which is paving the way for a nascent social model in the mainland, but also contributing to budget deficit, which the government seeks to keep at 2.1% of the GDP. Last year, government spending was cut by 35% and that of provincial governments by 26%. With its austerity drive, it is leading by example.

During the past year, Premier Li and President Xi Jinping began to push the largest reform agenda since Deng Xiaoping's great changes in the 1980s. The basic approach is now in place. The broad goal is recalibrate and reduce the government's role in the economy. In particular, more private capital will be injected into state-owned enterprise sectors.

The core sectors of the ongoing reforms include finance, taxation, state assets, social welfare, land, foreign investment, innovation and good governance. Due to the ongoing industrial transformation, the service sector surpassed the industrial sector, for the first time. In the past, China was seen as the "world factory," but now it is turning into a global R&D hub.

To overhaul the exchange rate, Beijing recently widened the daily float range of the yuan. In the coming years, it will liberalize the interest rate and fiscal system. Moreover, the government hopes to promote the establishment of small and medium-sized banks with private capital and to set up a bank deposit-insurance system.

Last summer, when Li struggled for the launch of the Shanghai Free Trade Zone (FTZ), he had to overcome strong, entrenched interests. But it paid off. The FTZ allows faster financial reforms, which are necessary to support the nascent social model. It is also triggering comparable FTZs in other major Chinese cities and provinces.

The challenge of local debt

In the advanced economies, governments are struggling with massive sovereign debt. That is not China's problem. In the mainland, the problems originate from the global crisis fall 2008, when a large stimulus package of $590 billion was launched to foster confidence and employment, and to build the nation's transport infrastructure.

Although many objectives did materialize, funds were also poured into local governments and state-owned enterprises. That led to overcapacity in several sectors, particularly shipbuilding, metals and mining, building materials, and solar equipment.

The list also includes weaker borrowers in the property sectors, especially those with high exposure to trust funding.

According to the National Audit Office, local government debt soared to $2.9 trillion by mid-2013, which accounts for 31% of GDP. As the leading international ratings agency Standard & Poor's noted recently, it does not see a credit crisis within China as a baseline scenario.

In accordance with international (Basel III) requirements, Chinese authorities now expect the minimum capital adequacy ratio of banks to increase to 10.5%, while larger banks must meet the 11.5% requirement. The authorities are aware that the longer the misaligned incentives in the shadow banking sector remain unaddressed, the larger the distortions will become.

Financial stress has been typified by bond, loan and trust product defaults, volatility and declines in asset prices (currency, real estate). To contain risk, the scrutiny of government debt will be tightened, along with the shadow banking system.

In Beijing, these objectives have become more urgent after the recent high-profile failure of a trust product and the subsequent murky bailout. As the government is now willing to let borrowers be subjected to market discipline, the financial reforms can foster a mature credit risk culture. In the short term, it will mean some pain and associated volatility.

Reforms anticipate more sustained growth

The bottom line is that China has now arrived at a "critical juncture where our path upward is particularly steep," as Premier Li recently said. The basic conditions underpinning development are under profound changes as "deep-seated problems are surfacing; painful structural adjustments need to be made; the pace of economic growth is changing; and downward pressure on the economy remains great."

That's the part of the story that has spooked investors. But there is another side to it. Beijing's leadership is no longer interested in growth for the sake of growth, but in growth that can support the shift from investment and net exports toward consumption and innovation. The challenge is to sustain that growth amid a massive transition, deleveraging, and struggle against corruption.

China continues to have the foundations - including potential for industrialization and urbanization - to maintain a significant rate of growth for some time to come. However, this shift requires greater ability from the investors to distinguish between short-term fluctuations and medium-term structural transition - as evidenced by Beijing's reform agenda, and the challenge of local debt.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.