Asia Global Institute

No Pain, No Gain

Friday, January 22, 2016

No Pain, No Gain

Asia Global Institute's Distinguished Fellow Andrew Sheng says Beijing will have to make some tough decisions this year to ensure the long-term goals of the 13th five-year plan are met.

The New Year started not with a bang but a whimper. International Monetary Fund managing director Christine Lagarde's prognosis at the end of 2015 was that global growth in 2016 would be "disappointing and patchy", blaming rising US interest rates, the economic slowdown in China, persistent financial fragility in several countries and lower oil and commodity prices.

Sure enough, on the first day of market opening on Monday, January 4, the Shanghai A-share market fell 7 per cent ((and again on Thursday), dragging global stock markets with it. The dominant story in 2015 was the slowdown of the Chinese economy and its impact on global commodity prices, including demand on luxury goods. Will this trend continue into 2016?

The IMF 2015 Article IV consultation on China, arguably the best available official "health check report," commented in August that China was "transitioning to a new normal, with slower yet safer and more sustainable growth." In 2014, growth fell to 7.4 per cent and was forecast to slow further to 6.8 per cent in 2015. Sure enough, by October, the IMF World Economic Outlook forecast was 6.3 per cent for 2016, not bad by any standards, but slower than that for India (7.5 per cent), currently the darling of foreign investors.

There are good reasons for being cautious. The foreign media's analyses of the Chinese economy are almost uniformly pessimistic. Not only do they think there will be a hard landing, but several analysts think a financial crash is inevitable.

The facts are quite clear on the risks. First, from 2008 to 2014, China's private debt-to-GDP ratio rose by 73 percentage points. The famous 2009 book by Carmen Reinhart and Kenneth Rogoff, This Time is Different, suggested that fast-rising private debt is the best indicator of financial crises. In the past five years, Chinese debt has grown fastest in terms of total debt. Second, the economy is clearly slowing, with both manufacturing and service-sector indicators being negative or showing a slowdown. Third, since last July, despite market intervention, the stock market index is still signalling downwards. Bank of America Merrill Lynch analysts are predicting a Shanghai Composite Index level of 2,600 for 2016, compared with a peak of 5,178 last June and current levels of 3,100. Fourth, there are capital outflows and concerns on renminbi depreciation.

On the plus side, proponents argue that, so far, the labour market has remained resilient because of the shift towards a more labor-intensive service sector. Household consumption has remained fairly firm, while inflation has been flat, helped by lower commodity and energy prices.

Unlike advanced countries, Chinese fiscal policy has much more room to manoeuvre, because total government debt was still less than 60 per cent of GDP at the end of 2014. By allowing more interest and exchange rate flexibility, the room to use monetary policy by the People's Bank has been strengthened. Despite concerns about the rising level of non-performing loans, the largely state-owned Chinese banking system has adequate capital to absorb these, and those of the shadow banks, which are slowly but surely being brought within the regulatory network. Up to the latest available data, credit and total social financing has decelerated, but there are no signs of abnormal illiquidity or debt deflation, since the property market has shown some signs of an uptick in first-tier cities.

On the external front, the balance of payments current account remained a surplus at 2.1 per cent of GDP, which offset the capital outflows as indicated by the loss in foreign exchange reserves.

Because the economy is so large, looking at China requires a longer-term perspective than normal. The "new normal" is that the Chinese economy is slowing naturally as it grows larger and the median age increases. Under the 13th five-year plan, the economy is being retooled to become a domestic-consumption-driven, innovation-and-service-driven, open economy that aspires for social inclusivity and environmental sustainability. The mantra on the supply-side adjustment is all about getting rid of excess manufacturing capacity and moving to energy and resource efficiency. The Asian Infrastructure Investment Bank, the renminbi joining the IMF special drawing rights, and Chinese aid to Africa and global climate change initiatives also imply that China will contribute towards global public goods.

All these aspirations must be achieved within the context of social and financial stability. No economy in the world has attempted all these ambitious goals simultaneously without some trade-offs. In such a massive transformation in scale and short time frame, some economic, financial or political pain is inevitable.

Seen from this perspective, the key question for China is whether the economic trajectory is J or L-shaped. In other words, are the reforms aiming for a short correction followed by more sustainable long-term growth, or will China join the rest of the world in a global secular stagnation phase?

China's debt problem is almost unique in that it is largely a domestic debt overhang, with state-owned banks lending mostly to state-owned enterprises with no net debt owing to foreigners. Since local governments and SOEs still own considerable net assets, now is the time to rewrite the national balance sheet with debt-equity swaps to cut back the debt and restore balance in the corporate leverage situation. The state-led system can deal with its state-driven debt problem.

But one factor to consider in the current system is whether the political cycle is in sync with the economic cycle. The anti-corruption campaign, which is designed to restore integrity and trust in the cadre system, has now pulled in a number of businessmen, which creates uncertainty whether public and investor confidence can be "business as usual."

The level of the stock market index is only an indicator of the complex mix of investor greed and fear. Just as GDP is no longer adequate as a benchmark of economic progress, policies and business decisions benchmarked against a stock market index can only be wrong.

Tough decisions will have to be taken in 2016 to ensure that the long-term aspirations of the 13th five-year plan can be achieved.

This article first appeared in the South China Morning Post on January 9, 2016 in the print edition as "No Pain, No Gain."

The views expressed in this article are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.


Andrew Sheng

Distinguished Fellow, Asia Global Institute

Andrew Sheng


Room 326-348, Main Building
The University of Hong Kong
Pokfulam, Hong Kong

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