Tough external environment may act as a catalyst to take decisive steps

This week the World Bank was in the limelight for its grave warning that there are risks of China falling into a "middle-income trap". In its China 2030 report, the Bank warns that without further structural reform, the Chinese economy will witness a sharp deceleration in growth and also talks of a serious banking crisis that may eventually lead to a full-blown economic crisis.

The timing of the report could not have been more crucial. It comes just before the annual meeting of the National People's Congress and the Chinese People's Political Consultative Conference, where the focus of attention would be on whether policymakers and the deputies would decide to continue with the economic reform agenda.

While there is growing consensus that the export-led growth model, which helped China become the second largest economy in the world, is not sustainable in the post-global financial crisis era, we should not ignore other factors like the aggressive reform of State-owned enterprises (SOE) and banks, and the integration into the World Trade Organization, that have helped achieve the remarkable growth.

The tough restructuring in the State-owned sector has paid off handsomely, particularly after the 1997-98 Asian Financial Crisis when the government pushed ahead with the plan. Many loss-making small- and medium-sized State-owned enterprises were privatized; large enterprises were consolidated and eventually listed on domestic and international stock exchanges.

State-owned commercial banks also went through a period of fast reform: non-performing assets were carved off; State-owned banks were corporatized as commercial entities and also went public. Proceeds from public listings and better profits allowed both State and commercial banks to write down non-performing loans, which, at that time, were estimated to be 20 to 30 percent of the bank assets.

China's WTO entry sharply lowered its sovereign risk. Chinese exports were no longer subject to the US Congress' annual review of most favored nation status. As a result, large flows of foreign direct investment were able to take advantage of China's inexpensive labor, vast market, and favorable fiscal incentives.

These days almost all the Fortune 500 companies have moved or started production in China, transforming the country into "the world's factory". The rapid industrialization has helped absorb millions of migrant workers, enhance productivity, speed up the urbanization process and improve infrastructure.

A period of fast global growth has also helped propel China's growth. A phase of unprecedented globalization, facilitated by the widespread adoption of technology, has markedly lifted productivity in advanced economies, leading to a period of fast investment and consumption growth. China's heavy investment in telecommunications allowed it to tap into the rapid globalization of production.

Meanwhile, strong consumption growth in the West facilitated by financial innovation made Chinese exports an easy sell, generating a breathtaking pace of export growth. From 1999 to 2008, China enjoyed GDP growth of 10 percent with limited inflation.

China's export-led growth took a hard hit after the global financial crisis of 2008, along with job losses and lower demand. To cushion the sharp fall in external demand, the Chinese authorities responded with a massive fiscal stimulus package of 4 trillion yuan (476 billion euros, $635 billion) in 2009-2010.

Although the large fiscal stimulus package was needed, the investment-driven package exacerbated an already distorted economic structure. The investment-to-GDP ratio climbed to over 50 percent by 2011 while the private consumption-to-GDP ratio declined to below 40 percent.

The extremely high investment ratio casts doubt on whether China can continue to rely on investment to stimulate growth. More importantly, default risks have also increased with some local government investment projects.

With the rampant growth in local government financing vehicles, many investments may never produce the required returns; if so, the non-performing loans of Chinese commercial banks may rebound sharply, increasing the risk of a banking crisis.

Rising risks to the financial system aside, the consolidated and now very profitable and powerful SOE sector is seen to be increasingly resistant to further reforms. Reform challenges on other fronts include severe environmental degradation as a result of China's energy and resource intensive growth and rapid industrialization; and a rapidly ageing population that requires urgent reforms in the pension system, and an adjustment to the three-decade old "one-child" policy.

China's growth appears to have hit a speed bump imposed by nature as well, with two-thirds of China's cities facing severe water shortages. Indeed, without urgent reforms, the threat of decelerating growth may become a reality, rather than speculation.

Despite these enormous challenges, China is actually in a sweet spot to push through a fast pace of reform. Unlike the tough SOE reforms of the late 1990s that required substantial job losses and cost cutting, the current reform program will help create more jobs in the service sector and offer more broad-based opportunities.

Rebuilding the social safety net and reducing the precautionary savings motives will help boost consumption and ensure a significant rebalancing of the economy. In fact, the central government is well endowed with fiscal resources to do so. The Chinese government may well be the world's wealthiest government with its 80 to 90 percent stake in large Chinese companies and commercial banks; its tax revenues have grown at a pace of over 20 percent a year, far above income growth but at less than 20 percent of the debt-to-GDP ratio. It also possesses the largest pot of foreign exchange reserves in the world.

Therefore, the government has ample fiscal resources to quickly build up the social safety net.

Deregulation will also help increase competition, enhance productivity and create more service sector jobs. This is especially urgent in the financial services sector in light of the push for the internationalization of the yuan. Without market-driven interest rates and the building up of a deep and broad debt market, China's fast-moving capital account liberalization will create new distortions to the domestic financial system and potentially threaten its stability.

Deregulation is also needed in State-dominated sectors such as financial services, medical care, education services, rail and air transport, infrastructure sector and other social services. In fact, allowing private investment in these services sectors will help China rebalance its industrial structure through much needed investment. In addition, by diverting private investment to these potentially high return sectors will help head off a property bubble in China.

China in many ways is in a strong position to address its economic challenges through accelerated reforms. The country now has both the resources and skill set to implement these difficult reforms. To some extent, the current tough external environment could also act as a catalyst for reform. The most recent example is the drastic restructuring of State-owned enterprises and banks in the aftermath of the 1997-98 Asian Financial Crisis. If this example continues to hold, it bodes well for the decisive reforms ahead. Indeed, it is never too late to accelerate China's reforms.

The author is head of Greater China Economic Research, Australia and New Zealand Banking Group in Hong Kong.

(China Daily 03/02/2012 page7)