Shyam Saran: China's supply-side reforms

It is 10 years since China committed itself to an early and decisive shift from an investment-, export- and manufacturing-led growth strategy to one driven by consumption and services. But this rebalancing has proven to be elusive. A high rate of gross domestic product (GDP) growth based on investment continues to be pursued, financed by ever larger injections of credit. The target for annual GDP growth set by the Chinese leadership for the current Five-Year Plan is within the range of 6.5-7 per cent, which can only be achieved through even greater credit expansion. Currently, the debt-to-GDP ratio is estimated at 280 per cent. The debt-servicing burden, which is rising at double the rate of repayments, can only worsen. Rebalancing the economy can only take place through reducing the massive debt overhang and lowering the GDP growth rate. This is irrespective of economic reforms directed at improving productivity and promoting innovation, which would show results incrementally only over the longer term.

Chinese policymakers have been reluctant to acknowledge the need for urgent and painful adjustments, such as reining in credit expansion, allowing inefficient firms to go bankrupt and compelling banks to acknowledge bad debts both on and off their balance sheets and, above all, accept significantly slower GDP growth, probably in the range of 3-4 per cent. Instead, attention has been deflected towards an animated debate taking place between “growth economists” and “supply-side economists.” 

The “growth economists” contend that Chinese debt, though large and expanding, should not be a constraint on greater investment since a growing economy will be better placed to service the debt. They claim that there is still enough headroom for growth, particularly in China’s vast western regions. The ambitious One Belt One Road (OBOR) initiative, through which China intends to invest massively in infrastructure development across Asia, Africa and Europe, would also take care of spare manufacturing capacity. These growth advocates also support market-based allocation of resources, reduced role of state-owned enterprises (SOEs) and minimal government intervention in investment decisions. 

The supply siders criticise debt-fuelled growth. A senior advisor to President Xi Jinping, in an article in the People’s Daily of May 16, said, “It is unrealistic and unnecessary to add leverage to pump up the economy.”

It was at the Economic Work Conference in December 2015 that supply-side reforms were introduced as a new strategy to achieve the rebalance of the economy. 

In spelling out what these reforms entailed, the official Xinhua News Agency explained: “The Chinese economy is no longer galloping ahead on the back of investment, exports and consumption. Adjusting banking regulations and interest rates have not been very successful in boosting investment or consumption. With growth falling below seven per cent China’s economy is in dire need of a makeover. Instead of working on the demand-side attention has turned to stimulating business through tax cuts, entrepreneurship and innovation while phasing out excess capacity resulting from previous stimulus. Such measures are intended to increase the supply of goods and services, consequently lowering prices and boosting consumption.”

A pivotal role is assigned to SOEs “as the core force of national economic development.”

Alongside, we see the assertion of party authority over corporate governance, a reversal of the trend towards relatively autonomous and professional management of SOEs with state ownership of assets being separated from management. 

The Chinese version of supply-side reforms is very different from the set of policies, under the same label, pursued by US President Ronald Reagan in the early 1980s. It assigns a central role to the state and SOEs, rather than the retreat of the state and pervasive elevation of the market principle advocated by the American supply side theorists. 

Surprisingly, some questions are being raised on Mr Xi’s flagship OBOR initiative. An editorial in the Chinese Caixin news agency stated, “Since officials have recently placed their hopes of avoiding painful reforms on the ‘belt and road’ initiatives, arguing that they will export their way out of excess. But new markets opened by these programmes will not be big enough to absorb all of China’s excess capacity. We have already witnessed backlashes in some developing countries against China’s steel exports. Such resistance will become stronger.”

The debate provides insights into the likely political and economic trends in the world’s second largest economy even though the contrasting approaches leave the challenge of rising economic imbalances unaddressed. What do these trends imply? 

One, while it is acknowledged that debt fuelled expansion cannot continue, the leadership remains committed to an unsustainable 6.5-7 per cent rate of GDP growth., which contradicts the intent to retire debt.  The risk of a financial crisis not only remains but continues to intensify.

Two, there will be more state intervention in the economy and the role of SOEs will likely expand as prime movers of economic change and innovation. We have already witnessed a return to active state management of the currency exchange rate and reimposition of controls on capital movements. The internationalisation of the yuan may remain stalled in the foreseable future.

Three, with the new Donald Trump administration in Washington threatening protectionist measures on Chinese exports and the likelihood of Chinese retaliation, even greater state intervention may be deployed to deal with the negative consequences of an incipient trade war between the two largest trade partners in the world; and, 

Four, there could well be a rethink on the OBOR initiative whose scale may be downsized.

These likely developments provide India with both political and economic opportunities to raise its own relative profile in the region and globally despite the uncertainties spawned by the Trump administration.
 

The writer is a former foreign secretary and currently senior fellow, CPR