November’s Third Plenum proposed significant economic reforms to rebalance China’s economy and reduce its addiction to debt, in large part by reversing many of the processes that drove growth in the past three decades. Of course this potentially radical shift in China’s development model will make predicting economic performance in 2014 more difficult than ever.
And we have already seen how difficult reform is likely to be. The past four years were characterised by a stop-and-go process of decelerating growth, in which periodic attempts by the regulators to constrain credit caused the economy to slow sharply but, as policy makers backed off each time, both GDP and credit growth subsequently reignited, although at gradually declining paces. We will see this even more sharply in 2014, with a continued unstable balance between attempts to constrain credit growth and attempts to keep the economy from slowing too quickly.
If Beijing does not manage growth rates down further in an orderly manner, China increasingly risks reaching debt capacity constraints, after which growth will drop in a disorderly way. Beijing increasingly recognises the risk, and so the most likely outcome for 2014 is continued but bumpy GDP growth deceleration, until by the end of the year consensus expectations for GDP growth for the rest of the decade drop to 5-6 per cent.
What I will be watching most closely in 2014 is evidence that Beijing is reining in credit growth in spite of the political and economic costs of doing so. More specifically there are four things I will be following:
1. Pressures in the interbank market. The Chinese interbank market experienced a sharp liquidity crunch in June and a second, milder crunch in December. Because both occurred following actions taken by Beijing that temporarily slowed monetary expansion, these show just how addicted the banking system has become to rapid money growth. A recent China Beige Book survey suggests that a large and rising share of new loans is being extended simply to roll over old loans that cannot be repaid out of operating earnings. China needs credit growth, in other words, just to avoid recognising bad loans, and any attempt to constrain money growth is likely to cause a surge in financial distress. Because credit constraints are most likely to show up first in the interbank markets, the more firmly regulators try to control credit the more often we will see disruption in the interbank market.
2. Interest rate liberalisation. While everyone recognises the need to liberalise interest rates, especially to the extent that ordinary households are able to benefit, doing so is likely both to raise financial distress costs and to undermine the powerful groups with access to bank loans. This makes it an important marker of the pace and direction of China’s economic reforms.
3. De-emphasising of GDP growth targets. By fixing GDP growth targets Beijing limits its ability to target other variables, most importantly credit creation. What is more, because rebalancing requires that growth in household consumption exceed GDP growth by a substantial margin (at least 3 percentage points annually for a decade), high GDP growth targets make rebalancing much more difficult. The sooner Beijing de-emphasises GDP growth targets (in favour, say, of household income growth targets) the smoother China’s economic adjustment is likely to be.
4. GDP growth as reflecting the reform process. For now, the market is encouraged by higher-than-expected GDP growth data and disappointed when GDP growth declines. It should be responding in the opposite way. Because only much lower growth rates are consistent with effective reform and rebalancing, GDP growth rates of 7 per cent or even 6 per cent should be seen as indications that Beijing is finding it difficult to implement them. The sharper the growth deceleration, in other words, the more confident we can be that China is adjusting and is lowering financial risks. High growth rates should be seen as evidence of failure to adjust and a higher risk of a disorderly adjustment in the medium term.
During the past two years China’s domestic imbalances have finally stopped deteriorating and may have marginally improved. During this period, although credit growth continued to accelerate, GDP growth dropped from the 10-11 per cent that characterised the previous decade to its current 7-8 per cent. This suggests the extent to which GDP growth will slow even further as Beijing makes a determined effort truly to rebalance the economy.
Decelerating growth, however, should not alarm us. It should be clear that the more aggressively China resolves its debt problem and unwinds the mechanisms that drove domestic consumption and investment imbalances, the more growth will slow in the short term. A steep but orderly reduction in GDP growth is likely to be the best evidence that Beijing is forcefully implementing reforms, and that China is preparing itself over the decade to regain growth on a healthier long-term basis.