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24 Jun 2013

China: faster reform, slower growth

Qu Hongbin

by Qu Hongbin

Chief Economist for Greater China, HSBC

China: faster reform, slower growth

China’s growth is increasingly driven by investment

Beijing’s new policymakers are putting reforms ahead of stimulus as the policy tool of choice to sustain growth. Cutting red tape for business approvals and removing entry barriers in the service sector will certainly help unleash private business and create more jobs. But reforms are also seen as the best solution to local government debt problems and other tail risks the economy is facing.

Beijing is also emphasising the quality of growth over quantity. Reforms are expected to address this issue by concentrating on structural problems.

While an aging population is an inevitable and irreversible trend in the medium term, maintaining labour productivity gains holds the key to sustaining strong growth

The focus on speeding up reforms should, once implemented, improve efficiency and revitalise private business. This will provide sustained and steady growth in the medium to long term. However, it will take time for the impact of the reforms to filter through, so growth is likely to stay subdued in the near term, especially given weak global demand.

We have thus cut our GDP forecast from 8.2 per cent to 7.4 per cent for 2013 and from 8.4 per cent to 7.4 per cent for 2014. However, we believe growth should rebound in 2015 when the impact of reform measures filter through.

That will hit China’s trading partners too. The impact on Korea’s export-led recovery has caused HSBC economists to downgrade their 2013 GDP forecast from 3.0 per cent to 2.4 per cent with the Consumer Price Index (CPI) inflation prediction cut from 2.9 per cent to 1.8 per cent. The growth outlook for Hong Kong has been reduced from 3.7 per cent to 2.5 per cent for this year and 4.4 per cent to 3.4 per cent for 2014.

This year is likely to mark the start of an era of new Chinese reforms led by the Xi-Li government. The reform agenda will be vital in boosting supply side efficiency and removing bottlenecks to medium and long-term growth. We believe it is the only solution to China’s daunting challenges, including a rapidly aging population, an elevated investment/GDP ratio, high environmental costs and a rising income gap.

While an aging population is an inevitable and irreversible trend in the medium term, maintaining labour productivity gains holds the key to sustaining strong growth. And the largest gains have come from investment and total factor productivity (TFP).

China’s growth is increasingly driven by investment but the TFP contribution has dropped by nearly 45 per cent since the financial crisis. This reflects the shift of growth driver from exports to infrastructure. Infrastructure is more capital intensive and takes longer to bear economic fruit, hitting productivity in the short term.

Reforms are thus needed to lift TFP and sustain China’s long-term growth. The key lies in redefining the relationship between government and the market. More market-driven reforms will raise the efficiency of supply by encouraging private investment, establishing long-term sustainable funding mechanisms, and releasing the potential of human capital.

Financial reforms are progressing faster than expected and could be the catalyst for sustaining rapid growth. Investment – a key driver of productivity gains – requires an effective allocation of capital: TFP gains require innovation to boost technology advances, which also need easier funding.

However, the current financial system – with a smaller, but still dominant, banking sector and underdeveloped capital markets – is unbalanced. Large companies and state-owned bodies have much easier access to funding than small and medium-sized enterprises.

Fiscal reforms are the key to changing the role of the government – turning a big government that crowds out private businesses into a smaller one still capable of providing adequate public services. Meanwhile, deregulation can lift the level of efficiency through greater competition and expanding the number of sectors open to private enterprise.

And urbanisation will mobilise the labour force and mitigate the impact of the aging population. It will also sustain the transfer of labour from agriculture to higher-productivity manufacturing and service sectors.

Yet, unlike stimulus, reforms won’t lend much support to near-term growth. The new measures will take time to have an impact as administrators and businesses get used to the new environment. For example, private enterprise has limited experience of investing in railway projects. And some reform initiatives are likely to have negative implications for demand and supply.

Given the expected slower growth, we also see less demand-pull inflation pressures and limited upstream inflation. We are thus also lowering our 2013 CPI forecast to 2.5 per cent from 3.1 per cent.

This research was first published on 19 June 2013.

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