The China Dashboard uses a selection of objective data, overwhelmingly Chinese, to evaluate China’s progress toward its self-defined reform imperatives. This is an exciting quarter in which to assess China’s reform landscape. Having reported 6.9% GDP growth for full year 2017, considerably above a planned target of “around 6.5%,” Beijing must once again explain how it will realize meaningful reforms on a broad spectrum of fundamental economic policies without incurring a temporary growth slowdown. High growth achieved by deferring reform today means mounting risks of a sharp fall in activity in the future. We do not believe reforms such as deleveraging, fiscal reform, and environmental control are costless to GDP in the short term, though they are better for growth in the longer term.
By our Dashboard indicators through the end of 3Q2017, it would appear that short-term activity remains strong because reforms are not yet in high gear. Outcome indicators for eight of our ten reform clusters are showing standstill or negative movement toward the self-stated objectives Beijing previously defined for policy adjustment. Innovation continues to show positive movement, but by using industrial policies favoring domestic players that are fomenting strong push back from Western policymaking. Environmental policy implementation, while mixed, is decisive enough to merit recognition for real positive movement – so much so that we expect this success to cause problems for local fiscal policy. Policy emphasized stability, in preparation for the (fourth-quarter) 19th Communist Party Congress. Much debate centered on whether policymaking would take on greater urgency after that once-in-five-years affair: instead, the theme most emphasized was continuity.
Expectations for reform are being steered down, and foreign governments are revising their responses in turn. Indeed, the limited evidence of fundamental reform, combined with Chinese signals trying to manage downward Western expectations about China’s intent to converge toward market norms, played a leading role in U.S. decisions to suspend economic dialogues and embrace more confrontational strategies at the end of 2017. This is critical and worrisome. But if China does manage to “surprise the world” with an early implementation of economic reforms, as presumptive Vice-Premier Liu He said at Davos in January 2018, then this will be evident in our Dashboard indicators and be the basis of a positive discussion.
Note: The assessment visualized above is the authors’ judgement based on the primary indicators.
The Dashboard Gauges: Primary Indicators
Our primary reform indicators gauge outcomes in China’s economic performance: we assess implementation of Beijing’s reform goals based on data and other economic evidence. Two of our ten primary indicators show significant movement in the right direction this cycle. Good things are happening in other areas too – such as deleveraging in the financial system – but on net not enough to outrun mounting challenges. On the positive side, the first area of progress is Innovation, which was the sole positive area last quarter. We watch the weight of innovative industries as a share of all industrial sector value-added. Continuing a trend that started in 2016, the share of innovative industries continued to rise through 3Q2017. At the current pace of adjustment, China will reach U.S. (2011–2014 average) levels of innovative industry share in total industrial output in just little more than a year. (In a subsequent edition, we will assess whether the United States has moved forward from that level.) This rise of China’s innovation share reflects both growing new economy output and efforts to shutter old-line industries. Some speculate that policy may be loosened soon to alleviate pressure on those more traditional sectors, including steel and cement: if true, this would alter this innovation trajectory. The rise is propelled by various industrial policies, subsidies, and other supports that are driving heavy criticism from abroad.
The other reform domain offering positive movement is Environmental Policy. Like 2Q2017, air quality on the primary indicator chart for environment is doing better, while water quality is getting worse. And yet, unlike our assessment last quarter, we attribute the poor water outcome to short-term weather conditions, while overall environmental enforcement is being meaningfully stepped up. We expect air quality to continue a positive trend and be joined by water in the next quarter. Supplemental indicators also tell a positive story.
Of the remaining eight reform areas we track, we characterize four as remaining neutral and four as backsliding. We scored Cross-Border Investment as moving backward in 2Q2017, due to extensive but nontransparent use of capital controls to staunch flows; in 3Q2017, new rules were made explicit and the direction of change stabilized, so we label this cluster as neutral – a modest improvement. Three other areas we count as standing still are Trade, Financial System, and State-Owned Enterprise (SOE) reform. On trade, our composite line stands in neutral, indicating no discernable increase in Chinese imports of highly protected products (none of the four product groups we aggregate into our index is showing significant positive movement). Our financial system primary indicator is a measure of the incremental capital stock growth/output growth ratio: this ticked down (a good thing) for the third quarter, but ever so slightly, and it remains at such a dangerously high level that we do not yet score this as reform progress (just slower bleeding). A deleveraging campaign is behind this, and it is real: but by squeezing credit to smaller banks and non-banks, financial risks are moved elsewhere. This has been underway since late 2016, but total loan growth – at 12.7% for 2017 – is still above nominal GDP growth, suggesting a continued increase in aggregate leverage. Speaking of SOEs, our state enterprise indicator looks for a falling share of the state in gross revenue in “normal” sectors of the economy: while some of the more industrial policy-led “pillar” industries did see an uptick in private revenue share due to new listings, in the normal industry set no meaningful change occurred.
At the root of many of China’s greatest risks was too much leveraged debt flowing through SOE and local government balance sheets, and dealing with this problem was the nation’s top priority.
In the four remaining clusters – Labor, Land, Fiscal Affairs, and Competition Policy – we register negative movement in terms of outcomes. Labor gets a negative score because migrant worker wage growth is still lagging GDP growth by a hefty margin. We will continue to rate land reform as falling behind as long as this urgent necessity receives just a handful of pilots despite huge scope for improvement, and key data are simply not available. Like the financial system quarterly incremental capital output ratio (QuICOR) measure, our gauge of local augmented fiscal gaps moved slightly in the right direction this quarter. But with mandated fiscal expenditures still 144% of total revenue, this picture is still slipping backward despite central pledges to fix the fiscal balance. On competition, our indicator simply points out that domestic firms continue to remain far less likely than foreign firms to face a merger review investigation, a prima facie indication that things are not changing. In fact, this quarter the measure shows the gap is widening, with foreign enterprises facing highly increased odds of a merger review, while domestic firms continue to have a slim chance of that.
The Policy Picture
Quantitative indicators reflect results so far, while our parallel analysis of the policy scene provides some insight into the future. As in 2Q2017, in this review period the policy picture was dominated by the 19th Party Congress, which was held in mid-October. Our policy perspective here in this Net Assessment reflects the details of government work in the review period, as detailed in each of the 10 deep dives into the reform clusters, and also the general policy environment through January 2018.
The most significant policy signal pre-Congress came from the National Financial Work Conference in July 2017. The meeting generated a crystal-clear diagnosis that at the root of many of China’s greatest risks was too much leveraged debt flowing through SOE and local government balance sheets, and that dealing with this problem was the nation’s top priority. Debt-driven growth through these nodes both makes those entities fragile and creates the risk of systemic crisis in the financial system where counter-parties stitch themselves together in a fabric of interbank inter-sectoral financing that is underregulated and highly risky.
We have discussed this situation in detail in our Financial System Reform section in the prior quarter and this one. More broadly, in the third quarter and through the Party Congress, there was reason to expect a deleveraging campaign to be the overarching theme of policymaking in 2018 and probably 2019. This was an important assumption. It supported the thesis that President Xi, having consolidated power in the first half of his 10-year tenure, was shifting to use it in a standard economic reform manner in the second half. The prospect of a sustained deleveraging also was the linchpin of the medium-term growth outlook. Deleveraging would mean disruption to elements of current growth that require the more speculative components of financing – parts of real estate, higher-yield debt and wealth management products, and some infrastructure come to mind. But it would mean stronger growth beyond the near term. Lower growth for a year or two is not a problem if investors believe the foundations for decades to come are being laid.
But at and after the Congress, the signs that deleveraging would be the categorical imperative have gotten fuzzier. Deleveraging did not get as full throated an endorsement as it had in the third quarter. The Central Economic Work Conference held in December seemed to give deleveraging short shrift. The importance of growth for its own sake got more play, although leaders did not preview a GDP target for 2018 per se at the Congress and did make a major doctrinal shift from emphasis on growth quantity to quality. As we finish this write-up, 2017 GDP growth came out at 6.9%, compared to the circa 6.5% forecast level set out earlier in the year. This despite monetary and credit growth being reported at multi-decade lows. And while in the third quarter the International Monetary Fund was modeling a GDP outlook anchored by a moderation toward 6% in the years to come (6.3% for 2018 seemed to be the collective expectation a few months ago), at the start of 2018 influential Chinese economists thought to be close to official thinking upgraded their 2018 forecasts to 7%, calling that conservative.
This reset of expectations toward stoking the spirits of expansion by signaling a GDP growth upturn is key. Deleveraging will not go away as the policy focus of technocrats, and regulators continue to target informal financing channels early in 2018. Monetary growth hit an all-time low of 8.2% year-on-year (yoy) in December 2017. But a heightened emphasis on growth raises concerns. The outlook for sustainable progress on almost all of our reform indicators is predicated on China’s believing that its material self-interest depends on efficient growth, and that efficient growth in turn depends on reform and opening to the world economy in a manner that requires decisive marketization. We expected fidelity to the Party, state involvement, and non-liberal approaches to the economy to compete with standard market approaches post-Congress. However, we did not expect Chinese economists to argue, as we hear them saying now, that the policy package China intended was never market oriented in the manner the term is used in OECD economies, and that different and non-convergent economic models are the new normal.
Expectations for reform are being steered down, and foreign governments are revising their responses in turn.
The View from Abroad
Senior officials in the United States, Europe, and elsewhere started espousing a point of view over the past quarter also reflected in the Dashboard, namely that the pace of reforms is largely stagnant. U.S. Treasury Undersecretary David Malpass asserted, “China is not moving in a market-oriented direction” and said that consequently the United States would suspend the Comprehensive Economic Dialogue established in the spring of 2017. He added, “The critical step is for China to change economic practices to be more in line with global rules and global market liberalization techniques.” This is not just a U.S. view: French, German, and British leaders are making similar statements that engagement with China is not an inevitability, that engagement is contingent on free and fair competition and reciprocal outcomes that are a long way off, and that the attractive benefits of interaction with China alone will not obviate the need for convergence.
President Trump has gone past the more-talk-than-action style of year 1 of his tenure to take concrete measures against Chinese imports and investment in 2018. The call to action is not just a result of this Administration, however. Legislation to tighten screening of foreign direct investment in the United States, acknowledged to be largely China oriented, is under debate in Congress, though the White House has also endorsed it. In Europe, a Union-wide national security investment-screening regime is being developed for the first time. In both Europe and the United States, trade authorities have made it clear that they plan to continue to treat China as a non-market economy for calculating antidumping duties.
The view from abroad is now fixated on the potential for dramatic changes in OECD policies and trade law, to confront and compete with China’s system rather than banking on convergence. The hope that Chinese reforms would address advanced economy concerns have faded notably this quarter. While Beijing is undoubtedly implementing policy changes and planning additional ones, few observers are confident that they will be adequate to address foreign concerns. In fact, many Chinese economists known to be close to government are saying explicitly that better policy alignment is unrealistic and not going to happen. This could trigger a broad policy rebalancing in response – a process that is now evident, but only just getting started. The core economic reform indicators analyzed in our Dashboard represent the canary in the coal mine that will signal, one way or another, China‘s future commitment to the reform blueprint announced in 2013.