ECONOMIC HEALTH CHECK
China’s Transition to Slower But Better Growth
August 14, 2015
- Growth slowing as vulnerabilities, notably credit growth, are reined in
- Policies need to be calibrated to ensure orderly slowdown
- Structural reforms key for creating new sources of growth
China is moving to a “new normal” of slower yet safer and more sustainable growth. This involves giving the market a more decisive role in the economy, says the IMF in its annual assessment of the economy.
China’s growth is expected to be 6.8 percent in 2015, down from 7.4 percent last year. This slowdown, in line with the government’s target of around 7 percent, reflects progress in addressing vulnerabilities, especially a needed moderation in real estate investment. The recent stock market correction will not derail the ongoing adjustment to a slower yet more balanced growth path, the report says.
“The challenge now is to take the next steps to a more open and market-based economy,” said Markus Rodlauer, IMF mission chief for China. This will require bold structural reforms, such as moving to a more market-based financial system, improving the management of government finances, and leveling the playing field between state-owned enterprises and the private sector.
“We also believe that China can, and should, aim for an effectively floating exchange rate regime within 2–3 years,” said Rodlauer. In this regard, the IMF noted that the new mechanism for determining the central parity of the Renminbi announced by the central bank is a welcome step as it should allow market forces to have a greater role in determining the exchange rate. Greater exchange rate flexibility is important for China as it strives to give market forces a decisive role in the economy and is rapidly integrating into global financial markets.
In its annual assessment, the IMF urges the government to push forward with structural reforms and accept lower growth in the short term to secure sustainable and stable growth in the long run—a trade-off that is worth making and in China’s best interest.
New direction underway
Since the global financial crisis, China has relied on an unsustainable growth model of excessive credit and investment, which has created large vulnerabilities in the fiscal, real estate, financial, and corporate sectors.
Moving to a more sustainable growth path requires reversing these trends. The Chinese leadership has set out a comprehensive reform agenda and has made considerable progress in reducing these vulnerabilities, the report points out. Credit growth has slowed significantly over the past few years, and shadow banking (borrowing from nonbank financial entities) has been reined in. Investment is cooling, led by a reduction in residential real estate growth. And a new budget law was passed to address off-budget borrowing.
However, in most areas the progress has just succeeded in slowing the pace at which vulnerabilities rise. Further progress, therefore, is needed to put vulnerabilities on a downward path, including a decline in the level of residential real estate investment, multiyear deleveraging to help close the credit gap, and medium-term fiscal consolidation.
Managing the slowdown
The report highlights the need for policymakers to strike the right balance between addressing these vulnerabilities—which will inevitably slow growth—and avoiding too sharp a growth slowdown.
In this regard, economic policies should be calibrated to achieve growth of 6½-7 percent this year and 6-6½ percent next year. With growth this year on track in this range and the inflation outlook benign, monetary policy should take a wait-and-see approach, especially as significant easing would risk exacerbating the credit and investment vulnerabilities.
Fiscal policy should remain accommodative given the headwinds to growth from slowing credit and real estate investment and consolidate gradually from next year to put public finances on a sustainable path.
Managing this slowdown is a key challenge. “Going too slow will lead to a continued rise in vulnerabilities, while going too fast risks a disorderly adjustment,” said Rodlauer. “The key to managing this trade-off is structural reforms to boost potential growth.”
Unfinished reform agenda
China has made good progress on a variety of structural reforms, such as permitting more flexibility in interest rate settings, gradually opening up the capital account, and establishing the new budget law. However, the country needs further bold reforms to transition to a more open and market-based economy.
The report highlights two key areas: financial sector and reform of state-owned enterprises.
Reforms aimed at liberalizing the financial system have advanced, with the introduction in deposit insurance and progress in liberalizing interest rates. But moving to a market-based financial system means that banks must set their deposit rates, lending rates, and loan policies based on market conditions and commercial conditions. This ensures that future companies—that will create the future jobs—can gain access to financing and expand into new growth areas.
The report also makes the case for deepening reforms of state-owned enterprises. Here, leveling the playing field between private and public enterprises is critical to make room for the private sector to grow and hence fuel future growth and create jobs. Additional reforms include increasing dividend payments, strengthening governance, and ultimately allowing the exit of unviable state-owned enterprises.
China’s success, China’s challenge
“China is now the world’s largest economy on a purchasing power basis, which is testament to its record of successful reforms and development policies,” said Rodlauer. But China still has considerable room to grow and its future success, like its past accomplishments, will depend on continued implementation of necessary yet often difficult policies and reforms.
“The faster the progress, the sooner the growth-enhancing benefits will materialize,” Rodlauer concluded.