Proactive Reforms Critical to China’s Medium-Term Growth Prospects

IMF News, August 11, 2016

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Growth at 6.6 percent in 2016.
IMF projection: growth to decline moderately from 6.6 percent in 2016 to about 6 percent in 2018 and a bit further thereafter, assuming continued shift from investment to consumption and from industry to services.
Scenario outcomes:
- "Pro-active" reform scenario: faster structural reform progress would boost medium-term growth to about 6 ½ percent but entail weaker short-term growth as highly-indebted firms are restructured.
- "No-reform" scenario: limited reform progress and continued reliance on unsustainable policy stimulus would keep growth high in the near term but produce weaker medium-term growth and a higher likelihood of a sharp slowdown.

External rebalancing:
- Progressed well—the current account surplus has come down a lot and net exports are not driving growth.
Domestic rebalancing:
- Progress uneven across three components: moving from investment to consumption, from industry to services, and reducing reliance on credit.
- Strong progress on switching to services.
- Reasonable progress on switching to consumption.
- Little progress on reducing credit reliance.
Environmental rebalancing:
- Mixed results: energy intensity of growth has declined, but air pollution remains very high.
Income distributional rebalancing:
- Mixed results: share of national income going to labor has increased, but income inequality remains very high with fiscal policy doing little to reduce it.

Overall pace described as strong, with impressive advances across a wide domain.
Key reforms over the last 12 months include:
- Modernizing the monetary framework and making it more market based, including a more flexible exchange rate regime.
- Improving fiscal structure, for example, extending the VAT to all services and a new budget law to improve local government financial transparency.
- Encouraging urbanization by improving rural land rights, making pensions more portable, and developing new urban registration systems so migrants can gradually qualify for basic social welfare and residency benefits.
Areas with slower progress:
- Strengthening corporate governance.
- Preventing weak state-owned firms from borrowing more.
- Tackling excessive corporate debt.
- Opening up state-dominated service sectors.
Consequences of uneven progress: worsened resource allocation, weakened longer-term growth prospects, and raised vulnerabilities.

Short-term risks (low probability):
- Potential loss of investor confidence.
- Renewed capital outflow pressures.
- Disorderly corporate defaults.
- A sharp fall in asset prices, amplified by an increasingly large, interconnected and opaque financial system.
Medium-term risk:
- Slow progress on reform and continued reliance on policy stimulus and credit to achieve growth targets—this supports near-term growth but weakens medium-term productivity and raises risks as credit and debt build up.
Upside risks:
- Recent stimulus measures may have a longer-lasting impact.
- Faster structural reform and curbing credit growth would significantly lift medium-term growth prospects and reduce downside risks.

Priority: slow credit growth by tackling root causes, including:
- The pursuit of unsustainably high growth targets.
- Soft budget constraints on state-owned enterprises and local governments.
- The web of implicit and explicit government guarantees.
- Excessive risk taking in parts of the financial sector.
Required policy measures:
- Implement a comprehensive strategy and decisive measures to address the corporate debt problem.
- Shift from public investment to fiscal measures that support consumption.
- Boost bank buffers and rein in risks in the financial system.
- Continue to make the exchange rate more flexible.
- Strengthen transparency, both in communications and data.
Social mitigation:
- Address social costs such as layoffs with targeted assistance through earmarked budgetary funds.

Context and scale:
- China’s corporate debt is approximately 145% of GDP.
- Nonfinancial state-owned enterprises account for around half of bank credit but only produce about a fifth of industrial output.
High-level decision needed:
- Stop financing weak firms and accept the likely lower near-term growth to pave the way for restructuring.
Operational approach:
- Triage firms into viable (restructure) and nonviable (liquidate).
- Recognize crystallized losses (for example on bank loans); regulatory authorities should encourage recognition.
- Allocate recognized losses to banks, firms, investors and, if necessary, backstopped by the central government.
- Restructure viable but weak firms using market-based, out-of-court processes supported by a strong market for distressed debt.
- Address social costs with targeted budgetary assistance.

Source: Proactive Reforms Critical to China’s Medium-Term Growth Prospects — IMF News, August 11, 2016.