Why ‘Strong Government’ Is Expected To Be Key To China’s Economy In 2018

While China laid out several stated goals at its central economic work conference at the end of last year, including maintaining financial stability, reducing poverty, and improving the environment, the biggest unstated economic outcome that we can expect in 2018 is continued strong government involvement in the economy. This comes with a host of problems as marketization of the economy is stalled.

Stronger government presence will be found in three major areas, based on past experience:

State owned enterprises. President Xi Jinping has repeatedly focused the reform process on enhancing state firms rather than on private firms and the market economy as a whole. Central state owned enterprises (SOEs), which often dominate their sectors, are being strengthened rather than weakened, with private capital going to support government-associated firms rather than to expand private sector competition. This will allow the government to continue influence economic outcomes and monopolize certain areas of the economy that it views as strategic such as the power, petroleum, railway, and telecommunications sectors. Many Chinese SOEs are also expected to be engaged in outbound mergers and acquisitions, particularly on China’s flagship One Belt One Road.

Financial markets. During President Xi’s first term, we saw a large amount of government intervention in financial markets. The biggest example is government interposition in the stock market crash that began in the summer of 2015. Regulators attempted to stem the rout by purchasing shares, injecting funds into the market, and imposing a selling ban on major firms. A circuit breaker mechanism was also implemented to halt trading when shares values fell to a certain point. Government intervention is also present in the property markets; when home prices rise or fall outside of a target range, local governments are directed to step in and change home buying policies.

As financial risks remain high in China’s economy, the government can be expected to play a strong role in preventing losses through 2018. After all, one of the major targets for this year is to maintain financial stability, not to introduce new financial reforms. Financial regulation introduced last year to end worst practices has not been fully implemented, and putting these into place without upsetting investors or institutions continues to pose a challenge.

Capital controls and exchange rate. China attempted to liberalize its exchange rate in 2015 as a step toward internationalizing the renminbi (RMB) with the introduction of the China Foreign Exchange Trade System (CFETS) RMB Index to reflect the RMB movement against a basket of currencies, with greater transparency. This was reversed when the central bank announced that it would introduce a “counter-cyclical” factor into the exchange rate calculation last year. Capital controls, which appeared to be shrinking in recent years, were tightened at the end of 2016 in order to maintain the value of the RMB, as depreciation pressures grew. These controls have been extended to restrict particular types of outbound direct investment to reduce capital flight through fraudulent international transactions. As China continues to experience a slowing economy and high levels of corporate sector indebtedness, officials will no doubt display strong control over the exchange rate via exchange rate valuation and the capital control regime through 2018.

Expanded government presence in the economy doesn’t come without costs, however.

First and foremost, SOEs are less profitable and efficient than private enterprises. They produce a smaller amount of GDP compared to that generated by the private sector, but consume about a third of bank loans and investment. Investment in SOEs crowds out private investment that could bring about greater economic growth. Even if the management of SOEs is improved to some extent, these firms are unlikely to be as growth-oriented as private firms. However, in the eyes of the government, this would also reduce state control over the economy.

Second, government intervention in financial markets has led investors to become careless. Despite the fact that new regulations state that investors are responsible for their own losses, those who purchase assets in China do not truly believe that the government will allow widely owned products to fail. China’s financial markets are not entirely governed by market forces, making it difficult to determine risks and rewards of investing.

Finally, capital and exchange rate controls stall China’s RMB liberalization and financial reform processes. While it is clear that China is interested in promoting an internationalized currency, without opening up of the capital account and exchange rate regime, this will remain a distant goal. Furthermore, capital inflows and outflows are restricted, reducing China’s participation in the global economy. In the past year, new controls have limited China’s own Going Out policy, which has emphasized outbound foreign direct investment.

Heavy handed state intervention will continue through 2018, for better or for worse. This will help to ensure stability, for sure, but at the expense of market reform, growth, and internationalization.
Source: Forbes