Three Keys to China

There are three key points to be made about China.  First, China has adopted a number of measures toward greater liberalization of the capital markets.  Second, the rebound in the real economy has been largely fueled by investment and credit and it is here that critical imbalance persist.  Third, expectations for the Third Plenary Session of the Communist Party next month is for a 'big bang" of reforms.  

Traditionally, the model of development through much of Asia, including Japan and China, has emphasized the market for goods over the market for capital. This has led to the under-development of the capital markets, which, in turn, constrains  many  countries' ability to absorb their own savings. 

Yet, it is in the financial sector that China's reforms have been remarkable over the past few months.  The floor for lending rates has been scrapped.  Bond futures have been introduced that will allow better management of interest rate risk.   Rules relating to importing and exporting gold have been relaxed.   A free trade zone in Shanghai has been launched that promises to liberalize capital flows and currency conversion.  The QFII quota has been doubled.  

In addition, China showed great resilience in the face of the recent sell-off in emerging markets.  This is helping to spur interest in the offshore (CNH) derivatives market.  The options market for the offshore yuan reportedly experienced a 3-5 fold increase.  Liquidity has improved with industry reports suggesting tenors out to two years and ticket amounts as large as $100 mln.  

The CNH option markets appears to have overtaken the NDF options.  Much of this is thought to be generated by corporations and in turn fueled by the increased amount of trade denominated in yuan.  Rent data suggests as much as a sixth of Chinese trade is now denominated in yuan.   

This is part of what is fueling the increase in trading in the yuan.  According to the Bank for International Settlements triennial survey, the increased turnover puts the yuan as the ninth most active currency.  The average daily turnover dollar-yuan was $113 bln compared with $31 bln three-years ago. The dollar-yuan turnover is nearly twice the daily turnover of the dollar-Hong Kong dollar for the first time. 

What is more is that the relationship between the offshore yuan (CNH) and the onshore (CNY) has tightened.  Measures, like the large swap facility between the Hong Kong Monetary Authority and the People's Bank of China will help minimize large swings in the spread between the two yuans.    The modest liberalization of rules allowing easier ability to use CNH in the mainland (converting CNH to CNY) helps keep to two integrated as well.   

II

The slowdown in the Chinese economy appears to have stabilized.  It appears to have been led by investment, though clearly nothing like the scale seen in 2009.   Increased spending on infrastructure-related projects by state-owned enterprises has been used to prime the proverbial pump. 

The investment-led rebound has itself been fueled by a further expansion of credit.  In each month in 2013, through August, the total value of outstanding credit has been 20% or more above the year ago period.  The credit expansion has seen total credit rise to 200% of GDP from 130% over the past five years. 

In addition to the expansion of credit, which tends to be worrisome insofar as state-owned banks are lending to state-owned enterprises, the reliance on investment boosts China's capital stock.  On a per worker basis, the China's capital stock is larger than Brazil, Mexico and Russia, but it has lower output per employee than they do. 

Overall industry profits are holding up and in August were 12.8% above a year ago.  The pace this year is about 11.6% above year ago levels.  The average last year was almost 1.2%.  The profitability of industry means that policy makers may not experience a sense of urgency.  Still, there are some notable warning signs.  For example, half of the steel producers were operating at a loss in the first half.  Car makers, too, are struggling as capacity is growing faster than sales.   The sector that has captures much attention is the housing, which accounts for about 9% of GDP.  Construction is outstripping demand.  

China spends the most on research and development after the US.  Yet China is pursuing a different model.  Almost 20% of the US R&D spending is on basic science.   About 1/20 of China's R&D budget is devoted to basic science.  This suggests China remains in a growth model that is relies on imitating technologies of the high income countries and producing it cheaper or better. 

III

The third plenary session of the Chinese Communist Party is typically the most important for new initiatives.  The first is about selection new leaders.  The second is typically about personnel in key positions.  It is the third one that brings together some 370 senior officials.  

Significant changes were announced at the 3rd Plenary session in 1978, when Deng Xiaoping launched post-Mao era and both political and economic reforms.  The 3rd Plenary session in 1984 ended the concept of central planning.  The 3rd Plenary session in 1993 saw the introduction of a 'socialist market economy'.    The 3rd Plenary session next month is being billed as potentially another important step on this path.  

While political reform and reform of the state-owned enterprises is unlikely to be on the agenda, important financial and economic reform is expected.  One of the government's goals it to boost urbanization.  In order to achieve this, land registration and internal migration must be liberalized.  However, local governments are reportedly pushing back.  The idea is that an open registry of property ownership would reveal the corruption and nepotism.  Beijing is expected to push harder.  

Further financial reform, such as freeing deposit rates, requires some additional reform first.  Deposit insurance is needed,  for example, and these is some speculation that this may be forthcoming.  China is also conducting a review of the debt at all levels of government and it is possible that the a local investment vehicle is allowed to fail, which is in keeping with the Chinese practice of  making an example of one to drive home the lesson for others.  There is a Chinese saying that captures this practice:  sometimes one has to kill a chicken to scare the monkeys. 

The 3rd Plenary session is likely to embrace a wide range of other reforms and there is some talk that officials are considering introducing an inheritance tax.  The focus is expect to be on fiscal and financial reforms.   There has long been speculation that China would widen the 1% band that the dollar-yuan trades in relative to the official fixing.  While this is possible, we suspect that the 3rd Plenary session is unlikely to be the forum where such a decision would be announced.