Four China Reforms to Watch
Investors are still chewing over the implications of the sweeping reform package Chinese leaders laid out at the end of a major Communist Party gathering earlier this month, but one thing is already abundantly clear. The Chinese government wants the world to know it is serious about opening up its economy and liberalizing its financial system. To that end, it unveiled a variety of planned initiatives, from land reforms to a relaxation of the infamous one-child policy, the majority of which are intended to help the country sustain long-term economic growth. And the world was impressed. Dong Tao, Credit Suisse’s Chief Economist for Non-Japan Asia, called the initiatives “the most comprehensive reform package we’ve ever seen in the history of the People’s Republic.”
The news comes at the right time. Credit Suisse Head of China Research Vincent Chan said that before the reforms were announced, the Chinese economy lacked clear drivers to even ensure steady long-term growth, let alone the blistering 7.5 percent-plus annual GDP increases it has enjoyed for the last decade. The $585 billion stimulus package approved in 2008 to stave off the effects of the global financial crisis buoyed the economy for two years after it was introduced, but the effects have since worn off. Economists have also become concerned about China’s soaring credit-to-GDP ratio, which has risen from 120 percent to more than 180 percent in the last four years, largely as a result of local government borrowing.
The most immediate beneficiaries of the reforms announced after the Third Plenum meeting will likely be China’s banks, which have an aggregate market capitalization of $850 billion. Though Chinese banks have enjoyed 28 percent compound annual earnings growth since 2009, their forward price-to-book values have dropped from 1.6x in 2009 to 0.9x today, according to Credit Suisse’s China banks analyst Victor Wang, primarily due to growing investor concern about their deteriorating risk profiles. Wang believes the banking sector should be valued 28 percent higher than it is at present, and thinks the announced reforms will be a catalyst for at least some measure of multiple expansion. “There will be a lot of positive spillover from the other reforms into the financial sector,” he says. “Some of the banks are trading at a meaningful discount-to-book value. That will be reduced soon.”
Credit Suisse also expects the insurance, property, transportation, energy, materials and consumer discretionary sectors to outperform as a result of the announced reforms. Though in many cases the government has not laid out a precise road map or timetable for implementing changes, “if even half (of the measures) go through, China will look very different five years from now than it does today,” Tao said on a recent call with investors. The Financialist has distilled the insights of Credit Suisse’s China team to provide an overview of four of the most important reforms.
Fiscal Reform
China’s banks are likely to be the biggest winners from an initiative that will see the central government take over responsibility for major infrastructure projects and social welfare initiatives from local governments. As it stands, local governments are responsible for a disproportionate amount of spending (85 percent), while getting a relatively small piece of tax revenue (52 percent). To this point, provinces and municipalities have borrowed money through specially created “local government financing vehicles” to bridge that gap. In the process, Credit Suisse analysts point out, they have racked up as much as 17 trillion yuan ($2.8 trillion) in debt, a not-insubstantial portion of which has been backed by infrastructure projects that might not have made it through a cost-benefit analysis in the private sector. By taking some of that responsibility for spending away from local governments, the country’s leaders are clearly hoping to slow down the accumulation of debts that have made investors nervous about Chinese banks.
Documents released after the meeting also call for creating an “early warning system” to flag when local debt levels are approaching dangerous levels. In most places, that “early warning system” is known as publicly available financial accounting, but to this point, that’s been a rarity among local Chinese borrowers. But that seems likely to change as well: Municipalities also received a formal go-ahead to raise money by issuing bonds, something that to this point has only existed on a small scale in pilot programs.
Of course, fewer large, local-government-financed construction projects will also reduce annual GDP growth rates from just below 8 percent to the 5-6 percent range over the next five years, Tao says. But for investors nervous about the solvency of Chinese financial institutions, higher-quality and more transparent growth will surely prove preferable to what was threatening to become unsustainably rapid economic expansion.
Reducing the Government’s Role in the Market
One primary message of the plenum was an intention to shift the balance of roles the free market and the government will play in organizing the Chinese economy going forward. The government, for example, is considering allowing markets to set prices on goods such as water, natural gas, power, transportation, telecommunications and oil. Wang points out that the government has also signaled a desire to give banks more latitude in the interest rates they are allowed to pay on deposits, which would force Chinese banks to compete with one another and potentially give households a chance to earn more interest on their savings as a result of that competition.
The reform package also stressed the importance of moving to a market-based exchange rate and full convertibility of the renminbi, China’s currency. That follows already-announced plans to test financial deregulation and relax restrictions on cross-border currency flows in free trade zones in Shanghai and Qianhai, a district of the Hong Kong border city of Shenzen.
Land Reform
In one of the most clearly articulated reforms, the government announced plans to give Chinese farmers more leeway to sell, rent or mortgage their land. For decades, farmers have “collectively” owned rural land, with the result that they weren’t allowed to sell it on the free market. Instead, local governments have acquired the land then sold it to developers for commercial, residential or industrial use, often at a healthy markup over the price paid to the farmers. (Some of that cash has then been used to invest in the local infrastructure projects mentioned above.)
Changing the system so that farmers can directly sell their land will result in a reduction in revenues for cities and towns. But if farmers stand to profit from appreciating land values, they will also have more money to spend on discretionary items, boosting domestic consumption. With urbanization still occurring at a frenetic pace, rural landowners might also choose to use their cash to buy or rent a home in one of China’s fast-growing cities, bolstering demand for urban housing. To make that easier, Chinese leaders also announced reforms to the hukou household registration system, which has to this point effectively denied the healthcare and education to which city dwellers are entitled to migrants who leave the rural provinces en masse for jobs in the city. As part of the reform, residents will be allowed to move more freely from the country to small and medium-sized cities.
Relaxing the One-Child Policy
China’s contentious one-child policy was first put into effect to keep the country’s enormous population in check. Today, rural couples can have two children if the first is disabled or a girl, but urban couples can only have two children if both partners are themselves only children. The proposed reform will allow urban couples to have two children if just one parent is an only child. Credit Suisse’s Dong Tao estimates that could result in an additional 1 to 2 million births on top of the current 16 million babies born each year.
Eventually – give or take, say, 18 years – today’s relaxation of the one-child policy will have produced more workers and taxpayers to support China’s aging population. In the short term, though, the reform will be of most interest to manufacturers of baby food, toys, and other goods. Tao estimates that if parents who choose to add an extra child to the family spend just $500 more a month as a result, it will increase economic activity between $500 million to $1 billion a year. “This is the most effective stimulus program, in my view,” says Tao.
Photo of Chinese President Xi Jinping courtesy of Kaliva / Shutterstock.com.
http://www.thefinancialist.com/four-china-reforms-to-watch/
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