Author: Yiping Huang, Peking University and ANU
Since taking office in mid-March, the Li Keqiang government has taken a different policy path from that of its predecessor. Its key economic policy framework, although yet to be fully detailed, can be summarised as ‘Likonomics’, and appears to consist of three key pillars — no stimulus, deleveraging and structural reform. If so, this implies further downside risks for the economy and markets in the near term. But such policy measures are necessary now for China in order to avoid much more disruptive outcomes in the future.
The economic policy of the previous Wen Jiabao government is regarded as having been strong on growth but weak on reform. Public sentiment is now especially negative about the 2008 RMB4 trillion stimulus package for causing overcapacity in certain areas of infrastructure, significant fiscal risks due to reckless local government borrowing, inflation, asset bubbles and the threat of bad debt following the huge credit expansion. There now seems to be a consensus that China should tolerate slower growth and focus on structural reform. This is the foundation of the three pillars of Likonomics.
Li has pointed out repeatedly that the room to rely on stimulus policies or government direct investment is not big. This is the pillar of ‘no stimulus’. Relying on government-led investment for growth ‘is not only difficult to sustain but also creates new problems and risks’. In fact, many heavy industries, such as steel, cement and aluminium, are already struggling due to serious overcapacity problems, and the government is downplaying the importance of fixed asset investment in China’s new urbanisation drive.
The days of 10 per cent annual growth are over for China. Growth potential is now around 6–8 per cent. Of course, the government is not completely passive in this regard. Government-led infrastructure spending on energy, water and transportation has been accelerating since the beginning of 2012, but the scale is much more constrained compared with earlier programs. As long as the unemployment rate does not surge, the government is unlikely to adopt new stimulus measures to boost growth. The minimum acceptable growth rate has also shifted down, from 8 per cent at the beginning of last year to 7 per cent now. It could fall further in the coming years.
Li said recently that banks must make better use of existing credit and step up efforts to contain financial risks. Following implementation of the previous stimulus package, China’s total credit had increased from US$9 trillion in 2008 to US$23 trillion by early 2013. Evidence suggests that countries experiencing rapid credit expansion for extended periods always end up enduring a painful economic adjustment. What is more worrisome for China is the divergence in growth rates between credit (above 20 per cent) and nominal GDP (below 10 per cent) in recent quarters.
The PBoC’s recent move to curtail the credit bubble in the interbank market underlines the authorities’ desire to deleverage and reduce future financial risks. This is pillar two. Their actions are a clear warning signal to financial institutions. While the authorities are likely to intervene to stabilise the market if needed, interbank rates could remain high for a long period. Policymakers probably also aim to strengthen market discipline as a preparatory step towards interest rate and capital account liberalisation. This implies that deleveraging is likely to continue and some of the smaller and weaker financial institutions may fail in the coming year.
Li has also advocated reform as likely to pay the biggest policy dividends for the Chinese economy: pillar three. While investors are anxiously waiting for the Third Plenum in the autumn for a clearer outline of economic policies, current policy discussion indicates reforms in the areas of financial liberalisation, the fiscal system, factor prices, land use, administrative controls, monopolies, income distribution and the household registration system — many of which could be approved before the Third Plenum.
Likonomics has some distinctive features. In Japan, Abenomics is about ending deflation and restarting economic growth. Likonomics is about deceleration, deleveraging and improving the quality of growth. Both Abenomics and Likonomics have also somewhat different approaches to the implementation of fiscal and monetary adjustments. But it is structural reforms that will determine the success or failure of both Abenomics and Likonomics. With the Chinese government actively preparing a wide range of reform measures, it will be up to the new premier to prove that he is a decisive leader.
Likonomics policy is exactly what China needs to put its economy on a more sustainable growth path. It is positive for the longer-term outlook of the economy. In the short run, however, such rebalancing and deleveraging point to further downside risks for both economic growth and asset prices, including the exchange rate. Based on an increasingly likely downside scenario, Chinese growth could experience a temporary ‘hard landing’, with quarterly growth dropping to 3 per cent or below within the next three years. But such a slowdown would only be cyclical, and would likely bounce back dramatically soon afterwards.
Yiping Huang is Professor of Economics at Peking University and the Australian National University.
Yiping Huang recently published a Barclays Capital report jointly with Jian Chang and Joey Chew, ‘China: Postcard from Beijing — What to expect from Likonomics?’ (27 June 2013, Hong Kong). In this report, the authors first coined the term ‘Likonomics’.