It featured a RMB4 trillion stimulus package in 2008, which admittedly helped China and a good part of the East Asian economy sail through the global financial crisis, but ended in overcapacity in some areas of infrastructure, and brought with it significant fiscal risks due to reckless local government borrowing, inflation, asset bubbles and the threat of bad debt following the huge credit expansion.
Under Prime Minister Li Keqiang — an economist who took his PhD from Peking University in 1994 — a new strategy appears to be emerging. Yiping Huang, author of this week’s lead essay, has called it Likonomics, a term that has rapidly become famous in the Chinese media. Likonomics consists of three key pillars — retreat from economic stimulus policies, deleveraging in the financial sector and structural reform. These policy strategies, as Huang suggests, imply further downside risks for the economy and markets in the near term. But they are policy strategies that are absolutely necessary to assure China’s transition to a steady higher-income growth trajectory and avoid financial and economic crisis outcomes in the future. The details of Likonomics are yet to be fully articulated. They will become clearer over the coming few months and more fully revealed in October after the Third Plenum. But a fundamental shift is clearly under way.
The term Likonomics mimics the slogan, Abenomics, that Japanese Prime Minister Shinzo Abe used to define his new strategy for rescuing the Japanese economy from the doldrums. Likonomics has three prongs to it too, like Abenomics. This is one of the similarities between Likonomics and Abenomics, as Huang points out. Another is the structural reform element, but one has to say that the chance of successfully implementing the structural reform dimension of Likonomics is considerably higher. There are differences. Abenomics is directed to ending Japanese deflation and restarting economic growth. Likonomics is about deceleration, deleveraging and improving the quality of growth. Both Abenomics and Likonomics also have rather different approaches to the implementation of fiscal and monetary adjustment. But it is structural reform that will determine the success or failure of both Abenomics and Likonomics. With the Chinese government actively preparing a wide range of reform measures, decisiveness from the political leadership is what will be critical on the reform front.
The rationale for policy change in China is well grounded. The room for relying on expansionary policies fueled by government spending is limited. Relying on government-led investment for growth ‘is not only difficult to sustain but also creates new problems and risks’. Many heavy industries (like steel, cement and aluminium) that have relied on government stimulus have serious over-capacity problems. Growth now needs to be led by household consumption and driven by the private sector and the new economy.
As Huang says, ‘the days of 10 per cent annual growth are over for China. Growth potential is now around 6–8 per cent’. Government-led infrastructure spending on energy, water and transportation has continued to increase but its scale is much more constrained compared with earlier public investment programs. If the unemployment rate does not rise rapidly, ‘the government is unlikely to adopt new stimulus measures to boost growth’. The potential rate of growth (the rate can be achieved with full employment and given technologies and their growth rate) is now lower, down from 8 per cent to more like 7 per cent, and likely to fall further in the coming years.
Li’s concern about financial market risks and how the banking system needs to make better use of existing credit is also on the record. Countries that allow rapid credit expansion for too long are likely to end up with a painful financial adjustment. Credit growth in China has been double the rate of nominal GDP growth in recent times. That’s why China’s central bank has recently moved to prick the credit bubble in the interbank market to deleverage and reduce future financial risks. The actions of the People’s Bank of China are a warning signal to financial institutions. Policymakers appear to be laying the foundations for radical reform of financial markets in preparation for liberalisation of the capital account: integration of Chinese capital markets with international markets that will put strong market factor disciplines on the Chinese economy in the way that trade liberalisation put strong market disciplines on commodity markets.
The reform pillar of Likonomics will doubtless be laid out more fully in the wash up from the Third Plenum next October. But the outlines are becoming clearer and include financial market liberalisation, fiscal system reform, factor price liberalisation, reform of land use policies, relaxation of administrative controls, dismantling monopolies, attention to income distribution policies and reform of the household registration system.
Huang concludes that even if there is a hard landing as these policies begin to bite — with the growth rate plummeting to 3 per cent or so — the Chinese economy will bounce back quickly. And he’s likely right, since the potential rate of growth is still around 7 per cent and the impact of the Likonomic reforms will be to release the entrepreneurial energies in the Chinese economy that ensure full potential is achieved and the economy does not run into the sand under the heavy hand of the state.
Peter Drysdale is Editor of the East Asia Forum.