Wednesday, March 26, 2014

Questions about China's "incremental" reform process

Amidst the spectacular economic success of China, we often forget the apparently far-sighted nature of its political leadership. In particular, the ability of Chinese authorities to manage the time, pace, and sequence of reforms in several areas has been an equally impressive achievement. Two recent events are illustrative.

First, in recent weeks, reversing its position, the People's Bank of China (PBoC) has allowed the renminbi to depreciate, albeit slightly, against the dollar. In fact, it has doubled the band in which the currency can move to 2% around a rate fixed by the PBoC each trading day morning. The yuan had been among the only major currency which has not declined against the dollar in recent months, and its persistent stability against the dollar had given the impression that investments in the renminbi assets can only appreciate.

As Prof Barry Eichengreen has written, by allowing the currency to depreciate, the Chinese government may be signalling that holding renminbi is not an one-way bet (with attendant consequences of massive carry trade drive capital inflows and imported inflation). It would re-shape the expectations of investors and set the stage for the government to not only pursue a more flexible exchange rate policy but also pursue financial market liberalization without distorted incentives in place.

Second, most recently, in the first case of domestic bond default, the government allowed Shanghai Chaori Solar Energy Science and Technology Company to default on an interest payment. Aimed at alleviating the entrenched belief that the government will always bailout struggling companies, it comes at a time when warning signals about corporate debt have become flashing red. There have been numerous reports of corporate, especially public sector entities, having accumulated massive debts on the back of permissive lending standards.

Analysts claim that this is the beginning of a policy to allow "incremental but controlled" defaults among corporates in certain sectors, so as to mitigate the moral hazard as well as to churn out the worst run and inefficient firms. About 80% of the China's 60.3 trillion renminbi corporate debt comes from bank loans, leaving public sector banks heavily exposed to any crisis.

I am not sure whether the Chinese government can keep orchestrating carefully calibrated moves on such complex issues repeatedly. Their success till date ought to be attributed more to the favorable headwinds from long-period of economic boom, which provided the cushion to initiate reforms, as well as plain good luck. Now that growth is slowing, and in any case the spectacular rates are no longer sustainable, the government's ability to pull off such deft maneuvers may have narrowed considerably. 

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