China needs to strike a fine balance between growth and reform for sustained economic gains

China's transition from a centrally planned economy to a market one has been neither easy nor linear. The government has tried to liberalize some sectors and privatize some industries, but certainly not all.

Overall, one can argue that the dominance of the state-owned sectors has been maintained with a special emphasis since the 2008 global financial crisis. Such strategic choice is also behind the continuation of an investment driven growth model.

However, the cost of such a model cannot be underestimated. Resource misallocation, overcapacity in capital-intensive industries, rising domestic financial fragilities as well as many social and environmental problems, are just some.

China's annual economic growth remained above 8 percent at the beginning of the 21st century, before moderating to 7.7 percent in 2012 and 2013 for two consecutive years. Despite having once again averted the hard landing feared earlier in the year, economic rebalancing toward domestic consumption has been very slow, with investment continuing to support growth.

In fact, the Chinese economy was sustained by exports and supportive government policies last year, including a mini stimulus package focused on infrastructure investment. However, economic indicators in early this year point to a further slowdown, following sluggish exports and soft domestic demand due to the authorities' tightening measures to curb financial fragilities.

The government announced its GDP growth target during the annual National People's Congress in early March. It remained the same as in 2013, 7.5 percent. However, in the face of recent growth headwinds evidenced by quite gloomy data, Premier Li Keqiang recently hinted that the government will fine-tune economic policies to sustain the economy within a "reasonable zone", which is interpreted as a combination of two limits: an upper limit of 3.5 percent for inflation, and a bottom limit of 7 percent GDP growth. Against the background of moderating GDP growth (7.4 percent year-on-year) and other poor data for the first quarter, maintaining growth above 7 percent means more fiscal and/or monetary stimulus, as Li acknowledged.

The need to push demand policies further and underpin growth above the floor target comes at a time when China really needs to deliver on structural reform. In fact, the long-awaited blueprint issued after the Third Plenum in November aims to enhance the quality of economic growth and promote rebalancing of the economy.

The document is ambitious and encouraging in its wide range of scope, reflecting the commitments of China's new leadership after taking power last March. The key elements of this blueprint can be classified as follows:

The first is financial sector liberalization, which includes greater private entry into banking, further interest rate liberalization and opening of the capital account as well as a more flexible foreign exchange regime.

The second is fiscal reform, including anti-corruption and anti-waste campaigns, as well as expansion of the value-added tax pilot program. The third key area is urbanization, with additional public housing construction and more channels for public housing finance. The fourth aspect of reform focuses on the always difficult nexus of the private and public sector.

Another aspect is SOE governance, for which mixed-ownership structure in state-owned firms is being considered along with market pricing for utilities and natural resources. Finally, there is a set of important social measures in the reform package including the relaxation of the one child policy as well as a further streamlining of public administration by reducing administrative tiers and cutting red tape.

However, the real question is whether China can press ahead with these reforms in a lax environment in terms of liquidity or needs to restrain credit to force firms to change. While some of the reforms may not be influenced by the availability of credit, it is clear that changing the incentive structure in which Chinese companies and banks operate will not be achieved without financial constraints, not to mention reducing overcapacity and improving the environment. This is where the tradeoff between growth and reform comes in.

To maintain a bottom line of 7 percent GDP growth this year, the leaders have already fine-tuned the policy stance toward a laxer one, at least in terms of fiscal policy. In fact, the government will disburse fiscal funds in a more timely manner, continue to build social housing and accelerate public infrastructure investment (railways, highways and water conservation).

As for monetary policy, interbank rates have been kept at lower levels than those in December. Further easing in the coming months cannot be ruled out, including cuts in the required reserve ratio.

There is room for optimism about medium-term growth in China, especially if the country presses ahead on reform. However, it is also important to understand that China's growth will decline given its population trends and its rising per capita income. In any event, growth will be higher with reforms than without. That is what matters.

Alicia Garcia-Herrero is chief economist for emerging markets of BBVA Research, based in Spain. George Xu is an economist. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 05/02/2014 page13)