Chapter 14. Summation

Anoop Singh, Malhar Nabar, and Papa N'Diaye
Published Date:
November 2013
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Markus Rodlauer

The previous chapters of this book make the case for a new and decisive round of reforms in China to shift the economy toward more inclusive, services-oriented, consumer-based growth. They also lay out the key economic reforms that will secure this transition, based on new analysis in many areas as well as insights from the experiences of other economies in the region. As is evident from this analysis, there are multiple dimensions to rebalancing China’s economy away from exports and state-led investment toward private consumption. To be sure, this transformation is already under way in many areas. For example, in recent years the tertiary share of employment has risen, and household consumption as a share of GDP has picked up slightly since 2010. Nonetheless, seeing this process through successfully is a challenge that has become more urgent and has rightly drawn the focused attention of the country’s policymakers. To summarize, what are the key reforms to be accomplished in the years ahead?

Financial Sector Reforms

The broad objective is to foster robust and inclusive economic growth, facilitate internal rebalancing, and safeguard financial stability by continuing the move to a more commercially oriented financial system and a market-based monetary policy framework. Because this transformation takes time along with some learning-by-doing, a renewed focus on early progress is critical to ensure that reform keeps pace with the rapidly evolving financial environment.

China already has a head start compared with other high-growth economies with regard to financial deepening. Bank deposits and credit as shares of GDP are higher in China than in many other economies, but financial intermediation needs to be shifted from the larger state-owned enterprises (SOEs) toward the services sector and dynamic, smaller enterprises. Put differently, the efficiency of credit allocation should be improved by curbing the incentives to advance credit to large corporations perceived to operate with a sovereign guarantee on their liabilities. The priorities are the following:

  • Interest rate liberalization. Notable progress has already been made with interest rate liberalization, including the greater flexibility introduced in mid-2012 and the removal of the lending rate floor in mid-2013. As the next step, the upward margin on deposit rates could be raised further, which will reduce regulatory arbitrage that currently favors wealth management products over bank deposits. Liberalization of deposit could be completed in the coming years by further widening the margin of upward flexibility.

  • Supervision and regulation. The priority is to further strengthen regulation and supervision of nonbank and off-balance-sheet intermediation to ensure that risks are properly disclosed and accounted for, institutions hold adequate buffers against potential losses, markets operate transparently, and the pace of growth does not result in systemic risks. As financial reform progresses and interest rates are liberalized, close monitoring and effective supervision of banks, particularly smaller banks, are critical to guard against the risk of destabilizing competition.

  • Institutional setting. Introducing deposit insurance and improving the resolution framework are key to dealing with weak or failing financial institutions in a manner that is predictable and orderly and that sets the right incentives for savers, borrowers, and intermediaries. Losses on assets backing nondeposit instruments should be borne by investors, which is a critical step to promoting risk-awareness and preventing the perception that investments are implicitly guaranteed.

  • Monetary framework. As interest rates continue to be liberalized and quantitative limits or guidance on credit are relied upon less and less, the central bank will need to use interest rates as the primary instrument of monetary policy. This shift will require improvements in liquidity management, including moving to reserve averaging as soon as possible and making it easier to use the central bank’s standing facilities, which should create a corridor for the targeted interest rate.

  • Continued strengthening and commercialization of banks. Major progress has been made on this front since 1990, including the listing of large state banks, recapitalization, and commercial reforms of key institutions. Continuing along this path will be critical to ensuring that reformed banks will be able to compete and intermediate effectively and safely in the new, increasingly market-oriented environment.

These reforms will yield significant economic benefits by improving the allocation of financing, especially to the more dynamic private sector; supporting domestic rebalancing by boosting household capital income while discouraging investment in low-yielding projects; and facilitating progress in other areas such as capital account liberalization and reforms to the SOE sector. In the rapidly changing financial environment, SOE reform has become increasingly urgent to contain financial sector risks and, thereby, help safeguard macroeconomic stability.

Reforms in Other Areas

To achieve the overarching goals of rebalancing—boosting household consumption while reining in excessive investment and raising productivity across sectors—the incentive structure that guides household and corporate decisions will need to be reshaped with additional reforms to the services sector, social insurance, the fiscal framework, and factor pricing. Besides financial sector reforms, the priorities are the following:

  • Services sector deregulation. The widening of labor market opportunities and the raising of household disposable income will entail dismantling barriers to entry across various sectors, especially in services such as telecommunications, banking, and utilities. Encouraging the entry of new firms and improving contestability would substantially raise per capita income. In this context, reform of the household registration system will enable workers to relocate more easily, facilitate a more efficient matching of workers with vacancies, and provide more flexibility to generate clusters of high-skilled workers and high-value-added jobs—all of which are essential if China is to continue climbing up the value chain.

  • Social insurance. Getting households to lower their precautionary saving will require further action on multiple fronts. The multiple national, provincial, private, and public pension programs should be simplified and made portable, with a view to ensuring greater participation in pension schemes covering all categories of workers—urban, rural, and migrant. Continued progress in broadening health care coverage and reducing out-of-pocket expenses will also help to reduce precautionary savings, especially with more comprehensive insurance coverage for catastrophic and chronic conditions.

  • Fiscal framework. Strengthening and reordering local government finances will reduce local government reliance on land sales for revenue and curb the tendency toward excessive investment. Improving revenue sources and achieving a better assignment of revenue and expenditure responsibilities at lower levels of government are key priorities. A broad-based property tax and new revenue-sharing arrangements between the central and lower levels of government, for example, could improve local finances. Very high social contribution rates act as a significant drag on household disposable income, and lowering them would lift the share of remuneration captured by households and induce them to consume more. Such reductions could be achieved in a revenue-neutral way by offsetting them by, for example, higher energy taxes, dividend payouts from SOEs, or other revenue measures that support the desired redirection of resources from investment and large SOEs toward smaller, domestically oriented firms.

  • Factor price reform. The relatively low cost of factor inputs has tilted the economy toward capital-intensive production. Allowing input costs to rise closer to levels in comparator economies and better aligning the cost of capital with its return would reduce the excess rents earned by firms, limit investment, and move it toward domestically oriented sectors.

  • Exchange rate policy. The pace of international reserves accumulation moderated significantly in 2012. Going forward, the market should be allowed to play an increasingly strong role in determining the exchange rate, including by continuing to reduce intervention in the medium term. Lessening intervention should allow the real effective exchange rate to continue appreciating in the medium term and facilitate resource reallocation toward domestically oriented sectors.

Together with the financial reforms outlined above, reforms in these areas will help accelerate the transition to more inclusive, services-oriented, consumer-based growth in China. In turn, more balanced, high-quality growth in China will contribute significantly to sustained global growth.

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