Fears are escalating over a “Japanifcation” of China as deflationary pressures rise and reforms are considered too gradual. The failure to implement decisive reform has exacerbated problems in the debt-laden engines of China’s economy, infrastructure and real estate. China needs to move away from deploying mass stimulus projects and embrace painful but necessary supply-side changes to remove overcapacity issues.
The slow pace of reform has been a perennial problem for Chinese policymakers. As China transitions from the old economic order to a new innovation-led economy providing higher-value exports and services, the government also needs to foster innovation and encourage the growth of the small and medium-sized enterprises.
The sluggishness of reform has been attributed largely to political in-fighting. While some members in the administration believe in supply-side reforms, others are opponents of any radical measures. Fortunately, it appears, from recent comments President Xi Jinping is now firmly in the camp that believes supply-side reforms are critical and excessive credit growth will plunge China into financial turmoil.
From our visits to the region, we are seeing encouraging signs on the ground. China is beginning to move up the value chain in terms of producing higher-value goods and services. It is also beginning to address the build-up of leverage in the system and public debt. China’s great transition will take time, but we are seeing exciting long-term opportunities in companies that will be beneficiaries of the following seven key reforms.
Rise of smart cities
What makes a smart city is the ability to track the movement of people in real-time and allocate resources swiftly according to demand. A part of the RMB 4.7 trillion transport programme is a focus on much-needed urban transit systems, which includes the creation of cutting-edge data networks. Urbanisation is an essential component in addressing the significant layoffs likely with aggressive supply side reform, hence investments in urban infrastructure are essential.
Indirect tax to boost services
After years of debate on this issue, the largest tax overhaul is now complete, with the majority of the sectors shifting from business tax to VAT. This will result in RMB 500 billion savings in the corporate sector as they will be eligible for input tax credit. Beijing will compensate the provinces for any tax revenues lost as a result. The overhaul is also positive for the service sector and will help the economic rebalancing process.
Growing innovation hubs
Several cities outside of Beijing, Shanghai and Shenzhen are growing faster than the national average. Strong leadership is turning these growing cities into innovation and talent hubs. For example, Xi’an has a high-tech industry zone where Samsung has established a large presence. Recently the city signed 23 new projects in the field of emerging technologies – new energy vehicles, IT and advanced manufacturing. Such targeted fiscal measures are likely to result in sustainable economic growth.
New economy industries
China has identified several essential industries in its transition to a value-added economy – including semiconductors, the internet, high-end manufacturing, alternative energy, environment protection and healthcare. The government is actively supporting a number of these industries and some of these have the potential to become meaningful in several years. It is crucial for China to accelerate development of new economy, to relieve over-employment and overcapacity in the old economy.
Reforming the old economy
China also needs to reform its old economy. For example, reforms in the oil and gas industry are encouraging private refining, and leading to the overhaul of the management of state run companies. The restructuring of China National Petroleum Corporation will eventually result in its spin-off into three or four service companies. In addition, the government intends to reduce overcapacity and address supply-side concerns in the coal and steel industry.
State-owned enterprise reform
The government is continuing on its programme of reforms at state-owned enterprise (SOEs). In total, 345 zombie SOEs have been identified (those displaying unprofitably, high debt, mismanagement or over capacity) – and a clean-up effort has been initiated. This may include the merger of SOEs but this will be less likely to happen if it creates a monopoly. Other efforts include overhaul through innovation, restructuring and personnel management reform including closures. The commission has set a three-year deadline for this.
The PBOC recently issued regulation, Document 82, which will have far reaching implications for the bloated banking sector. The reform aims to close the shadow banking loophole by regulating off balance sheet exposures. Implementation of the reform is key and is expected to be carried out over the next several quarters.
Notwithstanding the recent spike in economic activity, driven by the property and commodity sectors, we remain cautious about the overall prospects for China. Reforms are critical and we will be looking for signs of a change in political decision-making. It is increasingly obvious that strong leadership does not always translate into actions on the ground, due to differences in opinion and likely conflicts of interest.
Despite the macro risks, there are sustainable opportunities to be found in China. Many of these can be found in companies exposed to urbanisation, the strong middle class with high savings and disposable incomes and emerging new industries. These promising areas have the potential to cushion the economy against a potential ‘hard landing’.
Kunjal Gala is senior investment analyst on the Hermes Global Emerging Fund