China has put reform at the top of the agenda and plans to implement wide-ranging changes across the board. While such measures are needed to maintain the country’s growth, in the short term they may cause pain.

A tyre factory’s production line in Jiaxing. China is aiming to redirect its economy by promoting domestic consumption ahead of exports. William Hong / Reuters
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Beijing // On January 22 in Beijing, the president Xi Jinping chaired the inaugural meeting of the central leading group for overall reform, an agency formed at the third plenum of the ruling Communist Party in November.

While we will probably never know the details of what went on behind those closed doors, the fact that Mr Xi himself chaired the meeting is a sign that reform of the economy is a priority for his leadership.

The broad sweep of the reforms is aimed at continuing to boost ­urbanisation in China, reduce local government’s growing addiction to debt and selling land, and giving the market a bigger role in driving the economy.

At the same time, Mr Xi’s efforts to bring in a reform package could mean leaner times during the Year of the Horse for the world’s second-largest economy, as the necessary changes look set to force some painful decisions and lower economic growth.

China’s economy grew 7.7 per cent last year after lower investment growth led to a cooling in the final quarter. Growth in the Dh34.7 trillion economy was unchanged from revised levels in 2012.

“If successful, financial sector reforms have made China’s medium-term future much brighter. But over the next two years these hard reforms mean weak growth and increased financial distress,” says Diana Choyleva, the head of macroeconomic research at Lombard Street Research.

The growth slowdown this year will be faster than many expect “not least because the downturn over the past two years has been much weaker than the official numbers show”, she says.

China’s fundamental problem, Ms Choyleva says, is its excessive savings rate and “warped financial system”, which have skewed its development towards unproductive investment at the expense of consumer spending.

The UBS analyst Wang Tao expects Chinese policy this year to strike a balance between reform and growth.

“On the reform front, we expect those with clear consensus to be pushed more quickly,” she wrote in a research note.

Specifically, these reforms could include reducing government investment approvals, opening some service sectors to private participation, continuing with resource price reforms and pushing the ongoing expansion of China’s VAT reform, and pension and healthcare insurance coverage.

It also means proceeding with the interest rate liberalisation process and further widening the onshore yuan trading band.

“We maintain our 7.8 per cent GDP growth forecast for 2014. Net exports should contribute positively to growth this year, more than offsetting the weaker domestic investment,” Ms Wang says.

Recent data has shown some notable changes in the structure of the Chinese economy. The services sector is now bigger than the manufacturing sector. Its share of GDP rose to 46.1 per cent last year, outstripping the manufacturing sector for the first time.

This ties in with efforts by Mr Xi to retool the Chinese economy by promoting domestic consumption ahead of exports and investment, and China may lose further momentum this year.

A key challenge facing reform is bad debt.

Patrick Chovanec, the managing director and chief strategist at Silvercrest Asset Management, and a former associate professor at Tsinghua University’s School of Economics and Management, believes bad debt is crucial to understanding why China has too much money yet, at the same time, not enough.

China’s growth in the past five years has been largely driven by an investment boom, fuelled by easy access to credit but this has seen total debt rise sharply, Mr Chovanec wrote in a commentary for Bloomberg, from 125 per cent of GDP in 2008 to 215 per cent in 2012.

Loans have spiralled to US$24tn from $9tn at the end of 2008, which amounts to an additional $15tn, or the equivalent of the entire US commercial banking sector, lent out in just five years.

“The detailed blueprint for market reform published by the Communist Party in November encouraged many. China’s leaders clearly recognise the economy needs to move in a new direction,” wrote Mr Chovanec. “But the first crucial step, weaning China away from its addiction to debt-fuelled stimulus, is proving a lot harder than many imagined. China’s leaders are riding a runaway train they don’t quite know how to stop. And they’re running out of track,” he said.

As the government tries to steer the economy away from investment-led growth, expansion of fixed asset investment is at decade lows.

“We are likely to see a continuation of slower but more sustainable investment growth in 2014 as policymakers focus on rebalancing the economy to domestic consumption,” wrote Moody’s Analytics in a recent research note.

Investment in property in China accelerated by 19.8 per cent last year, a sign the booming market has resisted Beijing’s sustained efforts to cool it down. A parcel of land in a suburb of Shanghai sold for a record 10.1 billion yuan (Dh6.13bn) yesterday at auction, the most expensive plot of residential land ever sold in the city, the Xinhua news agency reported.

The winning bid by the Chinese developer Franshion Properties, a subsidiary of Sinochem Group, represented a premium of 115 per cent over the initial price of 4.7bn yuan.

The previous record for residential land in Shanghai was 7.2bn yuan set in 2009.

The 96,429 square metre plot is located in a northern suburb of Shanghai, where average new home prices rose 21.9 per cent last month from the same month the previous year, the strongest growth among 70 major cities in China, the national bureau of statistics has reported.

However, analysts forecast investment spending to deteriorate.

“With credit conditions likely to remain relatively tight, we expect investment spending and economic growth to slow further in 2014,” the economic research group Capital Economics said in a note to clients.

There were positive signs in the recent raft of data. Retail sales grew 13.6 per cent last month from a year earlier, while the amount of goods coming out of China’s factory gates rose 9.7 per cent.

“We maintain our view of “being optimistic and realistic”, analysts at Barclays wrote. Barclays expects good progress in areas that should help the services sector, such as deregulation, fiscal and tax reform, financial sector development, services liberalisation and rural-urban integration.

There is a gloomier backdrop among companies, however.

Business confidence slumped this month to the lowest level in four months, following last month’s sharp rise, with firms reporting falls in nearly all activity indicators, according to the MNI China Business Indicator.

The indicator fell to 52.2 this month from a two year high of 58.4 in December with some companies reporting weakened demand ahead of the Chinese New Year holiday.

The December high was potentially boosted by improved hopes for the Chinese economy following the third plenum meeting in November, which have now dissipated.

“While the stimulus measures over the summer of 2013 helped to boost some of the business activity measures in the survey, particularly new orders, many of these have now fallen back,” MNI said.

The Chinese government, as ever, remains upbeat.

“Key 2013 economic indicators have turned out to be within the range, as China created more than 10 million new jobs and inflation came in at 2.6 per cent for the whole year,” according to an official report from the Xinhua news agency.

Still, the debate about the risks provided by shadow banking, credit intermediation involving entities and activities outside the regular banking system, is likely to continue long into the Year of the Horse.

China’s eleventh-hour rescue this week of wealthy investors in a high-yield trust threatens to drive more money into the nation’s US$6tn shadow-banking industry, undermining regulators’ efforts to deter excessive risk-taking. Industrial & Commercial Bank of China, the nation’s largest lender, on Monday told customers who had invested in the 3bn yuan trust product they can sell their rights to unidentified buyers to recoup the principal. Some clients plan to visit ICBC branches to demand more interest ahead of today’s 5pm deadline for accepting the offer, according to Du Ronghai, a Guangzhou-based investor.

Averting the nation’s biggest trust default may reinforce investors’ belief in implicit guarantees and the government’s backing of such risky products, stoking appetite for products in the $1.67tn trust market.

“The rescue brings short-term relief to the market at the cost of brewing a long-term crisis,” says Zhang Jian, a Beijing-based strategist at BOC International.

“It aggravates the moral-hazard problem and makes it almost risk- free for investors to pump money into trusts, wealth management products and other shadow-banking sectors.”

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