China prioritises reform over break-neck growth

China’s leaders are focusing on reforms, cutting leverage and financial risks and opening up its financial market over the naked pursuit of economic growth, according to Premier Li Keqiang. These focuses could mean less stellar investment returns for investors over the short term but lower country risk over the long run, believe analysts and fund managers.

In a speech at the beginning of its 15-day National People's Congress (NPC) on Monday, Li announced the government's GDP growth target for 2018 was 6.5%, the same as last year. But he did not repeat last year's phrase of a desire to strive for better results than this rate.

The absence of such language indicates Beijing is more willing to accept a moderate economic slowdown without shocking the market, Aidan Yao, senior emerging Asia economist for Axa Investment Managers, told AsianInvestor.

In addition, Li deviated from normal practice by not announcing any growth targets for M2 or total social financing (TSF), which are typical indicators of liquidity and credit growth in the country. Removing such threholds means Beijing will de-emphasise the use of credit growth to drive GDP, said Yao.

“This [the absence of the MS and TSF targets] is very much in line with everything else; they want to focus on financial deleveraging,” added Karine Hirn, Hong Kong-based partner at East Capital, a fund house that specialises in emerging and frontier markets.

Goldman Sachs estimated China’s total debt to be Rmb262.1 trillion ($41.48 trillion), or 317% of GDP, at the end of 2017.

Beijing has increasingly emphasised “putting quality first” since the 19th Party Congress held in October 2017, tolerating somewhat slower growth in return for higher-quality economic activity, Haibin Zhu, chief China economist and head of China equity strategy, at JP Morgan, said in a note on March 6. Li mentioned the word "reform" 97 times in the nearly two-hour speech.

Apart from introducing rules to rein in shadow banking and deleverage, the government has sought to reduce regulatory arbitrage and open up China’s capital market. One of Beijing’s most dramatic moves to rein in financial risk was the China Insurance Regulatory Commission's takeover of Anbang. This offered a stark warning for other Chinese insurers not to use insurance sales to fund asset acquisitions, which writ large could pose systemic risk to the financial system.

Beijing has also aimed to cut industrial overcapacity by overhauling its state-owned enterprises, and sought to tackle environment degradation and air pollution.

But China is unlikely to reform its economy at any cost. Li said the growth rate of 6.5% would create adequate job opportunities, and Zhu of JP Morgan said policymakers don’t appear willing to see a disruptive deceleration in growth in exchange for aggressive structural reforms.

LURING FOREIGN INVESTORS

In his speech, Li also stressed opening up China's market and sweeteners for foreign investors.

He said the banking and clearance market will be opened up in an orderly manner, while not offering any more details. Foreign insurance brokerage firms will have less limits on their business, while the ownership limit on financial institutions will also be relaxed or scrapped, he said.

Li's speech underlined China's ongoing efforts to open up its economy. Last year vice finance minister Zhu Guangyao announced  the coming removal of limits on foreign ownership of mainland banks and the raising of the foreign-ownership cap on fund houses to 51% from 49% (and its removal in three years' time).

In addition, foreign firms will soon be allowed to own up to 51% of brokerages (and 100% after five years), and up to 51% of insurers after three years, with the latter limit removed after five years, noted Zhu.

Moreover, overseas investors will be granted tax deferral for any profits that they make in China and reinvest domestically, while there will be simplified procedures for setting up foreign-owned enterprises, said the premier.

Foreign investors said they would need more clarification on the tax deferral on investment gains, but broadly welcomed the announcement.

“Regarding overseas investment into China, any decision made by the Chinese government to liberalise its financial sector further is welcomed,” the spokeswoman for a US-based fund house that declined to be named told AsianInvestor.

China is striving to attract more investor inflows, but again at a cautious pace and not at the cost of policies higher in its agenda. Bond Connect, a mutual market access scheme that began in July last year, only allows northbound trading. The risks associated with outflows are higher as it would place depreciation pressure on the renminbi.

However, incoming investment flows come with certain risks too, said Axa’s Yao. Some of the inflows into China's equity and bond markets are from hedge funds and are thus short-term in nature. The unpredictable withdrawal of these funds could trigger more market volatility, he noted.

Investors' money transfers in and out of China are strictly controlled by the State Administration of Foreign Exchange, or Safe, and are only allowed after requirements for reserved capital and tax are met. 

WHAT TO WATCH FOR

The most controversial policy change in China’s parliament is set to be a proposed constitutional amendment to President Xi Jinping’s two term limit during its meeting. Foreign investors largely believe that allowing Xi to rule for longer should usher in more political stability, despite concerns of longer-term risks.

But other potential leadership changes worth looking out for during the two-week long meeting of the NPC could also have important implications for understanding China's balance between structural reform and economic growth.

Liu He is the most likely candidate to head the central bank in China, replacing the retiring Zhou Xiaochuan. He will possibly become one of the vice premiers in the country. He is already top adviser to Xi on economic policy. Given Liu’s past track record as a capable economist, the markets are likely to view his appointment positively.

Several observers also pointed out that Wang Qishan, secretary of the anti-corruption body Central Commission for Discipline Inspection, was sitting next to the Standing Committee members during Li’s speech. This could be a strong sign that he will play a critical role in the new administration, most likely in foreign affairs, Bank of America Merrill Lynch said in a report on March 6. 

Market participants are watching to see who will be oversee China’s foreign relations, given the possibility of a trade dispute between the US and China, said Yao. The individual responsible may have to quickly decide how to react to US president Donald Trump's threat of imposing tariffs on foreign steel and aluminium.

More importantly, boosting exports could offset the shorter term pains of structural reform. That could prove particularly critical for China's economy and its investment appeal, as the country de-emphasises credit growth.