“It will be very painful and even feel like cutting one’s wrist.” So predicted Li Keqiang, China’s premier, as he discussed the task ahead of him during his first press conference last March.
Not the most inviting prospect for investors looking to make a play on China. But they should certainly take heed of these words. Li is the man who, together with president Xi Jinping, must lead a reform programme regarded by analysts as the most fundamental in decades. It will affect almost every part of an economy worth $9.4tn (Britain’s annual output, for comparison, is $2.4tn).
So what are these reforms? And why does China’s new leader think that their implementation will be so painful? There are three key areas which investors should note.
The shrinking state
The first area of reform is reducing the role of the state in the Chinese economy. There is a broad consensus among analysts – and, increasingly, among Chinese policy makers – that the government’s influence over key parts of the economy is threatening the health of the economic system.
Nowhere is this truer than in the role the government plays in dictating key prices in the economy. By letting the state rather than the market set the price of key resources, distortions have developed which now threaten economic growth.
The cost of borrowing, for example, has been kept artificially low by the government. Real lending rates since 2004 have averaged just 2.9 per cent, and at times have even fallen below zero. The consequences have been dire. Cheap money has encouraged a splurge of capital expenditure on fixed assets and infrastructure, which has led to high levels of overcapacity in many parts of the economy.
Prices of everyday essentials such as water, oil, natural gas, electricity and freight have also been kept artificially low to make Chinese manufactured goods competitive abroad and to keep a lid on domestic inflation. But such low input costs have encouraged rampant overproduction, with devastating consequences for the environment. Industrial air pollution is now at dangerously high levels in many of China’s urban areas.
This level of state intervention is increasingly regarded as unsustainable. But reducing it will not be easy; it was the curbing of the state’s reach that Mr Li likened to “cutting one’s wrist”. He was referring to a Chinese legend, in which a warrior who had been bitten by a snake cut off his hand to save the rest of his body.
Managers of those companies that have benefited from artificially cheap credit and energy will almost certainly feel like cutting their own wrists. As the market has a bigger role in setting prices – and the state a smaller one – input costs will inevitably rise. Companies in the industrial and manufacturing sectors – many still state-owned and woefully inefficient – will be particularly hard hit.
Companies will also face higher financing costs if lending rates are liberalised. While the official one-year benchmark rate for loans is currently 6 per cent, annual lending rates in the liberalised, unofficial, shadow banking system are generally above 10 per cent. State-owned giants which have enjoyed preferential access to cheap loans from unquestioning banks will struggle to access finance on more normal commercial terms.