China’s Balancing Act

Reform. This has been the buzzword for Chinese politicians since last November's Third Plenum, where officials announced ambitious social, economic, and political reforms. That refrain has continued ever since, from March's National People's Congress (NPC) to a litany of policy announcements from the State Council and central bank. The goals are well-known: liberalizing interest rates, establishing deposit insurance, achieving full renmibi convertibility, and opening the financial system to private banks. However, there is a wrinkle: This year's GDP growth target was pegged at "around 7.5 percent," and the economy is struggling to get there. This raises a question: Can China address persisting structural issues in its economy while maintaining speedy growth? Skeptics might be tempted to say no, pointing to a few telltale signs of government intervention, but a broader look tells a different story. Even with the occasional step back in the name of growth, officials appear to be making good on recent reform pledges-a long-term positive, and a trend that should help China become more of a market force.

It's true leaders seemingly aren't shying away from the occasional U-turn in the name of growth. For example, as trade figures fell earlier this year, the central bank (coincidentally?) allowed the yuan to weaken. The party line said it was an effort to shake out currency speculators before further liberalizing rates, but the timing was rather uncanny-it made China's exports that much more affordable at a time when they needed a boost. Officials also passed up a chance to inject more market forces into the shadow banking sector, even after warning investors they shouldn't assume financial products carry an implicit government guarantee. Officials had the chance in January, when a wealth management product from China Credit Trust Company was on the brink of default, but they granted a last minute bailout to the tune of RMB 3 billion in an apparent attempt to ease investors' anxieties over potential contagion.

Yet a survey of all the government's actions year-to-date suggests these examples are outliers, and reform remains high on the agenda. Premier Li Keqiang has tried to set markets' expectations for both slower growth and continued reform, saying in March, "We are not pursuing GDP growth alone," and admitting the growth target was flexible. Even as trade, industrial production and retail sales sagged somewhat, officials resisted the temptation to launch a blitz of fiscal stimulus to shore up growth. Instead, they opted for smaller stimulus measures with a decidedly market-oriented slant. So far, officials have cut taxes for small private businesses, opened infrastructure projects to private investment and tried to promote traditional bank lending to small firms and entrepreneurs-essentially promoting the private sector, not the state, as the country's main growth engine.

There are also several other indications China's government is slowly unclamping its grip on the economy. In March, the central bank doubled the yuan's trading band, allowing for more volatility. Officials recently green-lit three new private banks as part of a pilot program, and they're supposed to go live within six months. Politicians stood pat when Shanghai Chaori Solar Energy Science and Technology defaulted on an RMB 89.8 million interest payment to its bondholders, China's first-ever onshore corporate bond default. Shanghai's promising free trade zone, introduced last year, has been a testing ground for freer interest rates-which were loosened again in late June. And last month, officials ordered banks to start including disclosures warning of the risk of loss on all wealth management products-a large subset of the shadow banking system-effectively ending banks' practice of marketing them as a safe, high-yield alternative to savings accounts. The market, it would seem, is gaining a foothold, and if this continues, it should improve the health and efficiency of China's economy in the long run.

This year likely won't be the last time Chinese officials face the temptation to intervene. If politicians follow through with market-based reform, Chaori Solar is likely only the first of many potential corporate bond defaults over the next several years. And with RMB 109 billion in shadow financing products maturing this year, another RMB 203.5 in 2015 and property markets struggling a tad, officials will probably get at least a few more chances to allow the market to deal with a shadow banking default. While allowing the market deal with all of these would benefit China in the long run, it's debatable how well the government's incentives are aligned with that end. The Chinese government relies on stability and steady growth for control, and any shock to the system could jeopardize their delicate equilibrium. The sheer desire to avoid that outcome and stay in power could drive officials to intervene again if they think it's necessary for maintaining social harmony-which some suspect happened in late July, when a construction company mysteriously raised enough money at the last minute to avoid defaulting on a private placement.

However, investors shouldn't interpret the occasional rescue as a wholesale shift away from reform-this has long been a balancing act and likely stays that way for the foreseeable future. If political concerns make reform a very gradual process, that won't come as a surprise to markets. Market-oriented changes, no matter how beneficial in the long term, tend to introduce some short-term speed bumps. When the state pulls its safety net and forces firms to stand on their own feet for the first time ever, it inevitably creates winners and losers, and Chinese leaders' incentive to minimize the number of losers is a very well-known issue. Most observers also seem to accept that reform won't be a seamless process. As we've seen with securities regulators efforts to modernize and restart China's IPO market, there will probably be some missteps and false starts. China's technocrats are well-studied, but they will still have to learn as they go. Markets know all of this. Moreover, markets likely don't need reforms to come fast and furious-what matters more is that the country moves more toward reform than not over time. Even gradual, occasionally bumpy progress is still progress.

Investors today should be mindful of this. Many get bogged down in slowing growth, but in our view, reform is a bigger swing factor for stocks, and slower growth coupled with gradual, continued reform measures is a positive. Growth might well slow further still as officials slowly let a freer market take the reins, as structural reforms often don't bear immediate economic fruit. Headlines might chew over every economic data release, but investors who consider the longer-term efficacy of reforms will have a clear, more complete view of China's potential.