Nicholas Lardy: China Is on the Right Track, but Reforms Must Continue
(Beijing) -- As one of the most well-known China experts in the United States, Nicholas Lardy's study on the country's economy has closely followed its reform progress in the past three decades.
In his most recent book, Sustaining China's Economic Growth after the Global Financial Crisis, the Anthony M. Solomon Senior Fellow at the Peterson Institute for International Economics argues that maintaining China's growth will require a rebalancing of the economy from export-oriented investment to domestic consumption. He has also written numerous policy briefs for the Peterson Institute, including widely cited studies like What Kind of Landing for the Chinese Economy? and The Future of China's Exchange Rate Policy.
In a recent interview with Caixin, Lardy shared his thoughts on several economic topics that have engendered much recent discussion, including the health of the property market, the fluctuation of the yuan exchange rate and whether China can sustain its present rate of GDP growth.
Lardy says that a collapse in the property sector may not be as likely or as damaging as some suggest, that recent moves in exchange rates have been driven more by the market than by policy, and that policy disalignment between central and local governments, often seen as an obstacle to reform, may in fact help push it forward. He stands firm in his support for reforms in the areas of financial markets and state-owned enterprises (SOEs) that go deeper than anything contemplated during the third plenum, calling for free entry for initial public offerings and the abolition of the State-owned Assets Supervision and Administration Commission (SASAC) in favor of a strategy that introduces SOEs to private competition.
Excerpts of the interview follow.
Caixin: One of the most imminent areas of risk, many people think, is the property market. We're already seeing trading volume down significantly and prices show signs of declining, and we're seeing various local governments relaxing controls on buying houses. Do you think this kind of government intervention is necessary at this stage?
Nicholas Lardy: I think it's debatable whether it's necessary, but more importantly it's debatable whether it'll work. In the past, people have had to have high down payments as the government has put in these restrictions on buying multiple properties. Maybe now some of those high down payment requirements will be eased or maybe even eliminated. But if people don't think prices are going to keep going up, it may not make any difference.
I think that the most promising move in the property sector would be to accelerate the development of so-called social housing. The central government should be providing more funds to local governments and making sure it's channeled into social housing. That would keep up demand. There's a huge unmet demand for social housing, while there's a big oversupply, it appears, of commercial housing. I think the mix could be changed fairly quickly and offset the decline in demand for commercial property, and I think that would be a much better policy approach than a loosening of monetary policy by reducing the required reserve ratio, as some people have suggested.
And maybe they should put in some brakes before a possible collapse. That's something they worry about as well.
Yes. But the good thing about the China property market is that compared to, say, Ireland or Spain or the U.S., the leverage in the property sector is substantially less. So there's a macroeconomic risk of a slowdown if the demand for property moderates, but the financial consequences could be significantly less than those other markets. And you might say that the government's been trying to slow down the property sector for years. Now it's finally slowing down a little bit, they should declare success.
Do you see the recent developments in the past three months with the yuan exchange rate as healthy?
Yes. It's consistent with the long-term desire of the central bank to have two-way movement of the yuan value, and the steady upward appreciation over a period of time led to a very substantial increase in the so-called carry trade – people wanting to bring money into China simply to take advantage of appreciation – and that had unfavorable consequences from the point of view of the central bank. So having a period of depreciation of the currency will be helpful in reducing those carry trades.
And I think that part of it – maybe even a large part of it – has been market-driven. It's not surprising that you'd see a currency depreciating a little bit when expectations of current and future growth are declining.
One thing everyone in China has been talking about is the rebalancing from investment to consumption. But at the end of the day we still need investment. What's your take on this?
There's no country in the world that has invested as high a share of GDP as China has over the last 10 years. And in many sectors now, there's excess capacity. In many sectors the return on assets has fallen quite sharply. So the efficiency of investment, in my opinion, has declined quite dramatically since roughly 2007. And even if China's share of investment in GDP were to fall, let's say, from the high 40 percents to the high 30 percents, China would still have the highest rate of investment of any country in the world. The growth of the capital stock would still be significant, with plenty of room for upgrading and plenty of room for continuing to build out the infrastructure so infrastructure doesn't become a constraint on economic growth. I think it probably needs to, over the medium term, maybe have investment in the range of 35 to 40 percent of GDP. But the current level, 45 to 50 percent, I think is way too high and has very adverse consequences.
On the capital markets side, the securities regulator said that there will be about 100 companies listed this year. What do you think of this?
I don't think there's any doubt that the government would like to reduce the reliance on bank lending for financing the nonfinancial corporate sector. So the plan to allow more companies to carry out IPOs is a very positive step. However, I would say, it's still not clear whether the government has given up the idea that it is responsible for price levels in the equity market. I think the history of the last 10 or 15 years shows that when the government thinks prices are going down, then they reduce the transactions tax or try to reduce the supply of new listings.
I think the government should get completely out of the business of taking any steps that are perceived as trying to influence the price. The prices should be determined by the market, and so there should be free entry for IPOs. After all, if that has a negative effect on price, fewer companies will want to list. Why would they want to sell off half the ownership of the company if the price that they can get for those shares is lower than what they think they're really worth?
What about the other pillar of capital markets, the bond market?
The strange thing about China's bond market now is that most of the bonds are actually purchased by the banks, so it's a little bit difficult to differentiate between bond financing and bank lending. So I think it's not an environment that's conducive to appropriate pricing of bonds based on the risk and the promise of different businesses.
But as for reducing reliance on banks, let me just say: it is still the case, even in the last few years when bank lending was at a very elevated level, that retained earnings are a more important source of finance than bank loans. So even though there are some problems in the banking sector and the bond market isn't working perfectly, that helps allocate capital more efficiently because more efficient firms have a higher return on assets, so they have more retained earnings and most of these earnings get reinvested.
Do you think the central government should take a firmer hand in resolving the disalignment of policy initiatives between central and local levels of government that has been an obstacle to reform?
I think we've seen over the decades that competition across localities can sometimes accelerate reform. For example, that was certainly the case in the establishment of free trade zones earlier. Everybody wanted to have a zone so they could have a better chance of attracting foreign investment. That led to more liberalization and deeper, quicker integration of China into the global economy, which I think has been a big plus over the last three decades. So I'm not so sure we need more coordination. Maybe we need more competition across jurisdictions.
On SOE reform, right now it seems that it's more on an individual basis. What do you think will likely follow this?
If the government really follows through on eliminating sectoral monopolies where state-owned firms have been highly protected – like in telecoms, financial services, oil and gas, and certain other service industries – it will open up a huge portion of the economy to more competition, particularly from private domestic companies.
That same process generated a huge amount of growth in the industrial sector, particularly in manufacturing, since the late 1970s, but in the service sector there's been much less introduction of competition because of these protections of the incumbent firms, which are invariably state-owned companies.
This is one of the reasons why I think that China can move to an environment with a lower share of investment because if the financial system is reformed in such a way that more credit flows to the private sector, where the return on assets is much higher, then China can generate the same level of growth with a much lower rate of investment.
More specifically, in terms of the approach to SOE reform, do you think it is right to focus on mixed-ownership models, rather than work to establish proper government structures? Should SASAC step away from micromanaging the daily operations of SOEs?
I hope that SASAC will be abolished. It has completely failed in its objective of improving the performance of state-owned companies. Since 2007, profit growth at firms under SASAC's jurisdiction has basically collapsed, and the profit growth that has occurred has largely been the result of growing assets even faster, which means that productivity has come down.
The return on assets of SASAC companies has come down dramatically. It's now in the neighborhood of about 3 percent, and everybody might have their own estimate, but it's impossible to think that the real cost of capital in China today is less than seven percent. So here you have this huge body of companies under SASAC that are only earning half the cost of capital. It's basically a tax on the whole economy and the Chinese population.
Do you think China's growth rate can be sustained at the recent level?
If the reforms outlined in the third plenum document are steadily implemented, then yes, I think so. There's an enormous opportunity for improving the efficiency of the use of capital by undertaking reforms in the financial sector and by de-monopolizing. In many of these areas you can produce twice as much output with the same capital if you allocate the resources more efficiently. So maybe the growth will dip down to 6 to 7 percent for a year or two, but I think over the next five years China could grow at an average rate of 7 to 8 percent.
Intern researcher James Bradbury contributed to the story
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