China should scrap its growth target
Last October, the acrobat Adili Wuxor walked, without safety nets, 100 meters above the Great Wall of China. His feat emulated what Chinese officials achieved in 2013: balancing the economy by alternately tightening and loosening economic policy ahead of the flagship Plenary meeting in November.
So far, China has proved a successful tightrope walker, weighing short-term policy judgment against longer-term considerations. But no matter how China tweaks its monetary policy, and no matter how it implements the reforms announced at the Plenary, it will not create true balance in its economy without one further measure: scrapping the government's economic growth target.
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Targeting growth is akin to marching across a tightrope at a set speed, almost guaranteeing instability if conditions change during the crossing. The policy forces China to place short-term requirements ahead of long-term benefits. If the Plenary's reforms result in a slowing of near-term growth, it is likely that credit will once again be called upon to "make up" the gap.
The Plenary's reforms exceeded expectations and attracted investors back on a tactical basis. The Chinese government intends to enable more private participation in the state-owned enterprise sector and improve privately-owned companies' access to credit. This should make the allocation of capital in China more efficient and may make its state-owned monoliths more shareholder-friendly.
In addition, the proposed changes to China's Hukou or fixed residency system may ease social tensions, improve workers' mobility and thus accelerate productivity growth. Plans to break the link between state banks and local governments and foster a "municipal" debt market may also enable more independent scrutiny of local government finances.
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But while these measures may help China regain its balance to an extent, their failure to address the structural problems created by the growth target ensures the relief will only be short-term. Any professional tightrope walker knows that sometimes you need to stop, or slow. Forcing yourself to stick to targets and marching ahead at all costs only leads to instability and ultimately increases the chance of a hard landing.
Unfortunately, in the months leading up to the November Plenary, China's policy maneuvering was less professional than observers had come to expect from the country.
At the beginning of the year, China's shadow banking system grew rapidly. With credit creation notably outstripping gross domestic product (GDP), the government attempted to reduce the risk that the system would foster a new generation of non-performing loans.
Yet it overbalanced. The ensuing clampdown led to a spike in interbank interest rates and very nearly caused a credit crunch. Credit creation dropped sharply, particularly in the non-bank sector, where new loans dropped to CNY815 billion in May, June and July from CNY2,900 billion in the previous three months. The negative consequences for growth were clear. Purchasing managers' indices were stagnant, and the Shanghai composite index dropped as much as 15 percent through June.
To correct this, China's government once again veered in the other direction, with a so-called mini-stimulus and a pick-up in credit growth. Now most economists expect yet another veer in the other direction.
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Following these short-term wobbles, investors should watch out for volatility surrounding the implementation of longer-term Plenary policies. One example of this is liberalizing interest rates. An underpricing of capital by state-owned banks and favorable treatment of state-owned enterprises have allowed inefficient and unprofitable businesses to stay afloat. Without letting rates move more freely, China's over-capacity problems are likely to persist.
But although such measures would help China regain its balance to a degree, none of them will create true equilibrium unless China scraps its growth target. When trying to keep their balance, professional tightrope walkers will calmly correct, pausing and sitting if necessary, before treading carefully forward. In contrast, amateurs swing violently from side to side before falling off the rope. If scrapping the growth target proves a step too far for the government, the best that can be hoped for is that China rethinks its strategy, slows down, and opts for a more measured march forward.
— By Alexander Friedman, Global Chief Investment Officer at UBS Wealth Management, and Kiran Ganesh, Cross-Asset Strategist at UBS Wealth Management
Alex oversees the investment policy and strategy for approximately $1.7 trillion in assets and heads up a team of 900 analysts globally. Previously, Alex was Chief Financial Officer of the Bill & Melinda Gates Foundation and a member of the foundation's management committee.He has been regularly interviewed by international media such as Financial Times, Bloomberg, CNBC, The Economist etc and contributes byline articles to the Financial Times.