We strongly believe the present Chinese government, led by President Xi Jinping, is committed to reform. We are pleased with the sweeping reform proposals announced after the Third Plenum of the 18th Chinese Communist Party Central Committee meeting concluded on November 12, 2013. The establishment of a top-level committee to plan and lead the reform initiative shows the country is serious about reforms.
The unknown part, of course, is how Beijing is going to implement these measures. While we believe the market will be excited in the short run about the reform proposals, we do not underestimate the challenges presented during the execution stage, when these reforms are implemented. The reform plan also shows that the top leaders are economically liberal but politically conservative.
Nevertheless, Xi’s new initiatives, if successful, would represent a radical change for the economy and his reforms would be ranked with the historic ones, such as the open-door policy adopted in 1978 by Deng Xiaoping.
Let us look at the five key areas of the current reform proposals:
Markets are going to play a decisive role rather than a basic role in allocating resources going forward. As markets play a bigger role, the government becomes less dominant in allocating resources on factors such as labor and capital, and more important in setting rules and providing social services for the public. State companies should return 30 per cent of their profits to the government by 2020 compared with the current rate of between 10 per cent and 30 per cent of earnings.
The measures also promise fully equal treatment of migrant workers in urban areas in counties and small cities, and therefore should allow workers equal access to social welfare such as education and medical care. While small cities will be fully open for Hukou reform (Hukou is a household registration system that identifies individuals as residents of a particular area), medium-sized cities will be relaxed in an orderly manner. For the tier-one cities, Hukou will be strictly controlled.
Land and one-child policy
The government is going to implement land reform and give farmers more protection of their property rights. There are also plans to liberalise the one-child policy, which will allow families with one parent who was a single child to have two children.
Foreign investors and financial sector reform
The government will explore a system that guarantees equal treatment of foreign investors in China, as long as they do not invest in strategically important sectors such as defence.
Property tax will be implemented across the nation at an appropriate time. The financial sector will see further liberalization on the interest-rate and exchange-rate front. Small and medium enterprises (SMEs) should find it easier to get credit. There will also be an opening up of the services sector as well as reduction of government administration on business registrations.
The new government has shown strong determination to conduct reforms, and these are clearly positive for China over the longer term. However, structural reforms entail corporate restructuring, and the outcome will likely be some bankruptcies and layoffs in the inefficient segments of the economy. This is deflationary and will prove to be painful in the interim. The benefits and dividends from the reforms will only be seen over time in the form of rising productivity and efficiency.
China’s equity markets, dominated by financial names and inefficient state-owned enterprises, have underperformed in the past few years both in terms of absolute performance and relative performance to global markets. It is interesting to note that the equity-market segments that are expected to benefit from reforms, such as small caps, have done better in the past few quarters. We believe the services sector will finally become more prominent and could offer good long-term investment opportunities despite an overall economic growth slowdown. For example, the education, health care, Internet and transportation sectors could enjoy better growth opportunities over time.
Overall, we firmly believe the Chinese government is serious about reforms, but we don’t underestimate the challenges ahead to implement the much-needed measures. If the authorities succeed in implementing reforms, the country’s efficiency will improve and productivity growth will revive. The economy will deliver sustainable growth and the stock markets will see strong performance in the second half of this decade. Meanwhile, pursuing structural reforms at a time when some segments of the economy remain overly leveraged could result in some volatile periods of performance.