Economics To Take Center Stage in China

Senior Chinese Communist Party members are to gather, probably in October, for the party's Third Plenum in Beijing to add substance to the country's economic reform framework, which could shed additional light for investors.

Their deliberations will be followed with great eagerness by the business community. Markets have been waiting for almost two years for Xi Jinping and Li Keqiang to demonstrate their control over China's economic and political apparatus. They have got off to a fast start, unlike their predecessors Hu Jintao and Wen Jiabao, apparently out of a sense of urgency that the economy is at a crossroads, and that there are major challenges to be met.

This isn't only in Li's grand plans to metamorphose from an export-led economy to a consumer one, built on his grand plan for urbanization. Li, China's first economist premier, believes that China must keep GDP growth at about 7.5 percent and inflation below 3.5 percent during the restructuring, and that the country can't tolerate growth below 7 percent. While saying no new stimulus measures would be put in place following the imbalances of the massive RMB4 trillion stimulus plan of 2008 and 2009, a variety of funding programs have been put in place. Li believes growth stability is a prerequisite to structural reform. Thus he believes domestic demand must be raised on public housing, information technology infrastructure, railways and particularly the country's small and medium enterprises.

While Beijing has continued to transform the economy and the financial system, they are faced with a new generation of people who don't recall the hardships their parents endured -- the balinghou, the so-called "little emperors" born in the first decade of reform and opening up, the first of the one-child generation. The balinghou were the first generation to grow up under social stability and high economic growth. Consequently, pursuit of personal satisfaction, self-fulfillment and pleasure are one of their biggest traits.

The balinghou have changed the lifestyles and moral values of Chinese society, generating a slew of buzzwords that reflect this social phenomenon. These buzzwords include Kenlaozu, a group characterized as "biting the old generation," which expresses their jobless existence, voluntary or involuntary, and their continued dependence on their parents. The yueguangzu are youngsters who spend their entire monthly incomes without making any savings. The fangnu and chenu are slaves to their mortgage and car payments.

Generational change thus must to be taken into account. Rising affluence means hundreds of thousands of young are a generation more concerned with the quality of life than previous ones who were mainly concerned with the rice bowl, iron or otherwise.

This is all occurring at a time when the trial of former Chongqing satrap Bo Xilai is going on, and with getting rid of him proving more difficult than thought. With a claque of followers in the streets, Bo has defended his position with fervor. But the timing of the trial and the method of prosecution are both interesting. Obviously the leadership wants to get Bo both discredited and out of the way before the plenum. And the prosecution is at pains to make sure the Chinese public knows it was corruption that Bo down, not his ideological alignment with the revolutionary ideas of Mao Zedong.

Against this backdrop, the cadres are expected to be given their marching orders, with new party secretaries and governors appointed throughout China, presumably with the rolls cleared of Bo's followers. Certainly, there are signs that change is in the air, reflecting the new urgency, although it is purely economic. But as western media reported this week, political reform in terms of western style democracy is decidedly off the table.

Instead Xi and Li will emphasize improving the effectiveness of the government's administration. Virtually every day for weeks the Chinese-language newspapers have headlined regulatory changes and new initiatives including a plan to wire half of the country's population for free wi-fi by 2015.

The exact dates of the third plenary session are yet to be announced, but most political observers expect it to occur sometime before this year's Mid-Autumn Festival (Sept. 19-21) or after the Golden Week holiday (Oct. 1-7). The meeting typically lasts four to five days, and may well span a weekend.

High on the agenda this year is likely to be the discussion of fiscal reforms, market pricing of natural resources and financial liberalization. The financial sector could be given additional policy clarity regarding the outbound QDII2 capital account trials and deposit rate liberalization. Beijing will likely pledge to cut more red tape as a way to boost the business environment and curb the potential for corruption. The meeting is also anticipated to touch on land and hukou-system reforms in the context of the broader urbanization strategy.

Fiscal and taxation reform are expected to be major topics as many are expecting more concrete tax proposals to stabilize the funding sources for local governments, and to orchestrate a significant transition from the current model which relies primarily on land sales. Property taxes will certainly take on an expanded role but the government will stay on guard against destabilizing the housing sector.

Meanwhile, the introduction of new local revenue streams such as consumption and environmental protection taxes are very likely. We consider these measures highly constructive to alleviate fiscal pressures on provincial governments from both heightened debt monitoring and growing expenditures to improve social security and living standards.

Market pricing of natural resources should push further along to suppress irrational environmental degradation and better reach equilibrium in supply and demand. In addition, electricity charges for large industrial enterprises are expected to rise and more accurately reflect true generation costs while preferential tariffs are increasingly phased out. China will probably also encourage electricity generation by independent power producers to boost market-driven supply.

Another key area of price liberalization is expected in the railway freight sector, in which we expect a flood of private investment. The drive to lower logistical costs will become a main theme, especially as the newly established China Railway Corporation takes form as a market-oriented SOE. Consequently, we also foresee tolls on roads to be under pressure from rising competition. Natural gas and petroleum retailers, power generators including IPPs, railway are expected to benefit but toll road operators and energy-intensive manufacturing face problems.

The financial sector could expect additional policy details for capital account convertibility especially on the outbound QDII2 investment scheme in Guangdong province with products on the Hong Kong Stock Exchange. We also are looking for more specifics on pushing forward cross-border renminbi financial innovation with Hong Kong via the Qianhai new district in Shenzhen.

Deposit rate liberalization will be another major subject for further deliberations but any move will likely be restricted initially to large sums and long tenors. Finally, as interbank market volatility has clearly subsided, there is a renewed chance for a widening of the RMB trading band as well further expectation for more transparency in the determination of daily central parity fixing. Hong Kong and China financial institutions - asset managers, banks and brokerages - are expected to be the beneficiaries.

Beyond the above three main areas of reforms, we expect to see Beijing reiterate its pledge to cut more administrative protocols as a way to boost the business environment and curb the potential for corruption. Creating a level playing field for smaller and private companies has been a cornerstone reform strategy of the new administration, but one that will also take a little more time for the policy effects to come to fruition.

Finally, the convention is also anticipated to touch on land and hukou-system reforms in the context of the broader urbanization strategy. There have been numerous proposals by think tanks to allow migrant workers to sell their farmlands for cash in order for them to gain a foothold in the cities. It is not hard to see that such reform must be tied in with corresponding policy changes to allow farmers to convert to city dwellership with formal residential registration. As Premier Li explained recently, as migrant workers feel secure about moving towards the cities, they will be more willing to settle down and make large ticket purchases of item such as cars and apartments. This is the medium goal underlying China's consumption strategy. Property developers, carmakers, banks and insurance companies are expected to benefit.

(Steve Wang is Director and China Economist for REORIENT Securities Ltd. of Hong Kong)