This year saw a smooth start to China's economic development, with economic operation within expectations. However, economic growth is also facing big downward pressure, as the trend of polarization in the real estate market has appeared and the risks of some financial products begin to surface. The country needs to move on steadily and properly handle the relationship of maintaining steady growth, promoting reforms, restructuring, improving people's well-being and preventing risks. It should also make great efforts to cultivate new driving forces for economic growth and build a new platform for economic operation.

I. Economic growth in 2014 can reach expectations

In the first quarter of 2014, the gross domestic product (GDP) had a year-on-year growth of 7.4 percent, 0.3 percentage points lower than that of the same period last year. From January to April, the added value of industries above a designated size increased 8.7 percent year-on-year, 0.7 percentage points lower than last year. In terms of the trend for the entire year, the export environment will get better and its growth rate is likely to increase from the first four months, with consumption growth steadily rising. Since the central government has strengthened efforts in areas such as railway construction and shanty-area renovation, there are few chances for a big drop in investment growth. In general, the demand is mild and controllable, and many indexes have begun to pick up and stabilize. If "stabilizing investment" is achieved along with restructuring and mechanism transformation, economic growth is expected to reach the targets set for this year.

The export environment is improving. The world economy is recovering after the crisis, and its overall situation is stable. The US economy has made headway in restructuring, and the employment situation has been improving. The US Federal Reserve's mild exit from the quantitative easing monetary policy will have a limited negative impact on its economic recovery. In April, the manufacturing and service purchasing managers'index (PMI) in the euro zone both stood above 50. A reading above 50 indicates expansion, while a reading below 50 reflects contraction. If the Ukrainian crisis does not spiral out of control, the euro zone is expected to escape the economic recession triggered by the debt crisis, enhancing confidence in the global market. In addition, stimulated by new economic policies, the Japanese economy showed strong growth momentum. As the policy effect becomes weak and consumption tax rate increases, its recovery process will be impeded. Recovering developed economies will increase their demand for exports from emerging economies, which promotes the economic growth of emerging economies. Even so, the decreasing growth rate of emerging economies will also continue.

The annual global economic growth rate in 2014 will be slightly higher than that in 2013, and China's external economic environment and foreign demand is likely to improve slightly. China's integrated effective exchange rate rose by 7 percent last year, which poses substantial pressure on exports. This year, the unilateral appreciation of the RMB has been replaced by the floating of RMB, resulting in the depreciation of RMB against the US dollar by 3 percent. In addition, the domestic producer price index (PPI) has been declining, which helps export enterprises reduce cost and become more competitive. In April, China's exports increased by 0.9 percent and reversed the trend of negative growth starting from the beginning of this year. The export growth is expected to bounce significantly, and annual growth rate is expected to reach national goals.

The consumption growth rate will increase slightly. In 2013, the year-on-year growth rate of the catering sector‘s revenue saw a decline of 4.5 percentage points, which contributed, negatively, 0.4 percentage points to the increase of total retail sales of consumer goods. During the period between January and April this year, the real growth rate of consumption was basically flat with the same period last year. If the declining real estate sales are not taken into account, general consumption has obviously bounced. In addition, consumption in the service sector, such as information, culture, education and healthcare, have further expanded, and consumption structure has gradually improved. According to the categorical data of the consumer price index (CPI), prices of service items in April saw growth 1.3 percentage points higher than consumer goods. It is expected that total retail sales of consumer goods in 2014 will have a slightly higher increase than that of the previous year, thus contributing more to economic growth. Investment growth faces downward pressure. In 2013, the total planned investment in newly-commenced projects and projects under construction increased by 14.2 percent and 16.2 percent, respectively, decreasing by 13.9 percentage points and 1.3 percentage points compared with 2012. Investment projects that can be carried forward to this year have contracted in scale. Fixed assets investment in the first four months increased by 17.3 percent year-on-year, down by 3.3 percentage points from the same period in the previous year. Investment growth is facing big downward pressure. In the current structure of investment, manufacturing accounts for 35 percent, real estate 25 percent, infrastructure 21 percent, other service sectors 14 percent, and agriculture and mining 6 percent. Influenced by factors such as weak demand from end users, overcapacity, rising costs and low profits, investment in the manufacturing sector, especially in the heavy and chemical industries, is likely to further shrink.

The real estate markets vary in different regions. Second and third-tier cities and below have an oversupply of commercial housing, and their inventory has markedly increased. The investment growth rate in property development is likely to continue to decline for the whole year. In addition, local governments are faced with difficulties such as the local financing platform’s high debt ratio, declining tax revenues, and a drop in the growth rate of land revenue. This year is also a peak year when local governments have to pay their government debts, resulting in scarce investment capacity in infrastructure and having an impact on investment growth in infrastructure. The country has made efforts to streamline administration, delegate more power to lower levels, ease restriction and expand investment access, which may motivate private capital to get involved in infrastructure. The effect is limited due to the large number of institutional and mechanism barriers and obstacles.

II. Pressures on the real economy are passed on to the financial system

China is now at a transition period from a high-growth rate to a medium-high rate. Due to volatile market expectations, the economy may appear stable and weak. Unstable economic operation is likely to cause risks and fluctuating economic growth. Though the drop of the economic growth rate at the beginning of the year was beyond expectations, the supply made positive changes with the development rate, quality and efficiency in a reasonable relationship. There was also a strong demand for labor that reduced the pressure on employment. The CPI was normal and there was no sign of deflation. All this shows that the foundation for medium and long-term economic growth remains unchanged. It is not advisable to give a negative projection of the economic outlook simply because of the short-term drop in the growth rate. It is worthwhile to note that as the real estate market and excessive capacity faces adjustment, pressure on the real economy will be passed on to the financial system, and local risks may begin to show up.

When the economy is growing at a high rate, local risks are easily covered up and eliminated because of the strong potential demand and the continued rise in asset prices. When the economy, however, is in a transition phase from a high-growth rate to a medium-high rate, and periodic economic slowdown occurs, the potential growth rate will markedly decline and the usual risk-eliminating mechanism can hardly work in an effective manner, with key market players failing to make adjustments accordingly. Local government land finance is difficult to sustain and enterprises are not willing to accept sunk cost and take the initiative to get rid of overcapacity. In order to avoid risks, banks will give most of their loans to government-sponsored projects, making it difficult for the real economy to get financial support, and giving rise to low efficiency in allocating financial resources as well as insufficient vitality in economy.

If the decline of the economic growth rate exceeds expectations, the pressures on the real economy will be passed on to the financial system. Financial products risks related to the polarization of the real estate market and overcapacity will surface.

Recently, the country has seen many financial risk cases, including the debt default event of China Credit Trust Co and Jilin Province Trust Co's inability to repay some trust products; some companies being on the watch list and downgraded by some rating organizations; the insolvency of property development companies in Hangzhou, Zhejiang province, and Nanjing, Jiangsu province; some guarantee companies exiting the market; the increase of risks in private lending and a run on banks; and rise of bad bank loans. Although the number of such cases is small, they deserve enough attention to make sure market expectations are guided in a correct direction and prevent systematic risks.

From a macroscopic perspective, the growth rate of the money supply in previous years was apparently higher than the normal growth rate of GDP. The social financing scale expanded rapidly and there was ample liquidity in the market. At the end of 2013, China’s M2 (broad money supply) stood at 194 percent of GDP, ranking among the top in major economies in the world. Meanwhile, the monetary market’s liquidity was a bit tight, and the cost of capital for the real economy was high. Financing difficulty and expensive financing are ubiquitous, and becoming even more serious. These problems were caused because of resources mismatch and maturity mismatch in the financial system, which extends the capital chain and results in market’s becoming sensitive to the liquidity policy made by the central bank. For enterprises that cannot get loans directly from banks, they find their channels of financing narrowing and face huge capital pressures. This not only affects the economic growth rate, but increases the possibility of triggering more risks.

III. Restructuring makes progress and more positive factors appear

The transition period appears to be characterized by the adjustment in growth rate and the transformation of new driving forces. The transformation of development pattern and cultivation of new driving forces for economic growth are the key points for economic operations, with an economy's scale, quality, growth rate and efficiency in a balanced relationship.

Since the beginning of the year, restructuring has made positive progress, with big downward pressure on economy and local risks. The service industry has developed with good momentum. Consumption has made bigger contributions to economic growth, and the employment situation continues to get better. The adjustment in the supply structure will also provide certain support for the steady growth of economy. All these positive changes show that China's economy is experiencing a smooth transition to a new growth platform.

First, the service industry maintains good momentum for steady development. In 2013, the proportion of the added value of the tertiary industry in China's GDP and its contribution to economic growth were both higher than the secondary industry. In the first quarter of this year, the added value of the tertiary industry had a year-on-year increase of 7.8 percent, 0.5 percentage points higher than the growth rate of the secondary industry. The added value of the tertiary industry accounted for 49 percent of GDP, which was 4.1 percentage points higher than that of the secondary industry. The service industry has taken the place of the manufacturing industry and has become the most dynamic part in economic operation, as well as a new driving force of growth. This shows that China's economic structure has undergone a huge change of historic significance. In April, the non-manufacturing PMI stood at 54.8 percent, 0.3 percentage points higher than that of the previous month. The postal service, ecological conservation & environmental control, public facility management, warehousing industry and air transportation were prosperous with their PMI standing above 60 percent and significant increase in business. Since the beginning of this year, the investment growth rate in the service industry, excluding property development and part of infrastructure, has been much higher than the average investment growth rate. Investment growth in modern services such as information and software, finance, commerce, scientific research and development, and culture & sports was strong. As urbanization proceeds, resident consumption grows, and the manufacturing industry is being transformed. The potential demand expansion for product and living services is huge, pushing the service industry to maintain a high rate of development.

Second, the contribution of consumption to economic growth has markedly increased. In 2013, the final consumption's contribution to China's GDP growth dropped by five percentage points over the previous year, with the contribution of capital formation rising by 7.3 percentage points, indicating that economic growth became more dependent on investment. In 2014, the growth rate of export and investment have declined substantially, while the real growth rate of consumption has remained basically flat compared to the same period last year, showing consumption's increased contribution to economic growth. In the first quarter, final consumption accounted for 64.9 percent of GDP, 1.1 percentage points higher than the same period last year.

Third, employment has become more adaptable to slower economic growth. With the working-age population beginning to decrease in 2012, new employment pressure has also eased. In addition, as economic scale constantly expands and a rising proportion of China's GDP is made up of the service industry, economic growth can bring more employment. In 2000, one percentage point of GDP growth required 98 billion yuan ($15.68 billion) of nominal added value. The figure increased to almost 530 billion yuan in 2013, 5.4 times greater than the former figure. China's economy increase in 2013 was about 42 percent of the economic aggregate in 2000. Each 100 million yuan of GDP may create 1,058 new jobs in the second industry; and 1,348 jobs in the tertiary industry, with the latter 30 percent higher than the former. 2013 saw China's GDP grow by 7.7 percent, creating 13.1 million new jobs in urban areas. Thus one percentage point of GDP growth meant 1.7 million new jobs. If industrial structure change is not taken into account, as long as this year's GDP growth rate can reach 7 percent, the target set for new employment increase in urban areas can be realized in 2014, calculated according to the current method.

Fourth, transformation and upgrade of the manufacturing industry have achieved positive progress. With the price of factors of production going up and the contraction of the traditional market, quite a few enterprises have been actively taking action to reduce costs and improve economic returns. In the first three months of this year, among industrial enterprises above a designated size, manufacturing enterprises saw their profits increase by 13.9 percent, 3.8 percentage points higher than the average for industrial enterprises. Electricity and heat production and the supply industry saw profits increase by 32.3 percent; the auto-making industry 29.8 percent; electrical machinery and equipment manufacturing 28.2 percent; non-metal mineral product manufacturing 26.7 percent; and computer, communications and other electronic equipment manufacturing 21.5 percent. Thanks to reforms in major areas such as streamlining administration and delegating more power to lower levels, tax reduction for small and micro businesses, and industrial and commerce registration, newly-registered enterprises will develop rapidly with strong ability in innovation and vitality in starting new undertakings.

Fifth, income growth of urban and rural residents has increased, and the income gap has narrowed. In recent years, China has seen bumper harvests for years running, and the price of farm produce has been increasing in a mild way. The number of rural migrant workers working in cities has been increasing. As the income of rural residents grows at a higher rate than that of urban residents, the urban-rural income gap keeps narrowing. In the first quarter of this year, the per capita income of rural residents and the disposable income of urban residents grew by, in real terms, 10.1 percent and 7.2 percent, respectively, 0.8 percentage points and 0.5 percentage points higher than that in the same period last year. The urban-rural income ratio has narrowed to 2.53 to 1.

IV. Focusing on reforms, maintaining steady investment, controlling risks, and cultivating new driving forces for economic growth

The downward pressure on economic growth is mainly reflected in the decline of the investment growth rate, so the key to realize the expected goals of the entire year is to "stabilize investment." Special attention should be paid to dealing with the relationship of stabilizing growth, risk control, restructuring, demand management and the promotion of reform. Considering stabilizing growth, risk control and restructuring, as potential growth drops significantly, the country has to expand its credit to maintain strong economic growth, which will increase local government debt and create an asset bubble and financial risks. Slower economic growth, however, especially a fast drop in a short period of time, may worsen excessive overcapacity and lead to tight employment, increase of non-performance loans in banks, and even systematic risks. Maintaining economic growth at a reasonable rate is essential for risk control. As far as demand management and reform are concerned, it is necessary to create appropriate policies to boost demand in order to deal with short-term economic fluctuation, particularly large swings. These measures, however, must be carried out along with adjustment in structure and transformation of mechanisms, otherwise, they are likely to worsen structural imbalance and make the original growth pattern more entrenched. The reform of the economic system should bring benefits.

Practice has proved that the core of the reform of the economic system lies in allowing the market to play a decisive role in allocating resources and allowing the government to play a better role. Those economic activities that can be effectively regulated by the market mechanism should be taken care of by the market so as to make the allocation of resources more efficient and give enterprises and individuals more energy and room to create wealth.

The role of the government should be brought into better play, and efforts should be made to improve scientific macro-control and innovate the administrative and management model, combining the market and government. Measures used in reform may take a long or short time to have an effect, and may be targeted at supply or demand. Those that may have an effect quickly and are used to boost demand should be used first to realize the expansion of demand and stabilization of growth in the short term. They may work with policies to promote demand to cultivate medium and long-term growth.

As a latecomer catching up with developed countries, China has many investment projects that will bring good economic and social benefits. The country still has huge room for investment. The transformation and upgrade of manufacturing provides tremendous room for equipment update and renovation. High-end manufacturing, strategically emerging industries and the modern service sector are in full swing, so they need a large amount of new investment. In addition, urban underground pipe networks need to be updated and transformed, and infrastructure comprehensively improved. Development in the central and western regions and in rural areas also lags behind, and many things have been left undone due to historical reasons. From a medium to long-term perspective, one of the major driving forces for China’s economic growth is improvement of per capita asset ownership, which is also a key direction in which efforts can be made to boost economic vitality. Considering the problems of economic operation and the challenges facing the economy, we should stress the importance of focusing on reforms, stabilizing investment and controlling risks. We should try to strike a balance among the three. The country should move on steadily and carry out proactive fiscal policies and sound monetary policies. Meanwhile, China needs to pay close attention to the short-term capital flow in the wake of the US exit of quantitative easing (QE). It should maintain moderate growth of social financing scale. Besides, the country should monitor the impact of financial risks in local regions and prevent risks from quickly appearing as well as from overlapping with the decline in growth rate. It should also strengthen investment and financing channels, increase support to the real economy and improve the efficiency of funds allocation. The role of fiscal policy in expanding demand and vitalizing the supply side should be brought into further play. Along with increasing expenditures and expanding the scope of tax reduction, all efforts should work with reform measures to magnify the effect, promote reform in key areas and cultivate new driving forces for economic growth.

In the short term, the country should continue to focus on adjusting the investment structure, stabilizing the investment growth rate, solving financial risks and pushing forward reforms. The country should regulate local financial platforms and promote local government finance sectors to raise funds in compliance with laws and regulations. It should also give support to the construction of housing and infrastructure with the help of policy-based financial institutions, in addition to speeding up asset securitization, vitalizing stock, leading public opinion, solving risks, accelerating depreciation, reducing overcapacity, and promoting industrial restructuring.

In the long term, priority should be given to reforms that will benefit economic growth, restructuring and transformation. This includes industrial reform to get rid of administrative monopolies and promote fair competition for high efficiency of non-trade departments; reforms in cutting enterprise cost and in land, finance and intellectual property rights protection; and increases in enterprise profitability and upgrade and transformation. China should expand the opening of the service industry and create the market environment with equal access and fair competition. It should enhance social public service infrastructure to alleviate debt pressure for local governments and enterprises.

Author: Li Wei, minister and research fellow of the Development Research Center of the State Council (DRC) 

Source: Qiushi, 2014 (13)