China’s Gradualist Reform Approach Reaching Bitter End

China’s step-by-step strategy of creating change is increasingly undermined by instantaneous market reactions

By Nathaniel Taplin

China's Premier Li Keqiang on Sunday announced a more modest economic growth target of ‘around 6.5%’. Photo: jason lee/Reuters


Reform is what makes China tick for investors. The more signs that Beijing is taking on tough problems, the more investors cling to the idea that the China miracle has room to run.

They are watching closely for signs of change at this week’s annual meeting of China’s National People’s Congress, when the country’s leaders map out the latest economic course. A more modest economic growth target of “around 6.5%” unveiled Sunday by premier Li Keqiang is another baby step toward acknowledging the need for change. But there is dispiriting news on the reform front: China’s gradualist approach to change may have run its course.

As China’s financial markets have grown larger and more complex, incremental reform has gotten tougher because lightning-fast market reactions accelerate the impact of reformers’ decisions and create a strong temptation to backpedal, according to a National Bureau of Economic Research paper by economists Markus Brunnermeier,Michael Sockin and Wei Xiong. The authors point to the botched rollout of stock-market “circuit breakers” in January 2016 as an illustration of how financial markets amplify and accelerate the impact of experimental policies, often causing reforms to backtrack and lose credibility.

China’s struggle to reduce industrial overcapacity is another example. In years past, steel and coal capacity cuts were difficult, but the impact unfolded slowly over time. Yet since coal and iron ore futures were introduced in 2013, when curbs are announced, markets react instantly.

A recent coal price fiasco is an example of this dynamic at work. Tough curbs on coal output were announced in April 2016 to try to curb overcapacity. But when import and electricity data began hinting at higher demand last fall, coal and iron-ore futures flew through the roof. Coking coal futures rose nearly 200% from late September to early December.

As prices moved higher, regulators rapidly watered down output restrictions. Prices have now fallen back—but in the future, capacity curbs may prove difficult to execute because miners are unlikely to believe they will last, and speculators will push up prices again.

Another area of struggle is ballooning corporate and local government debt. In the past, financial problems at important state firms could be handled behind closed doors by banks and local governments, with Beijing coordinating as needed. Changes in debt policy would take time to impact the real economy.

But now, debt markets react instantly—as they did in April 2016 when the central bank used tough language on cutting off “zombie enterprises.” After several weeks of hair-raising market volatility, the central banked stepped in with massive liquidity injections and tossed bonds back into a bull market. That avoided a major blow-up—but the message that pressure to deleverage would be temporary was reinforced.

Deng Xiaoping famously abided by the reform philosophy of “crossing the river by touching the stones.” These days, the river is running too fast and too deep for small steps.

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