Macro Expectations for the Second Half of 2013

By WILLIAM HILTON

DE SPITE continuing efforts by major central banks around the world to prop up growth by injecting money and credit into their respective economies there are signs that a number of the 10 largest global economies are starting to falter. As a major trading power， China is not immune to slowing growth abroad and will likely continue to feel a chill from relatively cool economies， including the U.S.， Germany， France and others that were cool to begin with.

Recent macroeconomic data from statistical authorities in China paint a mixed picture of the worlds second largest economy. Although policy makers in China can take some comfort that GDP growth for 2013 should come in at an enviable 7.5 percent for the full year， they still face a similar challenge to that faced by the major economies growing far more slowly： meeting the needs of short-term growth and job creation without exacerbating long-term risks.

On the whole， this is a year for looking at the big picture， rather than focusing too much on individual data releases for a given month or a given quarter. Closely watched indicators， such as purchasing manager indices， trade and foreign direct investment data， not to mention inflation， are still important， and the new leadership will certainly be watching them closely. However， hasty policy responses to short-term trends could undermine work underway to adjust the structure of the economy to make future growth more sustainable.

Long-term risks， from an over-reliance on debt-financed investment to lead output growth， not to mention the continued rapid growth in urban real estate prices， could easily become worse. If policy makers focus on the headlines rather than on the difficult task of driving through tough structural reforms， the cost of managing issues such as industrial overcapacity and income inequality will rise further.

All things considered， the weaker than expected growth data for the first quarter of the year shows that so far， the new administration is adhering to the idea that at this point in Chinas economic development， when it comes to propping up the economy less is more. Easing up on monetary policy through creating lots of new credit is no longer feasible. However， in the coming quarters policy makers will probably be more specific about how they will address the tension between shortterm growth and long-term policy goals. This could include increases in government expenditure to ease the current systemic dependency on debt and interest rates cuts to ease the growing burden on companies from quarterly debt servicing costs.

With all of these in mind， there are some important themes that will likely be given a lot of attention in the second half of 2013. The issues below will help to shape the evolving economic policy stance during the coming months.

Urbanization Is Not a Growth Cure

The new leadership in Beijing has stressed the importance of urbanization as a driver of future economic growth. On one hand， this is certainly true， as an estimated 10 million new urban residents per year will create fresh demand for housing and services； on the other， there is a lot about future urbanization policy that is still vague， as real estate development and infrastructure construction have already been important drivers of growth for more than a decade.

A worry among policy makers is that the current economic model – heavily reliant on urbanization related investment –is not creating enough jobs to keep household income growing at an acceptable rate. Additionally， regulators have recently been tightening up controls on financing channels that have allowed local government financing platforms and companies close to local governments to borrow extensively to fund such projects.

This speaks to the broader point that urbanization is not just about building cities. Equally important as the hard infrastructure – roads， bridges， housing， etc – is what one might call soft infrastructure： efficient and effective administrative services， an investment environment favorable to nonmanufacturing investment and an overall environment that stresses inclusiveness rather than exclusion. If hard infrastructure construction is about building walls （among other things）， then soft infrastructure construction is about tearing them down， and allowing new urban residents to be included in mainstream social programs， such as healthcare and education.

The experience of the past 10 years shows that this is harder to do than building transportation systems and housing complexes.

Getting Inflationary Expectations Right

Consumer price inflation appears to be under control. Based on official data， consumer price increases broadly measured continue to be mostly a function of spikes in the cost of food， most notably fresh fruit and vegetables. Excess capacity in many manufacturing sectors means that producers cannot easily transfer cost increases to their customers. In Chinas case， overall prices for things like home electronics and many other durable consumer commodities have been flat or even falling.

In the current environment， however， there is a potential new source of inflationary pressure， one linked to economic reforms that could get a lot of attention in the coming months： relative price adjustments to the costs of services.

What this means is that the cost of many of the services and commodities that the government provides， such as medical services and electricity， are set lower than the level necessary to earn back the full expenses of providing them. These are sensitive social and political issues， so over time it has been the norm to use various subsidies to cover losses incurred by producers rather than raise prices paid by households.

The problem is that over time these arrangements have led to inadequate capacity in many sectors， perhaps most notably in public services. Wages for doctors and skilled medical professionals are meager， in part because prices for medical procedures are too low. Consequently there has been a disincentive to invest in these areas. Part of the policy fix for this situation is to raise official prices， an act that could temporarily drive up inflationary pressure and utility prices.

When households anywhere hear the term “price hike”they tend to expect the worst. However， if managed well， such policy adjustments would not necessarily lead to rising prices elsewhere in the economy. That is to say， there is room to manage expectations of future price increases， and this kind of messaging may be an important component of successful policy reforms coming up to ensure that price signals help to attract enough supply.

Pace of RMB Appreciation Not Sustainable

Amidst a softening external environment and slowing domestic growth， policy makers in Beijing will likely not allow the current pace of appreciation of the Chinese currency to continue for much longer. The Renminbi has appreciated by more than one percent since the beginning of the year， a trend that has gathered momentum following recent meetings of the State Council and statements from the Peoples Bank of China. However， this is a case where expectations in the marketplace might be out of step with the state of the economy and the resulting policy orientation.

True， reforms to Chinas exchange rate mechanism， like reform anywhere in the economy， is not free， as some industries bear the cost of change while others benefit from it. But in this case， recent statements from the State Council regarding reforms towards the greater convertibility of the Chinese currency and the further liberalization of the capital account have to be interpreted in context： the depth and pace of long-term reforms will still depend in part on the effects that these reforms have on shortterm growth.

Additionally， statements of intent are different from actual policy announcements. It is likely to take a couple of months to half a year for the concerned ministries of government and senior leadership groups to come up with a specific roadmap for further currency reforms and put them into operation.

One of the major next steps in the currency reform process is to widen the daily trading band – the amount that the value of the currency is allowed to fluctuate every day. Those who are confident that major reforms are imminent have so far bet that the pace of currency appreciation may be allowed to increase in the near future. A word of caution is necessary， as policy makers also want to project the credible message that the RMB is not a one-way bet： what rises can also fall， and widening the daily trading band and allowing for greater absolute volatility in the value of the currency is a good way to get this message across.

Finally， speculation on the appreciation of the RMB is generally associated with inflows of capital into China to take advantage of higher interest rates and the potential for the value of the currency to rise. From within Chinas borders， many are looking at steps towards greater capital account liberalization as an opportunity to move funds out of the country more conveniently， to invest in real estate overseas or simply diversify the geography of investment holdings.

Rapid outflows of capital are almost as undesirable as rapid inflows， and managing expectations about the future pace of appreciation is important to mitigate this tide. A slowdown in the pace of appreciation， or potentially a depreciation， is likely in the second half of the year to discourage speculation.

Breaking up Monopolies Still Important

For the first time in decades there was an important sentence missing from the major economic policy documents issued during and after the 18th National Congress of the CPC： breaking up monopolies. This is a subject that has received a lot of attention for decades， as policy reformers and private companies urge the retreat of dominant state-owned firms and administrative agencies from controlling important industries to allow greater competition in the economy. Statements about the importance of breaking up various classes of monopolies have been cited in policy documents since the 14th National Congress of the CPC.

Many have noted the absence of such statements in recent documents. One partial explanation is that China has solved this issue legislatively through the passage of an anti-monopoly law， and special attention to the issue is no longer warranted. Such an explanation only goes so far， however. Many service sectors and manufacturing sectors where private innovation is sorely needed are still heavily dominated by big state-owned firms and plagued by administrative procedures that do not encourage （or make it easy） private capital and start-ups to enter.

Think of the many telecoms-related industries， aerospace and railway， to mention a few. Some of these sectors are deemed strategic and vital to economic security， and are thus allowable. But the reality is that in many downstream areas， especially in service-related sectors， the existence of a policy monopoly at the top of the industry chain has significant consequences for the evolution of downstream competition， increasing the risk for entrepreneurs and their financial backers.

Under normal circumstances， if a certain reform goal is not written into important policy documents that set the tone for the coming years， there is little possibility that it may be introduced later. In this case， however， a need for more domestic innovation and job creation may force the issue upon economic policy makers.

It may sound simple， but reform creates new room for future growth. The new leadership has a clear idea of the challenges facing the macro economy， but creating new room for growth will have to heed the processes that produce growth， rather than simply the outcomes such as growth rate targets. The issues cited above discuss the “what” questions， pointing out trends that may evoke short-term policy responses. However， at this stage in Chinas economic development the“how” and “why” questions are perhaps more important in implementing long-term fixes to old problems.