Stability is the key as further reforms loom

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A late December credit squeeze sounded a sour note at the end of what was otherwise a remarkably stable year for the Chinese economy.

After last week's cash injection through short-term liquidity operations, the People's Bank of China pumped 29 billion yuan (US$4.8 billion) into the open market on Tuesday in a bid to ease market fears of a credit crunch.

The seven-day Shanghai interbank offered rate, a key gauge of funding costs that measures market fund availability, finally ended a week-long spike on Tuesday, after soaring 448.5 basis points to 8.84 percent.

The central bank's intervention may be viewed as a stopgap measure, but the crunch provided some clues about underlying elements of the economy and possible drags on growth in 2014.

Liu Ligang, chief economist for China at Australia & New Zealand Banking Group, said something is askew.

"The central bank intends to calm down market sentiment because it understands that the market is facing some unusual conditions," Liu said.

Those "unusual conditions," Liu explained, are related to the US Federal Reserve's decision to begin tapering and eventually exiting its quantitative easing program next year. They may also be connected to recent reports that a few commercial banks in China can't settle their payments, though banks have responded with firm denials.

Bold reforms

The conditions are a fresh reminder of last June, when China experienced a liquidity crisis that led to the worst stock market crash in four years.

Zhang Zhiwei, a Nomura economist, said China's financial system remains vulnerable to liquidity shocks, the latest one exaggerated by the announcement of the Fed's decision to start closing some of its money taps.

"But, China has managed stable growth this year when the world is still besieged by uncertainties," Zhang noted.

Indeed, stability has been the watchword in Chinese economic policy this year as the nation's leaders slowly begin to roll out what many consider the boldest reform program in three decades.

In November, the Third Plenum of the 18th Chinese Communist Party Central Committee produced a sweeping 60-point plan for economic, social and legal reforms, with the cornerstone policy of allowing market forces to play a more decisive role by 2020. The blueprint is considered more detailed, more ambitious and more pro-market than many had expected.

At the Central Economic Work Conference earlier this month, China pledged to forge ahead with reforms, while maintaining stable economic policies. That sets the tone for 2014.

"Economic stability paves the way for deepening reforms, and the ultimate goal of reform is to sustain economic growth and make it steady in the longer term," according to a statement released after the conference.

China will stick to a "proactive" fiscal policy and a "prudent" monetary policy next year, the statement said at the conclusion of the four-day conference. Nothing very surprising there. China has maintained what it calls "proactive" fiscal policy since late 2008 and "prudent" monetary policy since 2010.

But the conference reiterated the importance of keeping a balance between growth and reform, triggering a debate among economists about whether China should cut its growth target to 7 percent in 2014. This year, the target was 7.5 percent, the lowest in eight years.

"Keeping the 7.5 percent growth target should help stabilize market sentiment as the government shifts its focus to promoting reforms," said Chang Jian, an economist at Barclays. "But it has become clear that achieving such growth is no longer easy for China."

Historically the government's growth target has tended on the conservative side, with actual expansion exceeding it by a wide margin. GDP grew 7.7 percent in the first three quarters of this year. Xinhua news agency said China is now estimating growth at 7.6 percent for the year.

"A lower growth target would be more consistent with other goals," said Xue Jun, an analyst with Citic Securities. "Otherwise, the government will likely face significant challenges in balancing objectives that include the reduction of financial risks, the adjustment of the economic structure and the promotion of reforms."

Bottom line for growth

China will unveil its official growth target for 2014 when Premier Li Keqiang delivers the government's work report in March. Barclay's Chang said "a 7 percent target would signal the absolute bottom line for growth."

Meanwhile, key economic data still point toward the upside.

In the third quarter of this year, China's gross domestic product expanded 7.8 percent from a year earlier, accelerating from 7.5 percent in the second quarter.

The Consumer Price Index expanded 3 percent in November, slowing from an eight-month high of 3.2 percent in October.

Inflation for 2013 is expected to come in at around 2.7 percent, which is well below the target of 3.5 percent.

Other activity data, including industrial production, fixed-asset investment and retail sales, all maintained double-digit growth in the first 11 months of the year. Industrial production and investment both showed moderating growth in November, with retail sales emerging as the star performer. That will hearten officials anxious to move the economy away from over-reliance on exports and investment and toward consumer spending.

Stephen Green, an economist at Standard Chartered, said growing household consumption, renewed export growth and the bottoming out of the industrial cycle will be positive drivers in 2014.

Still, he said, there are reasons for caution. He cited the possibility of tighter monetary policy, a slower property market, a cash crunch related to local government infrastructure and a mild rise in inflationary pressure.

These potential drags on growth are not new. How they will interact with progressive reforms is the big unknown.

Zhu Haibin, chief economist for China at JPMorgan, said he expects China's economic growth to come in at 7.4 percent next year, assuming a policy shift toward structural reforms such as limiting the scale of government spending and reducing excess capacity in state-owned enterprises.

The late December credit crunch may be a case in point, illustrating the tug-of-war between reform and growth as China moves to limit government interference in the market.

But, as Standard Chartered's Green noted, reform requires a certain level of growth to ease its implementation and the benefits from structural reform will likely not show up quickly enough to impact growth in 2014.

Next year is certainly shaping up as an interesting one to watch as China juggles the forces that define its economy.