Pioneer’s Lombardo comments on China’s economic reform plan

The macroeconomic case for increasing consumers’ purchasing power due to higher interest rates on deposits looks strong,says Pioneer’s CIO Giordano Lombardo.

China’s “Breakthrough” in the Making

The ruling communist party’s gathering (also known as Plenum) in early November was followed closely by the expected announcement of a major plan of economic reforms. Three major reforms that were highlighted during the plenum concerned:

  • State-Owned Enterprise Reform (SOEs)
  • Financial Sector Reform
  • Social Reform

State-Owned Enterprises

The most awaited pro-market reform concerned the role of large state-owned enterprises (SOEs). Xi Jin Ping made clear that the government should refrain from directly affecting the markets, though retaining the ownership of key economic assets. SOE’s should resemble other Asian countries, such as Singapore, where firms operate in a truly competitive environment and try to maximize profits rather than building up a lot of capacity through oft-unproductive capital expenditure. Bottom line: even though SOEs remain, as the name shows, in state hands, increasing the access of private enterprises to capital, land and energy markets should prompt SOEs to be more efficient in allocating capital or end up as losers in a new competitive environment.

Financial Sector Reform

The central bank (People’s Bank of China or POBC) is unlikely to speed up this part of the reform programme, in spite of the plenum’s full commitment to change. The macroeconomic case for increasing consumers’ purchasing power due to higher interest rates on deposits looks strong, but so is the need to keep bank profit margins from shrinking, if too much sector competition was allowed too soon. Some measures are aimed at helping banks manage the transition to a more competitive market.

The issuance of negotiable certificates of deposit in local currency should enable banks to get large amounts of funds at relatively stable costs, thus containing the risks of a volatile wholesale (inter-bank) market. Another, more structural, change would let them diversify their assets out of loans and make profits less reliant on the spread between deposit and lending rates. Bottom line: top Chinese banks’ balance sheets may eventually resemble their American and European counterparts with the amount of marketable securities invested.

Social Reforms

Rural land and urban residence reform was on top of the plenum’s agenda. The main changes affect rural dwellers, who will be allowed to buy land for building residential housing or infrastructure. Any limitation left to domestic migration, which curbed rural residents’ ability to move to the cities, is to be scrapped and help speed up the transition to consumption-driven growth. Cities are the engine of China’s household-led expansion, as the urban per capita income is about three times as high as the rural one. Bottom line: the rural population will eventually be entitled to the same rights as urban residents, which will benefit overall consumer spending.

China’s Investment Case and Outlook

The party’s concluding document outlined its strategy clearly but actual implementation is vital for China to become an investment case of its own. Xi Jin Ping enjoys wide-ranging powers that may enable him to withstand the likely resistance to change from some vested interests.

In conclusion, we believe that a positive Chinese investment case remains intact. The country seems to have a good track record on reforms and the new leadership is proving to be strongly committed to favor the quality of growth, even accepting a lower growth in the short term. In our opinion, the Chinese economy is less vulnerable to external shock than other emerging countries, and more exposed to the end of extra-loose monetary policies.

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