Goldman Sachs with David Daokui Li on China's policy motivations

Given recent rapid-fire developments in Chinese markets—and ensuing confusion about the country's growth and policy trajectory—many people are attempting to gain a better understanding of what is really going on in China. Allison Nathan (AN), senior strategist of Goldman Sachs' Global Marco Research and editor of Top of Mind interviewed David Daokui Li (DL) on China’s policy motivations, recent market volatility, and its implications for economic reforms. David is the Mansfield Freeman Chair Professor at the Tsinghua University School of Economics and Management and Dean of the Schwarzman Scholars at Tsinghua University. He is a former member of the Monetary Policy Committee of the People’s Bank of China and currently serves as a member of the Chinese People's Political Consultative Committee. His research on the Chinese economy has focused on areas including currency policy and structural change.

The [market] reaction [to the RMB reform] has convinced [policymakers] that the RMB is now too important to global markets—and too closely watched—to undertake major reform, at least in the next one to two years...I expect policymakers will aim to keep the currency fairly stable over this period. - David Daokui Li

The main body of the interview is as follows:

AN: Who is driving the economic and market policymaking process in China?

DL: The policy process is driven by a complex group of government agencies led by the Ministry of Finance (MOF), the central bank(PBOC), and the National Development and Reform Commission (NDRC). That said, critical decisions about currency and monetary policy are heavily debated and deliberated and finally decided within the central government by a group called the Central Leading Group for Financial and Economic Affairs, which is physically situated next door to China’s White House, Zhongnanhai.

AN: What are the Chinese leadership’s core goals? How are political and economic goals prioritized?

DL: The leadership no longer has a single-item agenda like it did under Deng Xiaoping in the early 1980s, when economic development was the top priority. The Chinese expression was that economic growth is the bottom line. But today, widespread corruption and signs of decreasing effectiveness of the Chinese Communist Party (CCP) have raised concerns within the leadership, prompting them to treat the sustainability of CCP rule as the top priority. As a result, they have put heavy emphasis on anti-corruption and ensuring the decency of party officials' behavior. But ensuring that the economy continues to grow at a moderately fast pace—say,6-7%—remains a priority. Indeed, economic growth remains the foundation of the resolution of many issues, including the party’s sustainability.

AN: How do policymakers view the potential trade-off between economic modernization and relinquishing control of the markets/the economy?

DL: Policymakers understand that in order to become more dynamic, the economy must become more efficient through reform. That tradeoff is very clear to them. But the bottom line is that they want to maintain macro-level control in order to defend the economy against systemic risk, and especially against financial crisis.

AN: Central bankers around the world are trying to achieve this balance. Aren’t the priorities in China somewhat different?

DL: The top leadership in China has many of the same objectives as policymakers elsewhere. But in addition to those objectives, they have a lower tolerance for things like widespread unemployment or large swings in the prices of food and gasoline, because they worry that such volatility could raise anxiety among the general public. The concern is that economic problems, combined with other social complaints, may provoke general political protests.

AN: Why have some areas of economic reform moved so much faster than others?

DL: Reforms that are highly technical in nature and difficult to understand by the general public, such as financial reforms, have tended to move faster than those that are more tangible and directly touch more people throughout the economy, like State-Owned Enterprises (SOEs) and property tax reforms. The reason is that we live in the internet era, so policies that impact people’s economic interests more readily arouse controversy and objections. Leaders in China do pay attention to opinions on the internet and are affected by them.

AN: Will the recent equity and currency volatility slow reforms?

DL: I don’t think the volatility will necessarily slow reforms. The response will be more nuanced. Certain areas of reform that are essential to controlling volatility and stabilizing the market will likely speed up, such as SOE reform, which will support valuation of many listed companies, and reforms to allow foreign companies to be listed on China’s stock markets. In contrast, reforms that might increase market volatility—like further currency reform—will be slowed.

AN: What are your initial impressions of the just-announced details of SOE reform?

DL: Given the wide range of stakeholders involved, some observers doubted whether the SOE reform announced two years ago—without a detailed plan—would ever be implemented. So the recent announcement that provided more details was a critical step forward. It confirmed a shift in the role of the government from managing the operation of SOEs to acting as fund managers, possibly holding shares of foreign enterprises, via Government Investment Corporations. It also announced the division of senior SOE executives into two categories: government officials who are appointed with salaries comparable to those of civil servants; and others who are recruited as professional managers, with salaries set by the market. This should help address public concerns about the status and compensation of public officials at the helm of these firms. During the past year, many SOEs have been responding to those concerns by cutting the salaries of their senior executives regardless of whether they were hired in the marketplace or appointed by the government, which in my view has been counterproductive. So this policy should provide some relief. But so far it is just an announcement; we need to see action.

AN: How have recent events in the equity markets affected the thinking of policymakers?

DL: The equity market volatility was a surprise to senior policymakers, frankly speaking. During the first few rounds of volatility in late June and July, they literally worked day and night to come up with measures to calm the markets. The key lesson learned—from both the market turbulence and the policy response—is that policymakers need to have a much more sophisticated toolkit to deal with equity markets. The longer-term implication is that policymakers will be much more cautious about how they regulate certain financial instruments and trading practices. Margin financing and short-selling are two examples.

In addition, the episode has impressed upon policymakers the importance of market fundamentals and the quality of listed corporations. If you compare China’s A-share market with the Hong Kong exchange and with Chinese firms listed in New York, it is fair to say that A-share companies are of lower quality in terms of governance, profitability, and so on. So I expect there will be discussions about how to invite some of the most exciting companies in the world to be listed in China to enhance the quality of Chinese stock indices. This will be akin to China’s basketball association inviting NBA stars to play in China—at the market price, of course.

AN: What about the recent developments in the FX market around the renminbi (RMB) devaluation?

DL: The currency market is an entirely different story from the equity market. In my opinion, policymakers implemented the August currency reform to allow the exchange rate to better reflect market forces. However, the market instead perceived that move as a sign of further weakness in the Chinese economy and an attempt to jumpstart exports with a cheaper RMB. This perception and the market volatility that followed came as a surprise to policymakers in China. In my view, the reaction has convinced them that the RMB is now too important to global markets—and too closely watched—to undertake major reform, at least in the next one to two years. So I expect that policymakers will aim to keep the currency fairly stable over this period.

AN: Wasn’t it reasonable for markets to assume trade-related motivations for the devaluation?

DL: Not really. Exports are no longer the engine that can carry the Chinese economy. China is already the largest exporter in the world; there is simply no room in the rest of the world to absorb a meaningful further increase of export volumes. So the hope to use trade to boost and even stabilize the economy is an illusion.

AN: Some believe that another significant depreciation is inevitable. What is your response?

DL: I don’t believe it is inevitable for two reasons: intentions and instruments. China’s intention is to stabilize the RMB so that other emerging market (EM) countries do not have reason to blame China for their economic troubles and then further depreciate their currencies. The aim is to stabilize the RMB, which should steady other EM currencies, support trade, and, in turn, help China’s economy.

Secondly, China has instruments to manage its currency. This year, China is on pace to have a record trade surplus, 6% of GDP, reaching $600 bn thanks to drastic decreases in imports. And currency reserves remain around $3.5 tn. The only challenge is illegal capital outflows that tend to accelerate if people believe the currency will depreciate. It is typically SOEs with international branches that conduct illegal operations across the border, claiming that they need foreign currency overseas. These internal forces are formidable, but the government is currently putting pressure on SOEs to stem these illegal outflows.

AN: Does the government have a strong grasp on the markets and the economy today?

DL: The Chinese government has many instruments to use to stabilize the economy. The challenge is that this volatility is new to them so they are still learning which instruments are the most effective. They just have to learn. And the recent rounds of volatility have been a good learning experience.

AN: What should policymakers be doing to achieve their economic goals?

DL: The government needs to focus on the nerve points of the Chinese economy—what I call the three needles of acupuncture, in contrast to the “three arrows” of Prime Minster Shinzo Abe’s economic policies in Japan. The first needle is infrastructure. The government must ensure that announced projects, like rapid rail projects, are implemented in a timely manner. The anti-corruption campaign has slowed progress on these projects because local governments are now much more concerned about doing things properly than quickly. That’s the right intention, but the pace has slowed to a point that is hurting the economy. So the government must make sure that projects are on pace. Second, policymakers must start implementing a number of reforms, including the SOE reform, and show real cases of reform progress to regain momentum in the economy. And third, interest rates must be cut and long-term domestic debt must be expanded in order to lower lending rates in the real economy.

AN: You don’t consider China’s debt level too high already?

DL: Perhaps I am a contrarian, but I have long held that China’s debt-to-GDP ratio is not too high. To the contrary, it may be too low. The amount of debt an economy should tolerate depends on (a) how much it saves and (b) its potential growth rate. Given that China is the highest-saving economy in the world and can still approach near double-digit nominal growth, its debt level is not a concern; neither is the pace of credit growth, only about half of which is going into the real economy as opposed to the financial sector. The real concern is the structure of the debt. Right now, financing costs for enterprises and local governments are exceptionally high—sometimes close to 10% on a term of no more than two years. Lower interest rates and extended debt maturity to finance long-term infrastructure projects would free up shorter-term debt for enterprises that are currently being crowded out.