MERICS Economic Indicators Q1/2018
Stable economic growth to face headwinds in 2018
MERICS Q1 analysis: Economic reforms aim to optimize Chinese capitalism
This year’s National People’s Congress (NPC) laid the groundwork for sweeping changes to the government structure, which will shape China’s economic system. The CCP has further centralized power and expanded its control over the economy as part of its ambitious project to transform China into a leading economic power by 2049. It is time to become realistic about what China really intends to accomplish.
Foreign governments and companies had largely misunderstood China’s economic reform announcements of 2013 as a commitment to strengthening market forces. Yet, Western style market liberalization was never on the table. Instead the recent NPC extended the Communist Party’s (CCP) grip on the economy, for example by elevating the status of the former “Leading Small Groups” dealing with finance and economics as well as economic reforms. These bodies were renamed “commissions,” effectively institutionalizing the CCP’s power over the economy.
Other policies introduced in 2017 include expanding the influence of party organs in companies, including private and foreign enterprises, or the introduction of the Cyber Security Law, which will likely lead to greater access to company data for the government. Most importantly, China is working on the forceful implementation of Made in China 2025, the strategy at the heart of a state-backed pursuit of technological upgrading in China’s industry.
In his recent speech before the Bo’ao economic forum, President Xi Jinping sought to reassure the international community of China’s continued opening process with a mix of vague promises and small policy changes. In the spirit of good marketing, these efforts will then be oversold to the international audience. As a result, full scale liberalization will always remain just around the corner. The problem is that radical economic liberalization would not be compatible with the CCP’s version of Chinese capitalism. Economic policy is guided by a deep distrust of free markets, which the CCP associates with volatility and potential instability.
Rather than breaking with the old state-backed economic model, China is reshaping it. The current reforms adopt some elements of the open market to optimize Chinese-style capitalism, which is dominated by a state that is increasingly synonymous with the party. China is reinforcing its economic model that is geared towards pursuing strategic national targets while minimizing structural risks. Controlling debt, consolidating state-owned enterprises, aligning the private sector with national targets in favored industries, and reducing overcapacities are just some examples of how the Chinese leadership under Xi Jinping attempts to modernize state planning. Market mechanisms will be used to some extent, but they will continue to be eclipsed by the ongoing shift towards greater control by the CCP.
Through policy and statements, China’s leaders have made it clear they consider the extension of state control of the economy necessary for China’s aim to reclaim its leading position in the world. Suspicion of Chinese acquisitions of technology companies in Europe or the United States as well as the looming trade war with the United States are the first signs of an emerging clash of competing economic systems. The international pushback is something Chinese state planners will need to adapt to. Businesses should brace themselves for increasing frictions between the major economic blocks.
The MERICS China Confidence Index (MCCI)
The MERICS China Confidence Index measures households’ and businesses’ confidence in future income and revenues. The index is weighted between household and business indicators. It includes the following indicators: stock market turnover, future income confidence, international air travel, new manufacturing orders, new business in the service sector, urban households’ house purchase plans, venture capital investments, private fixed asset investments and households’ consumption share of disposable income. All components have been tested for trends and seasonality. The MCCI was first developed in Q1 2017.
Focus topic: Local governments power up to advance China’s national AI agenda
China’s government has identified Artificial Intelligence (AI) as a key technology to push its Made in China 2025 agenda and leapfrog to global technological leadership. When the State Council published its “New Generation of Artificial Intelligence Development Plan” in July 2017, it kickstarted its top-down industrial policy routine which is currently unfolding at full speed. The overarching goals are for China to catch up with advanced countries and create an AI core industry worth 150 billion CNY by 2020, to achieve major technological breakthroughs in AI by 2025, and to become the globally-leading innovation center for AI by 2030. With the overall framework set, China’s industrial AI policy has entered the next crucial phase, trickling down from the national level to individual provinces, municipalities and cities. By mid-April, governments within 18 provinces and municipalities had released AI plans to promote their local AI industries.
In the pursuit to outbid each other, their local targets even exceed ambitious national goals. 11 local governments published targets for their AI core industries for 2020. Accumulated, this would create an AI core industry of almost 400 billion CNY in 2020, exceeding the national target of 150 billion CNY more than twofold. While the unparalleled enthusiasm of local governments will accelerate China’s AI development considerably, it also carries the risk of creating overcapacities.
Frontrunners in the AI race are China’s most advanced economic centers Beijing, Shanghai and Shenzhen. As tech hubs and headquarters of the pioneers of China’s AI drive such as Baidu and Tencent, and of major AI startups including leaders in facial recognition technology SenseTime and Megvii, these cities will harness a massive impetus with powerful state backing.
The municipal government of Shanghai drew up the most ambitious AI plan of all, aiming for an AI core industry size of more than 100 billion CNY by 2020. To achieve this, Shanghai is building AI industry zones in multiple locations across the city. Last December, Shanghai’s Lingang Area Development Administration signed agreements with 15 leading Chinese AI firms, including Baidu Innovation Center, iFlyTek, Horizon Robotics, and Cambricon. Beijing thus sees its position as China’s leading science and technology hub with its stronghold in Zhongguancun seriously challenged. In response to Shanghai’s advances, Beijing’s government announced a 14 billion CNY AI industrial park in Mentougou district in January 2018.
Beyond first tier cities, other localities are also well positioned to compete for dominance in specific AI technologies. In Hefei, for example, the AI-focused industrial base called “China Speech Valley” (中国声谷) is already in full swing, hosting around 200 companies including China’s global champion in speech recognition, iFlyTek. The Anhui provincial government and the municipal government of its capital city Hefei are now joining forces to turn the industrial park into the country’s largest and strongest hub for speech recognition technology products. Together they plan to spend 3.2 billion CNY on R&D and application of intelligent speech and AI technology until 2020.
Provinces that have thus far kept a lower profile now desperately try to jump on the AI bandwagon as well. For example, China’s economically struggling northeastern provinces of Heilongjiang, Liaoning and Jilin all issued their own AI plans at the beginning of this year. According to the ambitions set forth in its plan, Liaoning seeks to transform from a blank spot on the AI map into the biggest AI innovation center in Northeast Asia by 2030.
China’s various AI plans feature a common narrative: governments at all levels mobilize a lot of money to attract the cream of the crop of AI companies and talent. Changzhou in Jiangsu province, for example, plans to hand out between 200,000 and 300,000 CNY to companies and research institutions for each world-class or national-level AI talent who settles down in Changzhou Science and Education Town. In another example, Hangzhou tries to lure highly skilled workers with subsidies e.g. for auctions of highly-contested car license plates.
The message is clear: China is aware of its limited pool of AI experts. The run on exceptional AI talent, however, is a global phenomenon. Chinese and US companies try to snatch talent away from each other by establishing AI research centers in proximity to one another in Silicon Valley, Seattle and Shenzhen. As a result, salaries in the field of AI have skyrocketed. By entering an already fierce and pricy battle over such a small talent pool, China’s local governments more than ever risk burning through a lot of cash without yielding the envisioned results.
In its effort to tackle the talent shortage in AI, China’s national government is also looking to attract foreign experts. In the annual work report for the National People’s Congress last month, Premier Li Keqiang pledged to accelerate efforts to surpass the United States in advanced technologies such as AI by wooing overseas talent as one of the state priorities for 2018. A set of initiatives already underway includes express green cards to foreign high-end talent and their families (see also p. 11). Foreigners of Chinese descent as well as Taiwanese have been a special focus of China’s efforts to attract talent to work or set up companies on the mainland.
China is determined to play a leading role in global AI development. The country’s dynamic tech environment benefits from the sheer amount of data generated by its 800 million smartphone users and a legal system that does not provide effective protection of private data. Even though the AI sector is currently dominated by private companies, the national strategic interests in AI business applications and AI usage in defense as well as public security have prepared the ground for more active state involvement. The current top-down approach in China’s AI industry is thus in line with the country’s overall industrial policy, in that it mobilizes massive amounts of capital and labor towards a specific target even at the at the risk of creating inefficiencies and wasting resources.
Economy: Growth remains robust - for now
- Trade frictions, strong CNY and deleveraging campaign so far not affecting real economy
- Rising construction activity lifts secondary sector growth, while service growth slows
According to official statistics, the Chinese economy expanded at 6.8 percent in the first quarter. In Q1, consumption contributed 77 percent of economic growth. This does not signal a structural shift, as consumption usually contributes the most to growth in the first quarter. A sharp increase of private sector investments also contributed considerably to growth. Net exports, which had lifted growth in 2017, served as a brake in Q1 amid stronger import growth.
Industrial sector and construction growth, which had both slumped in the second half of 2017, have picked up speed, growing at 6.5 and 5.4 percent respectively. This caused growth in the secondary sector to increase from 5.7 percent in Q4 last year to 6.3 percent in Q1.
Having grown at 8 percent in Q4, the largest sector, the tertiary or service sector, slowed down slightly, growing at 7.5 percent. Despite the slowdown, it is still the fastest growing sector. The slowdown was across the board, as most sectors grew at a lower pace than in the previous quarter. IT-related services (29.2 percent), transport and logistics (7.7 percent) and business services (10 percent) where the only sectors that expanded above the headline service sector growth.
There are several clouds on the horizon. The Chinese government’s still somewhat cautious campaign to reduce the use of credit has slowed but not reversed the growth of credit-to-GDP. So far, the deleveraging campaign has not affected growth in the real economy. But growth is bound to take a hit should the campaign accelerate.
A second concern is the mounting trade pressure from the United States. The Trump administration has proposed tariffs on a long list of Chinese exports. If these measures are implemented growth will be hurt. In the meantime, the threat of tariffs could have the opposite effect. There are signs that some Chinese companies attempt to maximize their exports before getting hit by potential tariffs.
The fact that growth so far this year has exceeded the official target of about 6.5 percent, gives the Chinese government some room to implement further structural reforms and press on with its deleveraging campaign. Growth of around 6.5 percent is deemed necessary to comfortably reach the goal of doubling the size of the real economy from 2010 levels by 2020. It is therefore extremely unlikely that the government would let growth fall below this level.
Financial markets: Regulatory action slows but fails to reverse credit accumulation
- Major reorganization and staff changes in regulatory agencies announced during NPC
- Deleveraging campaingn leads to a reshuffle of financing sources
Financial markets have seen policy action intended to contain risk and will continue to do so for the remainder of the year. During their speeches at the National People’s Congress in March both President Xi Jinping and Premier Li Keqiang reiterated the importance of financial stability. The NPC then acted by reorganizing the financial regulatory bodies and by introducing new policies to target risky lending practices.
Two key staff changes stand out. After serving for 16 years, the previous governor of the People’s Bank of China (PBOC), Zhou Xiaochuan, was succeeded by his previous deputy Yi Gang. Yi reiterated the bank’s commitment to “prudent and neutral” monetary policy.
After the reshuffle, the bank’s neutrality seems more in question than ever before. Guo Shuqing, who previously chaired the banking regulatory commission, was appointed as chairman of the newly merged banking and insurance regulatory commissions as well as the Party secretary of the PBOC. It unlikely that Yi Gang will be able to be as outspoken as his predecessor in the face of such a powerful CCP presence in the bank.
China’s dilemma of maintaining high levels of growth while reducing the reliance on credit remains. However, in contrast to 2017, in which only regulatory tightening was used, the regulators also used some cautious monetary tightening in Q1.
A number of new policies are intended to combat excessive risk taking as well as to provide implicit government guarantees. Some of the most remarkable steps are: state-owned financial institutions can no longer directly issue loans to local governments, they must instead buy their bonds; new rules restricting wealth management products (WMPs) with guaranteed returns have been introduced; incompliant banks have been issued large fines and the debt-to-equity swap program has been continued and extended.
On the monetary side the PBOC raised the controlling rate incrementally, and reduced liquidity substantially. Despite monetary tightening and new regulation, both long-term treasury and corporate bond yields have trended downwards since the beginning of the year. The falling rates are likely an indicator of high demand, especially as treasury issuance saw no big changes.
Despite regulatory and monetary tightening, total credit growth continued outpacing nominal GDP growth. In Q1 nominal GDP grew at 10.2 percent while total credit grew at 11 percent, down from 12.4 in the previous quarter.
The extra regulation appears to have caused a reshuffle in financing sources. The growth of corporate bond financing and bank financing were both largely unaffected. The growth of trust loans on the other hand, a form of financing favored by local governments, fell from 29 to 22 percent.