Facing an L-Shaped Economy

Editors Note： China has entered the 13th Five-Year Plan period （2016-20）， which is pivotal for building a moderately prosperous society， and this year its also confronting the arduous task of carrying out supply-side structural reform. In the first quarter， China managed sound economic growth， structural upgrading and the improvement of peoples livelihoods despite numerous complex domestic and overseas factors. At the same time， it still faces a series of deep-seated contradictions and problems. How can the Chinese economic restructuring be assessed and how will the reforms be carried out？ In a recent interview with the Peoples Daily， a top government source shared views on these issues. This is an edited excerpt from the interview：

Overall economic situation

Q： In the first quarter， Chinas GDP grew 6.7 percent year on year， which remains within the reasonable range and is higher than market expectations. Other economic indicators showed a recovery. These， in the eyes of some people， indicate “a good start”or a moderate rebound of the economy， which bodes well for future growth. Some optimists even believe Chinas economy has bottomed out and will see a “U-turn.” Is it safe to say that Chinas economy is turning around？ Whats your prediction on the short-term and mid- and long-term trend of Chinas economic growth？

A： By and large， Chinas economy has realized stable growth since the beginning of this year. The overall situation is in line with expectations， with some sectors faring better than anticipated. However， inherent problems in economic development still persist， and new challenges have emerged. Given that， its hard to simply describe the situation as “a good start”or a moderate rebound. To make an accurate analysis， one should take into consideration Chinas development phase as well as the international context it operates in.

In the first quarter， some sectors realized stable growth as hoped， and there was even a recovery in some areas. With GDP growth standing at 6.7 percent， employment was stable， incomes increased， economic and financial risks were brought under control. Furthermore， the price of some industrial products bounced back， the performance of industrial enterprises began to rally， and fixed assets investment picked up. The number of newly started projects also increased， and supply and sales were robust in the real estate market with the acceleration of de-stocking measures.

Progress was also made in sectors that we had hoped to boost. The service industry accounted for a larger share of the national economy， new models and types of businesses sprouted up， and some high value-added and hi-tech products experienced rapid growth. In addition， household consumption kept upgrading， and domestic tourism boomed during the May Day holiday （April 30-May 2）.

Moreover， the Yangtze River Delta and Pearl River Delta—two developed regions in east and south China， respectively—took the initiative to adapt to the economic “new normal”by pursuing innovation， quality and efficiency， and saw their economic growth become more stable. Beyond that， all regions and sectors became more conscious of the importance of the supply-side structural reform， and carried out the reform according to requirements from the Central Government， which has yielded some results.

However， there is no denying that some inherent problems have not been completely resolved and that new ones have surfaced. Stable economic growth still relies heavily on investment. In some regions， the balance between financial revenues and expenditures faces great pressure as economic risks have increased.

Whats worse， as investment from private enterprises declines precipitously， risks from real estate bubbles， excess production capacity， bad loans， local government debt， and volatile stock， foreign exchange and bond markets， as well as illegal funding， have all increased. In regions featuring a lower degree of marketization， lowend industries and single industrial structure， downward economic pressures are accumulating， employment problems are becoming prominent and social conflict risks are growing. Therefore， improvements are necessary to establish a foundation of economic stability. More progress should be made in solving supply-side， structural and institutional problems， regardless of how long it may take to accomplish such a task. So far， the new growth engines are not strong enough to prop up stable economic growth.

All things considered， Chinas economy is likely to experience an “L-shaped” trajectory， rather than a “U-turn” or a “V-shaped” rebound.

Whats worth mentioning is that the L-shaped trend will not come to an end within one or two years. In the next few years， sluggish demand accompanying overcapacity is not likely to experience a significant improvement， and the economy is unlikely to register consecutive rapid growth following a rebound as seen in previous years.

We are nonetheless confident in the future of Chinas economy. Given its huge potential and strong elasticity， Chinas economic growth will not suffer a sharp slowdown. Therefore， one should not be overly optimistic or distressed about the rise or fall of some economic indicators.

While Chinas overall economy shows signs of recovery， economic development remains polarized with growth in east coastal areas picking up and other regions struggling. What does this imply？

This is inevitable for the economic development of a market economy—resources always flow toward high-yield fields， which eventually results in excess production capacity. Excess profits will consequently diminish due to over-competition. Then， some resources will shift to new fields， leading to innovation， and other resources will stay where they are. That is how economic development becomes polarized.

Under the “new normal，” China urgently needs to optimize resource allocation， foster new growth engines， and form new industrial structures. Some regions， sectors and enterprises will stand out. Those that dont fare so well will learn a lesson and will have to adapt， which is a good phenomenon.

Since Chinas reform and opening up in 1978， its economy has become polarized. In this process， a batch of vibrant regions， competent enterprises and famous brands have sprung up. After the global financial crisis in 2008， the world economy has also become increasingly divided. Entering the “new normal，” Chinas economy has begun to experience further polarization. Last year， the Central Government noted that businesses which chose to adapt themselves to the “new normal” and value innovation， quality and efficiency experienced prosperous development， while those failing to do so confronted great pressures.

This year， the trend continues and has become more conspicuous. In the foreseeable future， more energetic regions， internationally competitive industries and enterprises will emerge， while some regions， industries and enterprises will find it more difficult to survive.

Its better to confront such challenges and find out solutions rather than putting up with the problems. Now， the people and government officials in these regions， industries and enterprises are trying to get rid of any delusions， become self-reliant， and embrace reform and innovation in an effort to catch up.

Macroeconomic control

Reviewing the economic situation in the first quarter， we found that the rebound of fixed assets investment played a leading role in stabilizing economic growth. Therefore， some people argue that a short-term stimulus is still viable and effective and should be employed again. What do you think about that？

Its a question arousing great attention both at home and abroad. Whether or not China is able to properly handle such a policy will have both short-term and far-reaching impacts for the countrys future.

To promote healthy macroeconomic development， measures should be taken from the perspective of both the supply and demand. The focus changes with different development stages. At present and for a long time to come， China will take steps to push forward supply-side structural reform while expanding aggregate demand. Thats to say， the major issue lies in the supply side， and carrying out supply-side structural reform should be the main target. Since the demand side can only create the environment necessary to settle the main problem， investment should be properly expanded.

While advocating the new development concepts of innovation， coordination， green， opening up and sharing， adhering to the general principle of seeking improved stability， and carrying out a stable macroeconomic policy， accurate industrial measures， flexible microeconomic policies， practical reforms and inclusive social security， three points should be highlighted in formulating the macroeconomic policy：

The first is expanding the aggregate demand and sticking to a proactive fiscal and prudent monetary policy. Another is firmly pushing forward supply-side structural reform by focusing on rectifying the mismatch in supply-demand structure and allocation of production factors. The five tasks of de-capacity， de-stocking， cutting costs， de-leveraging and shoring up weak growth areas should also be carried out. In addition， efforts should be made to promote the positive anticipation of and confidence in economic development.

Looking back at the first quarter， we found that some problems were being settled， and at the same time， some new problems emerged. What should be the focus of macroeconomic control？

Different countries face different difficulties，which also vary with different stages of development. The question is how to correctly analyze the difficulties and find out solutions. Since Chinas reform and opening up， the nation has been courageous and has persevered in confronting and overcoming difficulties and has made significant progress on this front.

Admittedly， a number of problems are emerging from Chinas economic development. For one thing， the pressure of an economic slowdown is looming. For another， the real economy faces high leverage. If we rush to alleviate the downward pressure， the leverage ratio will rise even further. Therefore， efforts should be made to analyze the problems in order to discover the crucial factors needed to surmount the dilemma.

In China， the contracting labor force and upgrading industrial structure will help make sure that even if there is a remarkable slowdown， employment will remain stable， not to mention that the chances for a sharp slowdown are small.

However， high leverage will definitely lead to high risk. If its not well controlled， high leverage may spark a systematic financial crisis and negative economic growth. Many might lose their savings.

Therefore， policies targeted at the stock， foreign exchange and housing markets should be committed to resuming their functions and respecting their rules of development， rather than being used as an instrument to maintain economic growth.

Stock market policies should resume their financing functions， protect the rights and interests of investors， and give full play to the regulation function of the market mechanism. They should also improve the fundamental systems concerning issuance， delisting and trading， strengthen market supervision， elevate information disclosure quality， and crack down on insider transactions and stock price manipulation.

Foreign exchange market policies should give priority to the improvement of the monetary policys autonomy and give way to the self-correcting mechanism of the international balance of payments. They should also facilitate the formation of an exchange rate operating mechanism that is flexible in both directions and is based on market demand and supply. For the real estate market， excessive inventory should be reduced in the process of pursuing people-oriented urbanization.

In carrying out these policies， attention should be paid to two key aspects.

First， the government should avoid behavior oriented to achieve short-term goals. It will take a long time for the world economy to ride out of the global financial crisis. Its also a prolonged process for China to complete structural adjustment. Given that， we should strengthen confidence， resolution and patience， and address both the symptoms and root causes with a focus on the latter.

Second， these policies should be carried out properly. Even if the direction is correct， once overexerted， such policies always fail to achieve their expected results and may even lead to added risks.

Supply-side reform

Chinas supply-side structural reform has caught the attention of both the international community and Chinese society. Has a set of specific implementation measures been formulated？ Looking at first-quarter economic performance， what are the focuses and difficulties involved in further pushing forward the reform？

The Central Government has made it clear that carrying out the supply-side structural reform will be its main task in terms of economic work for some time to come. In the long run， supply-side reform can help China overcome the middle-income trap， which is a battle that we cant afford to lose. Globally， other countries are increasingly aware that structural reform is essential to get out of their economic predicaments. We should make full use of our institutional advantage， facilitate consensus， strengthen determination and leave no stones unturned in carrying out the reform.

Since last year， the Central Government has made all-around plans for the supply-side reform， ranging from theoretical reflection， toplevel design， policies， measures and main tasks. During a meeting of the 12th Central Leading Group for Financial and Economic Affairs held in January， special attention was paid to the supply-side structural reform. The group clarified aspects of the current situation， the direction， goal and plans of the reform， as well as who should carry it out and how.

The Central Government and related departments have formulated specific work plans， and efforts will be made to put them into operation. At the same time， provinces including Guangdong， Jiangsu， Zhejiang and Shanxi， and Chongqing Municipality have published their own reform schemes. Some enterprises have voluntarily suppressed their impulse to expand blindly， focused on their main business， and moved on from the stage of reducing output and pursing higher quality to boosting both output and quality.

The five major tasks of supply-side structural reform are interrelated， supplementary and arduous. Since the beginning of this year， an array of policies has been promulgated to reduce costs and boost the areas showing weak growth. In the days to come， further efforts need to be made in reducing excess production capacity and tackling “zombie companies.”In other words， dealing with employment and debt problems will be inevitable.

Since the beginning of this year， the governments policies aimed at cutting overcapacity and destocking have achieved some effect in some places. However， administrative intervention has played an important role in the process. There are suspicions that cutting overcapacity is seen as a one-size-fits-all approach， and it is reminiscent of measures taken in a planned economy. Do you think administrative actions are necessary to push forward supplyside reform？ How should the government and the market position themselves in the reform？

The goal of the structural reform is to reduce administrative intervention and allow the market to play a bigger role. How can this goal be accomplished？ Its inadequate to solely rely on the market to fix this problem， therefore administrative means are necessary. For instance， we cannot reduce subsidies to “zombie companies” without the governments instruction.

For those sectors wherein the market system functions well， the government shouldnt intervene in their attempts to reduce overcapacity. The consumer products sector， for instance， is already highly market-oriented and has sufficient market competition—this curbs overcapacity naturally.

All levels of the Chinese Government should take the initiative to accomplish the five tasks：

Cutting overcapacity： Local governments should be clear about their specific tasks and targets as well as enforce stricter requirements for environmental protection， energy consumption， quality， standards and safety when granting market access. They should also strengthen the enforcement of laws and regulations in these regards in addition to dealing with “zombie companies” by cutting off subsidies and loans to them.

Deleveraging： The government should avoid using stimulus policies. Furthermore， loan and trust companies should abandon the practice of ensuring the return of investorsprinciples. The government should also crack down on illegal fundraising， in accordance with the law， in order to regulate the market.

Destocking： The government should step up the reform of the household registration system and establish and improve fiscal， taxation and land policies to encourage rural migrant workers to buy homes in urban areas.

Reducing costs： The government should reduce taxation， cancel unreasonable charges and streamline procedures of administrative examination and approval.

Improving weak links： The government should carry out targeted poverty alleviation， promote sci-tech innovation and environmental protection， and improve the transparency of funds used for infrastructure construction.

There are concerns that cutting overcapacity and deleveraging are contradictory to stabilizing growth and will increase downward pressure. Whats your view on this？

The key is how to perceive the relationship between short-term and mid- and long-term effects.

In the long run， stabilizing growth is in line with the countrys economic restructuring， which drives and guarantees sustainable economic growth. For instance， cutting overcapacity and deleveraging will help to optimize the economic structure and promote healthy and sustainable economic growth.

However， in the short term， stabilizing growth while restructuring may seem counterintuitive. For instance， cutting overcapacity may affect some regions GDP and fiscal revenues， while deleveraging can expose hidden financial risks. Nevertheless， without reducing overcapacity and deleveraging， the number of “zombie companies” will continue to increase and debt will further accumulate， exacerbating fiscal and financial risks. Therefore， the key is to properly deal with the relationship between stabilizing growth and restructuring through more profound reforms.

It should be noted that economic growth fueled by excess capacity is unsustainable and the pain that such growth could incur would be far greater than the pain that would arise from the process of cutting overcapacity. For instance， some companies with excess capacity are suffering losses， owing both money to the bank and wages to workers. These companies should be closed in order to release scarce resources such as land and loans. Next， their employees should be covered by social safety net， and support should be given to help them find new jobs after receiving relevant training.

While cutting excess capacity， the supply of effective products should be increased， and new growth engines should be nurtured. Many places， including those in central and west China， have developed a series of new growth engines in the ongoing round of structural reform. However， places which shoulder huge burdens in terms of overcapacity may not be able to see instant results from the short-term restructuring. They should nevertheless take a leap of faith and go through with the reforms.

Expectation management

In recent years， expectations about economic prospects have been unstable， with both pessimistic and optimistic forecasts being aired. How can we properly guide social expectations on these prospects？

These expectations havent appeared out of thin air. Theyve come from real experiences and can influence reality. Macro-control under a market economy is essentially expectation management. The world economy has become more complex and volatile after the global financial crisis， leading to increased uncertainty in expectations. Under such circumstances， the government needs to strengthen its guidance of the publics expectations.

The key to stabilizing expectations is to stabilize the governments policies.

Macroeconomic policies should be stable. The more resolutely and substantially we implement the supply-side reform， the more positive the market expectations will be. To the contrary， if we continue to spur growth through the old method of stimulus measures， suspicions are bound to emerge.

We should also strengthen forward guidance of our policies and increase their transparency by clearly elaborating on their purposes and meanings so as to reduce the chance of misreading and to correct misun- derstandings.

Moreover， its important to improve the credibility of the media. On the one hand， positive reports are necessary to improve confidence. On the other hand， reports which blow up achievements while ignoring the problems will damage the publics confidence and lower expectations. Furthermore， we should allow scholars and professionals to express their opinions on the economy freely， which will also help to stabilize perceptions.

Under the current economic climate， the roles played by people， especially three kinds of people—entrepreneurs， innovators and officials， are particularly important. How can they be motivated to push forward the supply-side reform？

People are the most active factors in production. In order to get used to the “new normal，” the vitality and creativity of these three kinds of people should be made better use of. However， in reality， a lot of work remains to be done in order to spur the vitality of these people， because some of them cannot understand or get used to the “new normal.”

Entrepreneurs play a central role in optimizing the allocation of resources and improving the supply and demand structure. Their creativity should be made use of in order to push the supply-side reform forward. A new type of relationship between the government and entrepreneurs should be established in order to grant the latter equal rights and opportunities and a greater sense of security.

Risk prevention

Since last year， a decline in bank profits and the rise in non-performing assets have drawn intense scrutiny. The capital market also experienced fluctuations in the first quarter. How can China avoid systematic and regional financial risks when facing downward pressure？

Finance is the core of the modern economy. Problems in the financial industry will hinder the realization of a moderately prosperous society. Although financial risks are controllable on the whole in China—especially since the banking sector has a strong capacity to withstand risks—the fluctuations in the stock and foreign exchange markets since the beginning of this year nonetheless reveal the weakness of the financial sector.

This volatility has stemmed not just from speculation but also from the vulnerability of the financial market. A high leverage rate is the real culprit behind such high financial risks. Against the backdrop of high leverage rates， risks from the foreign exchange， stock， bond and housing markets， as well as bank credit risks， will all increase.

The most important thing is to steadily and proactively push for deleveraging according to the requirements of the supply-side reform. As the effects of monetary policies diminish， the practice of using monetary easing to spur growth should be dropped. Financial regulators should take stock of potential market risks and be prepared for any consequences.

Currently， non-performing loans from the banking sector are increasing， which is a reflection of problems in the real economy. As long as we take proactive measures to cope with the problems instead of hiding risks， the consequences wont be insurmountable.

In the process of cutting overcapacity， workers in some enterprises will be laid off， especially those in the steel and coal industries. There have even been protests in some places. Do you think cutting overcapacity will negatively impact employment and endanger social stability？ How can laidoff workers be properly resettled？

Stabilizing and increasing employment are important goals within Chinas macroeconomic policies. Currently， employment is stable on the whole， with no great fluctuation. In the meantime， there are some deepseated structural problems. For instance， high-caliber technical workers are in short supply， while there is a surplus of low-skill laborers. Therefore， its urgent to strengthen technical training for laborers.

The most urgent task is to resettle workers laid off in the process of dissolving “zombie companies” and restructuring industries with excess capacity. This round of layoffs is occurring mostly in state-owned enterprises （SOEs）， with many of the laid-off workers aged 40-50. We should prioritize their relocation， improve relevant policies and be prudent in the process of cutting overcapacity.

First， China must be resolute in its push for supply-side reform. It should attempt to make the employees secure rather than focus on the companies when dealing with“zombie enterprises.” Mergers and reorganizations should be prioritized over bankruptcy liquidations. However， companies that cannot be saved should be closed down or declare bankruptcy in accordance with the law. Debt-to-equity swaps， which will not solve the problem but only add to the governments burden， should be avoided.

Second， the resettlement of workers should be given utmost attention when dealing with “zombie companies” and reduc- ing excess capacity. Some workers should be given proper training and transferred to other positions. As for those who cannot be transferred， they should be given basic social insurance benefits.

We should put ourselves in their positions， thereby helping them solve their difficulties in their lives and improve their skills for new jobs. Although over 10 years have passed since the last round of SOE reforms， the low efficiency of a number of SOEs is still prominent. The ongoing round of SOE reforms should make a breakthrough in this regard to build SOEs into modern enterprises dedicated to quality and efficiency and capable of facing market competition.

Meat and vegetable prices have been constantly on the rise this year. Ordinary people have shown concern over this. How can the government avoid the risks of inflation and deflation？

Stabilizing prices is a perpetual task for macro-control policies.

Worldwide， the United States has been wary of signs of inflation， while Europe and Japan are making efforts to prevent deflation. The price situations vary in emerging markets， where the fluctuations of major commodity prices have been exacerbated. For China， the price situation is becoming increasingly complicated.

While the producer price index is declining， prices of steel and coal have experienced a conspicuous rebound. Although the consumer price index remains stable on the whole， pork and vegetable prices have risen by a large margin and have remained high since February. Although vegetable prices have dropped recently， pork prices will still remain high for some while.

Meanwhile， housing prices in first- and second-tier cities are rising rapidly， and prices in the service sector keep increasing. Consequently， there are growing numbers of people who believe that inflation is on the horizon， while others forecast deflation.

In my opinion， its too soon to make a judgment. On the one hand， the decline of industrial product prices will continue due to overcapacity issues. On the other hand， serious deflation is unlikely to occur given the markets adequate liquidity level and the strong consumption capacity of the average Chinese household.

Nevertheless， we should be on the alert and pay close attention to changes in prices， especially the prices of industrial products， consumer products and assets. Regarding the rise of food prices， the government should increase supplies through the proper allocation of products. However， the government shouldnt overreact to price surges in order to avoid misleading the market. The government should also offer subsidies to those who belong to low-income urban groups to guarantee their livelihoods amidst the rise in prices.