Economic Reform: Recovery Medicine

The pace of new COVID-2019 transmissions is coming down in China, but the pathway to economic recovery remains deeply uncertain. Much-needed economic reforms will be necessarily delayed, but Beijing can improve the outlook by demonstrating firm intent to reinvigorate the reform agenda post-virus.

It has been a rough year for China’s sloganeers. Instead of banners celebrating China’s arrival as a “moderately prosperous society” in the run-up to the 100^th anniversary of the founding of the Chinese Communist Party, party cadres had to pin up posters ordering citizens to wear masks and stay indoors. While China’s official coronavirus case numbers have, thankfully, been falling this week, the economy remains severely dislocated and a quick economic recovery is unrealistic.

Our view, and the stated view of China’s leaders themselves, is that the path to sustainable long-term growth depends on a profound economic reform program, which will mean necessary short-term pain. Our framework for measuring China’s reform successes, the China Dashboard, has shown that this program has stalled—or even backtracked—in recent years.

In light of COVID-2019, Chinese policymakers can’t make hard reform choices just now. Short-term efforts to prevent collapse and hasten economic recovery take precedence. But this does not mean leaders can mute the reform agenda discussion. To the contrary, the economic path forward must involve slogans of a different sort: a strong messaging campaign in support of renewed reform when the crisis ends. Far from an isolated economic shock, the virus has exposed the risks of China’s imbalanced growth trajectory and the ineffectiveness of the half-measures taken to address it. A strong reform voice from the top is essential for giving recovery a sustainable foundation.

Standing on shaky ground

China endured a severe economic downturn in the first quarter of 2020. Transportation numbers are the most telling—there were 82% fewer trips in the 25 days following the Lunar New Year in 2020 relative to 2019, an early signal that workers were not coming back from the countryside. Coal consumption by the six largest power plants in China fell over 40%. Property sales in major cities were near-zero through February. Manufacturing and services recorded major contractions according to government and private surveys. The shutdown of China’s economy is even visible from space—satellite readings show that nitrogen oxide and dioxide emissions (indicators of activity) from swaths of the industrial heartland all but disappeared.

It is certain that 1Q 2020 GDP growth was negative, whether it will be reported that way or not. What is not yet certain is the pattern of China’s recovery. Many pieces of China’s economy remain out of place. The government reported on March 10^th that half of the country’s migrant workers remain distant from their jobs. The next hit to come—a looming global slowdown as the virus spreads—will take a toll on China’s exports and imports of intermediate goods. The crisis will weigh on investment as well. Private enterprises, which rely more heavily on migrant labor than state firms, will delay capital expenditures. Overseas firms will likely also put off China expansions until the global outlook improves.

These first-order challenges will exacerbate existing challenges in the Chinese economy. Beijing has introduced forbearance measures on loan defaults through June—a temporary measure to prop up banks and small businesses facing a short-term cash crunch. (The US Federal Reserve has signaled something similar though vague guidance.) But even so, not all these loans will eventually be repaid, and provisioning for additional non-performing loans will put greater pressure on the already-strained books of China’s banks. The crisis also raises risks to China’s balance of payments outlook. We have argued that capital outflows from China are an inevitable consequence of the rapid expansion of China’s financial system, and capital controls cannot stem them forever. To avoid a balance of payments problem, outflows must be balanced not just with a trade surplus (no longer a sure thing: the quarter just ending saw a deficit) but with capital inflows from global investors. The global economic downturn in the wake of the pandemic makes near-term flows to China unlikely—unless there is a pro-reform surprise.

Far from an isolated economic shock, the virus has exposed the risks of China’s imbalanced growth trajectory and the ineffectiveness of the half-measures taken to address it.

The bottom line is that the coronavirus represents the most serious economic crisis since China began on the reform path in 1978. The virus and its knock-on effects have exposed and exacerbated weak points in China’s economy in ways that could further hamper recovery. In lieu of implementing economic reforms now, China’s leaders can publicly commit to a reform program that eases fears and builds confidence in the Chinese system.

Messaging is the best medicine

Demonstrating a commitment to reform is a necessary part of the best-case pathway to economic recovery. While the economic dislocation from the virus is indisputable, it is uncertainty about the post-virus outlook that will hamper recovery in the months ahead. Policymakers should take away three points:

First, a clear reaffirmation of reform is necessary because the virus has dispelled the illusion that piecemeal measures, like the Phase 1 trade deal with Washington, can patch Beijing’s international relationships and interests. Strategic mistrust still rules the day. If there were any hope that China could meet its purchasing commitments as part of the US-China deal, the collapse in energy prices this week—and the economic slowdown more broadly—have dashed it. In Europe, regulators are moving forward on measures to buffer local firms against Chinese state-backed competition. These are issues that only a clarion call for deep, substantive economic reform will solve.

Second, investment from private companies is critical to rebuilding China’s growth engine. Yet these companies still play at a disadvantage against state firms. While private companies far outperform state-owned enterprises in their business fundamentals, the SOE sector remains nearly as big as it was four years ago. Despite the fact that SOEs underperform in the market, few are ever privatized or exit the market. To the contrary, recent moves have increased Party control of companies in ways that increase political intervention in the economy and hurt private firms. This policy environment—combined with sluggish demand in the early stages of post-virus recovery—is a recipe for anemic investment. Signaling a policy turnabout that bolsters private enterprises, rather than hobbles them, would pull private investment into the engine of economic recovery.

This is important for foreign investors as well. Overseas portfolio investment into China’s financial sector is a small fraction of what it ought to be, given China’s economic weight. Foreign asset managers see opportunities in China, and hoped it would be months, not years, until they could meaningfully engage in China’s equity and bonds markets. But pandemics and oil shocks are bad for investor risk appetite, and a prolonged global slowdown would further delay capital inflows that could boost post-virus recovery. A decisive message that Beijing is ready for bolder financial reform is needed to restoke foreign investor interest.

Third, Beijing should resist the temptation to hear global approval of the success of its authoritarian playbook in responding to the virus as an endorsement for statism in dealing with economic problems. The tools of state coercion in enforcing social distancing, quarantines, and cordons sanitaires are the exact reverse of what is needed to promote a flourishing economy.

China and the rest of the world are wrestling with economic disruption unlike anything seen in years. The economic shock is severe, and the pace of recovery uncertain. China has been credited for its response to the coronavirus outbreak, after a terribly delayed and imperfect start. Beijing now has the opportunity to take its leadership a step further. Redoubling economic reform would demonstrate to players at home and abroad that China is ready to do business pragmatically. Hard economic choices must wait until the crisis calms, but for now strong reform messaging is the best medicine for a faster recovery.