What's Driving China's New Economy?

Three months after the conclusion of China's Third Plenum, the state seems to be fulfilling every prophecy set out by economists. These meetings, used by Chinese political leadership to set policy goals and the general direction of the country, seem to show that the state may be giving up its usual stance on intervening in the market for something a little more hands-off. This move is still in its infancy, but in an economy expected to be the world's strongest by 2020, the move seems to be one a long time in coming.

Although China's slowing economy has been compared to a near-apocalyptic sign of failing markets, indications show the slow to be a forced suppression of an economy that had been bubbling in the early 2000s. This bubble is now being deflated, says Professor Yiping Huang, by Premier Li Keqiang's government who seeks less market volatility. In an economic view that has been dubbed "Likonomics," the Chinese premier calls for the establishment of a market built on no stimulus, deleveraging of current assets, and structural reform.

Explaining the three pillars of the new system

- No stimulus

Why should the Chinese economy accept slower growth?

Recent issues arising from over-investment in several sectors (such as steel, cement, and aluminum) have highlighted the relative difficulty of sustained government investment. While aggressive stimulus packages have previously multiplied growth in China, under Li the government will be acting in a much more constrained role with a greatly reduced market investment strategy. Although only 30% of these sectors are directly state controlled, the Chinese government directly owns 41% of assets. While the market has slightly opened for newer private companies, state firms dominate the market, offering the highest salaries.

Even then, there are indications new economic policy seeks to encourage foreign investment as opposed to being dependent on central government action. Probably the greatest example of these, the Shanghai Waigaoqiao Free Trade Zone, the first free trade zone absent any government financial restrictions, has shown a marked increase in investment opportunities, but it seems too early to understand the complete picture.

The lack of sustained government stimulus means the days of 10% Chinese growth per annum are gone. In its place are more modest growth figures that are expected to grow even more modest as the Chinese economy slows in the coming years. This does not mean that there will be no new major stimulus packages ever in the country, but, as Li notes, the economic picture must decay significantly before any such moves are attempted.

- Deleveraging assets

Deleveraging, or reducing the percentage of debt on a single or set of balance sheets, the Chinese economy is the next pillar of Li's market policy. Before the new government took power, the Chinese system has been undergoing a massive surge in taking on increasing amounts of debt. While this has amplified market gains in positive growth economies, this has also always had the potential to amplify any losses sustained.

Considering the unstable Asian market that has manifested since November's meeting, this has turned out to be a smart move.

As Huang notes, Chinese credit has boomed by an average of $2.8 trillion over the last five years to a grand total of $23 trillion; in the past, huge credit booms have tended toward harsher landings once economic growth slows. With a less integrated world economy, this may be less worrisome, but given China's market share, curtailing the credit bubble now will pay off in modest long-term growth (as opposed to a burst of short-term growth followed by potential recessions).

- Structural reform

The last pillar of Li's approach to China's economy could be summed up in one sentence: whenever the market seems to be functioning properly, the government should not intervene. This move has proven to be remarkably efficient in its operation thus far. Unfortunately, there has been a healthy amount of skepticism, especially from party officials, about the proposed changes. Coupled with a set of reform plans that feels like knee-jerk economics (that is, economic policy that is created haphazardly to suit rapidly changing conditions), this may be the hardest area to overcome entrenched party leadership.

The takeaway for investors

Likonomics seems to be a system implemented to encourage the freer flow of capital between market actors, both inside and outside China. Given that liberalizing a market tends to speed up financial flows, this will only allow a more vibrant Chinese market, and the ongoing attempts to further liberalize the market should finally end the gloom-and-doom projections that have been made for the last decade. While the market is slowing from the bursting economy it had been, the ongoing reforms indicate a stable market that should continue to attract investment opportunities into the foreseeable future.

There is one caveat: to continue to be an attractive location for investment, the Shanghai zone must be seen by the government as a financial and political success. If this is the case, then Likonomics are going to be an institutional step toward establishing lasting Chinese market dominance.

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