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Forty years of manufacturing change

BlackRock |Feb 4, 2019

China’s structural reforms and their investment implications

China’s historic reform process turned forty in 2018. This conversation with Wenjie Lu, our Shanghai-based China Investment Strategist, revisits main chapters of the past four decades of Chinese reform, with a focus on current reforms and their investment implications.

Q: When people talk about “structural reforms,” what exactly do they mean?

A: They mean realigning past structures and controls to create sustainable growth. China’s model of a socialist market economy underpins rapid growth because it enables the government to pull resources rapidly to meet specific policy targets. The model, however, has led to imbalances between the public and private sectors and among various interest groups. For example, government income1 grew 6.5 fold between 2005-2018, exceeding the growth pace of the corporate (5.8) and household (3.7) sectors. Today, China’s government and its state owned enterprises (SOEs) account for about 55% of China’s total debt and 40% of GDP, but less than 15% of employment2 – a significant imbalance. Structural reforms seek to correct imbalances left by uneven economic growth. They cover many areas of the economy and affect the government, corporate, financial and household sectors. A few examples are:

  • Capital reallocation – mostly impacting the financial sector
    Financial deleveraging, interest rate liberalization.
  • Income redistribution – mostly impacting the government sector ,
    Property tax, household and corporate tax reduction.
  • Market regulation – mostly impacting the corporate sector
    Supply-side reform, environmental protection.
  • Institutional framework – impacting the corporate, household and financial sectors
    Intellectual property protection, Hukou reform, capital account opening.

We identify 22 reforms currently in progress in China at various stages of development. The China’s Key Structural Reforms table shows our classification framework, based on the sector most directly impacted by each reform, as well as our assessment of the priority, stage of development and related effect of each reform on short-term growth. We consider the long-term impact of all reforms to be positive for growth.

1. Fiscal and off-budgetary land revenue as of November 2018.

2. Data cited is from: Wind, BIS, China Ministry of Industry, China Ministry of Finance and includes BlackRock calculations, as of November 2018.


China’s key structural reforms

Q: What are some milestones in China’s 40-year reform journey?

A: Over the past forty years, China’s gross domestic product (GDP) has grown dramatically, from about 2.3% of global output in 1977 to 15% in 2017, according to the World Bank #1 estimates, as of November 2018. In this process, private enterprises went from non-existent to account today for about 80% of industrial output, 90% of exports and nearly all new jobs#2. Broadly speaking, we can talk of four main stages in China’s opening up to the world.

Potential Investment

Q: Is structural reform in China distinct from other countries, and if so, how?

A: Traditional economic and sociopolitical theories would suggest that the two overarching goals of China’s structural reforms are incompatible: One seeks to harness the advantages of state controls; the other the vitality of a free market economy1.

Small economies, such as Singapore’s, may provide some useful historical signposts, but structural reforms in an economy of China’s scale call for unprecedented policy design and implementation. For example, urbanizing 15 million people each year (by state target) requires intricate demand-supply rebalancing (by market forces) in infrastructure, housing, consumer goods and social services. This is unprecedented.

 Deng Xiaoping’s reform analogy “crossing the river by feeling for stones” concedes that leaders do not have all the answers and at the same time underscores his conviction that motion comes first and fixing problems second. Since Xiaoping's days, Chinese reform has indeed occurred by trial and error. A few reforms can claim initial success, such as price reform and financial market opening, but most reforms are far from perfect. Zigzags and apparent policy incoherencies have been common, but China’s economic transformation over the past 40 years is truly unmatched in history and reforms have played a key role.

Q: What do people misunderstand most about China’s reform process?

A: People misunderstand what triggers or who orchestrates the reforms. Structural reform, especially in China, is believed to be entirely designed by the top leadership. Sometimes it is not. The Internet and non-government groups such as public intellectuals, entrepreneurs and the middle class have played a role in shaping the focus or pace of reforms. For example, a small group of researchers pioneered birth control relaxation policies; certain regional governments and enterprises piloted programs in land reform, debt restructuring and free-trade-zones; and some middle-income families paved the way for environmental protection laws.

Bottom-up forces can find top-down blessings at the National People’s Congress, policy consultation conferences, or via certain Politburo members reading social media posts. Effective structural reforms, in terms of policy design and implementation, ideally address common stresses across the government, corporate and household sectors.

Another factor often misunderstood about reforms in China is the non-linear path they follow. Reforms can pause, or take two steps forward and one step back. It is incorrect to view this as lack of resolve or commitment by reform planners and executors. Rather, we believe, it demonstrates their pragmatism ‒ expressed by a willingness to be flexible, learn from mistakes, and take into consideration social and economic factors that are constantly in flux. Ultimately, this reinforces the conviction that reform is more art than science.

1. In the original words of reform agenda -the Communique of the 3rd Plenum of the 18th National Party’s Congress in 2013, the reform target is to “improve and develop socialism with Chinese characteristics…promoting the development of socialist market economy…making sure that the vigor of labor, knowledge, technology, managerial expertise and capital keeps bursting forth.”

Q: Who is in charge and how are they held accountable?

A: China’s Party-State dual governing system shares responsibility for carrying out reforms. The Party’s Central Deepening Reforms Commission, led by President Xi Jinping, coordinates the reforms; the State Council, led by Premier Li Keqiang, implements them. Senior leaders often sit in both the Party and the government institutions to ensure consistent policymaking and implementation.

Almost all reforms have a dual-leadership structure. Financial reform, for example, is led by the Party’s Central Financial and Economic Commission, but implemented by various governmental bodies, including the Financial Stabilization Commission of the State Council, the People’s Bank of China (PBoC), the China Banking and Insurance Regulatory Commission (CBIRC) and China’s Securities Regulatory Commission (CSRC). State-owned think tanks, such as the National Academy of Social Sciences, and media outlets, such as Xinhua Newswire, also play an important role in policy consultation, communication and evaluation. Official metrics to determine the relative success or needed adjustments of specific policies are discussed behind doors, while power shifts among the leadership can be seen as measures of success and accountability. 

Q: How does the state prioritize reforms, particularly in the current stage?

A: In the long term, all reforms seek growth stabilization and sustainability. In the shorter horizon, the government chooses between two paths that are seemingly at odds based on their impact on economic growth. These are pro-growth and pro-welfare reforms. Pro-growth reforms help the public sector: Government and SOEs quickly gather capital and human resources. Pro-welfare reforms help the private sector: Non-SOEs and households benefit from resource redistribution.

When top leaders are comfortable with economic growth, such as in late-2013 and mid-2017, pro-welfare reforms tend to follow. For example, anti-corruption and finance reform for small and medium enterprises (SMEs) came out in 2014, and financial deleveraging in early 2018. In contrast, when leaders are concerned about growth and stabilization, as in late-2015 and mid-2018, pro-growth reforms become priorities. For example, financial deleveraging, which causes growth deceleration, paused in summer 2018, as U.S.-China trade tensions and global monetary tightening blurred the economic outlook.

In addition, social and economic events can accelerate certain reforms. Capital market reform followed the crash of A-shares in mid-2015, and environmental protection emerged after air pollution reached hazardous levels in the winter of 2015. 

Q: How can the current trade tensions impact China’s reform path?

A: The trade threat has led China’s government to fine-tune the pace of certain reforms. The near-term focus is to cushion the negative impact by accelerating corporate-and household-related reforms by encouraging domestic consumption and capital expenditures. In the longer term, many reform programs in the government and corporate categories will require re-calibration. This entails: 1) Levelling the playing field between foreign and Chinese corporates in both onshore and overseas markets, 2) Liberalizing the capital account and FX policies to facilitate cross-border trade and investment activities, and 3) Limiting U.S. dependency for technology and trade cooperation while broadening relationships with other countries.

It is hard to see China's socialist market economy entirely removing state controls over trade and industrial policies to accommodate U.S. demands. We see a risk of global trade taking one or two steps backwards.

Q: What structural reforms matter most to investors and how do these reforms translate into investment opportunities?

A: The scope, scale and surprise factors of structural reforms determine their impact on capital markets. In early 2016, for example, supply-side reforms cut capacity cut targets for steel and coal by 10% - 20%. Partially as a result, China’s producer price index (PPI) inflation reached 7.8% in Feb. 2017, up from -5.9% in December 2015. This boosted profitability in heavy industrial sectors in 2016-2017, underpinning strong performance across benchmark equity indexes. The CSI300 and the MSCI China returned 60% and 122% respectively from their troughs in 1Q 2016 to their peaks in Jan. 20181.

Reforms may enable investors to pick up structural benefits and build more diversified bond and stock portfolios. The Investment Implications table presents broad strokes of what we believe is a much more nuanced picture. For example, financial deleveraging can be positive for certain banks and negative for others, and price reforms may impact various sectors differently, or even have different effects on the same sector over time. However, we believe certain themes will play out over the next two to three years, and we look at these through the lens of our priority and stage-assessment for each reform. Not all reforms within a “view” category apply to the related “potential beneficiaries,” and the process is very dynamic. For example, intellectual property protection escalated recently to a high priority, creating what we believe could be a tactical bet. This table is illustrative and does not seek to provide investment advice.


china- reform-journey

1. Capacity and inflation data comes from Wind; index returns from Bloomberg.