A softer attitude to slower growth

New economic policy regime may lead to more sustainable expansion

The focus of China's new leaders differs substantially from that of their predecessors.

In the first quarter of this year, GDP growth was 7.7 percent, down from 7.9 percent in the fourth quarter of last year. In April and May, indicators such as industrial production continued to fall, pointing to a significant likelihood that in the second quarter, GDP growth will fall further toward - and perhaps even reach - the official GDP growth target of 7.5 percent.

The government's reaction to such data in the past decade would probably have been to highlight the downside pressures on growth for a prolonged period and then start to take action to boost domestic demand, especially investment demand. However, so far the tone of most senior policymakers has been very benign and relatively relaxed.

It was not until June 17, during a visit to the National Audit Office, that Premier Li Keqiang acknowledged that "the economy faces downward pressures".

This reflects the fact that the new leadership is more tolerant of slower growth, although it is not completely disregarding the growth rate.

Instead of in effect viewing the 7.5 percent GDP growth target as the lower limit of a tolerable growth range, it probably views it more as a real target that it is comfortable with.

The official GDP growth target for next year is likely to be reduced, probably to 7 percent. This new approach suggests that, given the first quarter's GDP growth of 7.7 percent, there will not necessarily be an automatic policy response even if GDP growth falls below 7.5 percent in any quarter this year. The focus on financial risks has been the main driver of the recent liquidity tightening.

The new leadership is also more focused on structural issues, such as anti-corruption measures, environmental protection, financial risk, work/food safety and a reduction of administrative controls, among others.

It will probably take time for these measures to have an impact on the economy. By contrast, the shift in the monetary policy stance since mid-May, probably driven by risk control considerations, will put more downward pressure on near-term activity growth. In particular, tighter financial conditions in the interbank market have attracted the attention of the market.

But instead of viewing this as a random event caused by special one-off factors, we see this in part as a result of tightening aimed at preventing the leverage ratio from reaching an even higher level. This is because the control of funding costs for financial institutions via open-market operations is becoming an increasingly important policy tool, given that the narrowly defined renminbi loan supply is now an increasingly smaller part of overall liquidity supply.

While initially there were some doubts about whether the rise in the interbank rate early last month was a temporary pre-holiday (Dragon Boat Festival) phenomenon, the fact that the interbank rate had already started to rise meaningfully in mid-May and stayed at an elevated level for several days following the holiday suggests that this rise was not simply a pre-holiday liquidity squeeze.

It can be argued that the central bank did not actively drive up the level of the interbank rate, and that it was driven by a much lower level of foreign exchange inflows and more net fiscal withdrawals.

However, the fact that the central bank monitors these changes and that it took no action even though the interbank rate changed in real time says something about its stance. Moreover, a number of tighter regulations have been introduced in the financial system to control systemic risks: there have been tighter controls on interbank business activities and closer scrutiny of fixed-income trading, including the arrest of a number of traders for illegal activities. All these suggest an orchestrated attempt to fix the holes in the financial system to make its development more sustainable, possibly at the expense of short-term growth.

One issue closely related to the above discussion is the communication of policy thinking. While Western observers may assume it is a universal rule that policymakers should try to guide market expectations by communicating their thinking to market participants, this is still not always the case in China.

This could in part be because of the difference in the way policymakers view the issue conceptually and in part because of the practical difficulties in making the reasons for decisions explicit.

The loosening we saw in the third quarter last year, for example, was much more low-profile, in terms of the policy tone given the level of policy actions, than the 4 trillion yuan ($653 billion) package, probably because of the political transition and some criticism of the 4 trillion yuan package. Whether we believe these criticisms to be justified is a separate issue.

The tightening bias may be much more sustainable than what is expected by the market.