A softer attitude to slower growth(2)

Unlike a tightening driven by concerns over inflation, a tightening motivated by risk control may prove to be more sustainable, as control of the leverage ratio needs to be, almost by definition, a continuous process. At the risk of being simplistic, over the previous two decades, economic policy making could be divided into the period under the then premier Zhu Rongji (1992-2002) and that under former premier Wen Jiabao (2003-2012).

The decade under Zhu had a strong focus on fundamental reforms, including entry into the World Trade Organization, the bankruptcy of SOEs and the substantial restructuring of the government.

In the decade under Wen there was a much more limited number of fundamental reforms, and the policy focus was more on the cyclical management of the economy to prevent it entering a sustained period of deviation from trend growth. While it is not always necessary to choose either reform or cyclical management as the primary focus at the expense of one or the other, in practice there is often a bias, and sometimes specific short-term and long-term goals do conflict with one another.

For example, loosening driven by fixed-asset investment is viewed as both necessary and effective from a cyclical management point of view but it tends to make air pollution worse as it tends to be more closely linked to heavy industrial production.

From the relatively limited amount of information available, the decade under President Xi Jinping and Premier Li Keqiang may fall somewhere between the previous two decades, with less focus on cyclical management than in the past decade but more than in the decade before that, and more fundamental reforms than in the past decade but less than in the decade before that (ideally, we would like to see more fundamental reforms, but realistically the reform process is likely to be challenging given the political and social structure).

The change in the administrative structure at the People's Bank of China, the central bank, could have played a particularly important role in the change in monetary policy stance. As Governor Zhou Xiaochuan moved up the political hierarchy and became by far the most experienced monetary policymaker in China, the PBOC has in effect, although not necessarily institutionally, gained more autonomy in the setting of monetary policy. Given that the new senior leadership is less dovish and social criticism of "excess liquidity" is, rightly or wrongly, widespread, the PBOC may have found it easier to implement a hawkish bias.

While the individual preferences of most senior policymakers matter significantly for the above overly simplified description of policy making styles, the latter also reflects a change in social preferences.

When the economy was running well in terms of wealth and job creation during the early 2000s, it was more difficult to push for aggressive fundamental reforms, as many in society and government probably believed that "if it isn't broken, don't fix it".

While we believe the system is far from broken, social preferences are likely to have changed as a result of sustained economic development, with its heavy toll on the environment and increased wealth for a significant portion of the population. For example, wealthier citizens and policymakers may now value clean air more highly than financial wealth.

On the other hand, as the economy has expanded continuously (it was still expanding even at the trough of the cycle), the absolute level of pollution by various measures has also increased continuously. The high levels of air pollution in many Chinese cities since last year may have marked a turning point in the social attitude toward pollution controls, and the policy comments and changes since then are to a large extent a result of this. Such a change in social preferences is another reason why the PBOC's hawkish bias may last longer than would otherwise be the case.

But it is not all bad news.The flipside of this seemingly bad news for the near-term growth outlook is that we may see a reduction in systemic risks, especially in the financial system, provided there is no persistent over-tightening.

The latter could result in a debt deflation scenario that would lead to even more risks. We think policymakers understand these risks in principle, although exactly how much tightening is too much is never an easy question to answer. However, if the recent level of interbank liquidity tightness is maintained, we would probably see a normalization to a tighter level than earlier in the year but not quite as tight as now.

Furthermore, more reforms can raise the level of potential growth. Whether this would be sufficient to offset the demographic headwind is much less clear and will depend on the decisions taken at the forthcoming Third Plenary Session of the 18th Party Congress.

As a baseline scenario, we may continue to see a gradual fall in potential growth, but a long way off the collapse foreseen by many bears. Our relatively cautious stance is partially based on the observation that there has been a clear willingness to implement some important reforms, such as reducing the administrative burden on the economy.