Chinese workers rest at a construction site in Beijing. Applying the supply-side theory that embraces productivity gains and reduced tax barriers could reinvigorate the public sector, while potentially freeing up room for private enterprise, according to proponents.

Bloomberg
Hong Kong

When China’s top Communist Party officials met in October at the heavily guarded Jingxi Hotel in Western Beijing to ink a new five-year economic plan, a significant policy shift was discussed.
Assembled policy makers were reviewing how a year-long effort to stoke demand with interest-rate cuts and fiscal spending had done little to accelerate growth. At risk was President Xi Jinping’s aim to keep the $10tn economy growing by a minimum of 6.5% through 2020, the pace deemed necessary to become a “moderately prosperous society.”
During the meeting, the discussion explored stepping up supply-side reforms such as dealing with overcapacity and excess labour in state-owned industries and tax cuts, according to a party official familiar with the discussions. Applying the supply-side theory that embraces productivity gains and reduced tax barriers could reinvigorate the public sector while potentially free up room for private enterprise, according to proponents.
If adopted, the shift would mark an acknowledgement that a policy “troika” that previously focused on investment, consumption and exports wouldn’t be enough to deliver the government’s ambitions for 2020.
“Productivity enhancement, and the supply-side reforms required to achieve it, is China’s only option to avoid the dreaded middle-income trap that has proved so problematic for most developing countries over the long sweep of history,” said Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia.
The battle to avoid that fate - as recorded in economies like Brazil’s that have seen incomes plateau and growth stall before they could attain rich-world status - was the driving force behind Chinese Communist plans laid out in March. Since then, there’s been months of disappointing data, a $5tn stock market rout and a tepid response to six interest-rate cuts, prompting officials to shift gears.
Since that October gathering, there’s been a flurry of activity: the nation’s infamous one-child policy became a two-child policy, new rules were announced that will make it easier for companies to list shares, and changes to the residency registration permit system have been floated that may further free up the movement of labour.
In the bloated and inefficient $16tn state-owned enterprise sector, China Minmetals Corp, the nation’s biggest metals trader, will buy China Metallurgical Group, a government-owned engineering and mining group. The move will combine two state enterprises with about $96bn in sales.
Xi’s right-hand-man on economic affairs, Liu He, is among those urging supply-side reforms, said the official familiar with the matter, who declined to be named as the policy discussions aren’t public.
Official media have chimed in, with now frequent references to the supply side. The Xinhua News Agency ran a commentary this month stating that “industry remains the backbone of the economy,” including a pointed statement that services and consumers alone won’t be enough to drive growth. The aim of the economy’s transition “is to make the traditional industrial sector more competitive, rather than less significant,” it said.
The comments signal that policy makers see the strength in consumption and services industry - something confirmed again in November economic data December 12 showing a jump in retail sales - as being insufficient to achieve their goals.
“Supply-side reform has emerged as the number one catchphrase in China’s policymaking discourse,” says Societe Generale China economist Wei Yao.
To some, the focus on supply-side reform suggests a possible reprise of the late-1990s, government-led overhaul of state-owned companies and banks. Former Premier Zhu Rongji pursued an aggressive agenda by steering China into the World Trade Organization, shutting down 60,000 inefficient state companies that triggered 40mn job losses. He also shook up the banking sector.
Zhu’s legacy remains. When the leadership made its annual pilgrimage to the seaside resort of Beidaihe in August, they sought advice from Zhu, according to people with knowledge of the matter.
Where Zhu’s shock therapy set the economy up for a decade of supercharged growth, this year, China will be lucky to hit its growth target of about 7% and is set for its slowest expansion in 25 years.
Last time the economy needed a boost, China’s stimulus efforts centred around a massive infrastructure-building programme rolled out during the global financial crisis. Left with a $28tn debt overhang after that spree, a new tack is now being taken.
Along with the policy shift, criticism has surfaced among senior officials, who have long adopted a public face of consensus on major issues. In a party where slogans and set phrases have been fundamental since the days of Mao Zedong and his Little Red Book, public comments by Premier Li Keqiang came under scrutiny at the top-level October gathering in Beijing.
Finance Minister Lou Jiwei, a veteran policy maker and a close ally of Xi, and People’s Bank of China governor Zhou Xiaochuan suggested changes to terms used for explaining the economy’s conditions, according to the person familiar with proceedings of the party’s Fifth Plenum from October 26-29. Criticism over wording is rare and could indicate a lack of consensus among the top ranks of policy makers.
Among the phrases used by Li that were singled out by Lou was “gaige niu,” which translates as reform bull and was used to justify the stock market’s rally as the bubble inflated before the mid-year collapse, according to the person.
Zhou took issue with the term “discretionary adjustment,” used by Li to describe China’s shift by mid-2015 toward supporting growth and away from a focus on deleveraging. Zhou said the phrase “counter-cyclical adjustment” would be better understood internationally.
To be sure, the current focus on supply-side reform isn’t unique. In 2013, the State Council published a list of industries it said were suffering from chronic overcapacity.
“China is slowing down rapidly, so giving up demand management is not an option,” said Yao Yang, dean of the National School of Development at Peking University. “Supply- side reform is a long-term process and in the short term it can hardly show an effect. China needs more demand now, we need to utilize the capacity rather than simply cut it.”
So while the pendulum has swung to the supply side for now, Xi must also keep growth ticking over to maintain political backing for policy changes ahead.
“Structural reforms will be undertaken, as long as growth does not collapse below the targeted levels,” said Stephen Jen, co-founder of SLJ Macro Partners in London and a former International Monetary Fund economist. “All of the reforms are meant to enhance the quality of growth, rather than ‘quantity.’”