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CN: What are supply-side structural reforms? 7 Apr 2016 Economics China: What are supply-side structural reforms? DBS Group Research 7 Apr 2016 • China’s “supply-side structural reforms” differ from Western “supplyside economics” in terms of theory, application and objective • In China, the temptation to resort to demand-side stimulus will remain high Xi Jinping discussed China’s “supply-side structural reforms” in a speech at the 12th meeting of the Central Leading Group for Financial and Economic Affairs on Jan 26, 2016. He emphasized that the fundamental objective of the reforms was to increase ‘social productivity’ and to put in place a people-centered development approach. Appropriate demand expansion should be complemented by trimming overcapacity, inventory destocking, deleveraging, cost reduction and improving weak links in the economy. In addition, in the field of production, there is a need to enhance high-quality supply, increase effective supply, improve the adaptability and flexibility of the supply structure, and increase total factor productivity to make the supply-side more adaptable to changes in the evolving structure of the economy. Western supply-side economics primarily focus on lowering tax rates In the Western context, supply-side economics emphasizes economic growth achieved by tax and fiscal policy that creates incentives to produce goods and services. In some instances, supply-side economics has focused on lowering marginal tax rates [1]. The idea is that tax reductions may increase the after-tax rate of return from work and investment, bringing more supply. This is important because increased supply brings lower prices with it, whereas increasing aggregate demand does the reverse. As such, supply-siders shun demand-side expansion to prop up the economy, and urge monetary restraint to cap inflation. Supply-side policies were often debated in America in the 1970s to address stagflation. China’s supply-side structural reforms have little in common with Western supply-side economics It is clear from the above definitions and descriptions that China’s supply-side structural reforms are not the same as Western supply-side economics. Their only similarities are: 1) That tax cuts, central to Western supply-side economics, are also being proposed in China (tax cuts fall under “cost reduction”, mentioned in Xi’s speech). However, it is only one of the many means to address structural problems facing China, and cannot be deemed as central to China’s supply-side reform concept; 2) The supply of goods and services, as well as improvements in productivity are being emphasized. Beyond these similarities, however, lie many differences: 1. Theoretical differences The Laffer curve hypothesized a tradeoff between tax rates and the total tax revenues collected by the government. It was argued that tax reductions in- Chris Leung • (852) 3668 5694 • [email protected] 1 CN: What are supply-side structural reforms? China’s emphasis is on cutting overcapacity and increasing effective supply 7 Apr 2016 crease supply / GDP while lowering prices and/or inflation. There is no singleeconomic theory or theorem behind China’s supply-side structural reforms. In terms of production, the focus in China is less about increasing supply of goods and services than it is about increasing “effective” supply, i.e., supply that better matches consumer demand. In addition, China’s supply-side policies are not premised on a vertical or nearly vertical supply curve, and as such the inflationary impacts of expansionary demand-side polices are also not emphasized. With respect to tax cuts, the tradeoff between tax rates and tax revenues does not seem to be the Chinese government’s key concern at the moment. The government has acknowledged that tax revenues will fall and the budget deficit will widen in 2016. What’s important is incentivizing (effective) production and improving company profitability, and rebalancing its economic structure through tax cuts. For example, as part of tax reform, services industries such as real estate, financial services and insurance, and lifestyle services (hospitality, food and beverage, healthcare and entertainment) will all be subject to VAT with effect from 1 May 2016. The services industry is expected to reap tax savings after transitioning to VAT from business tax. This important move should help China transition towards a more service-based economy. 2. While Western supply-side proponents shun demandside management, China is actively employing it The application of Western supply-side economics is characterized by the means by which economic problems are solved, primarily through “supply-side” measures. These measures are namely: 1) Tax reduction, in particular marginal taxes and capital gains taxes; 2) Deregulation and minimizing the role of government; 3) Exercising monetary restraint by linking money supply to GDP. Accordingly, Western supply-side proponents shun demand-side management, claiming such policies create little or no economic value. The application of China’s supply-side structural reforms is characterized by solving economic problems – many of them on the supply-side – using whichever means are most appropriate under China’s current institutional and macroeconomic context. This means that demand-side expansionary policies – both monetary and fiscal – are to be employed to maintain a reasonable pace of growth and stability in China. China is planning to increase the intensity of its proactive fiscal policy, increasing the deficit-to-GDP ratio to 3% in 2016 from 2.4% in 2015. The enlarged deficit will allow the government to “increase government spending and central budgetary investment by an appropriate amount” [2]. In particular, it is expected that more government spending would be directed to targeted industries in the upgrading of China’s industrial structure, and to support urbanization efforts. 3. China’s supply-side reforms entail heavy government intervention Application differences Ideological differences The essence of Western supply-side policy is to allow markets to work more efficiently by lessening government intervention, with the belief that markets will correct any imbalances itself. In other words, less government is called for. The supply-side polices that the Chinese government is pursuing require government guidance on all fronts and levels. In China, major reforms are often initiated through government controlled pilot schemes. In SOE reforms, the government decides which firms to reform first, as well as the method and extent of reform. As for the task of trimming overcapacity, the government’s hand is also very visible. According to a report by the Ministry of Finance, “The market should serve as a check, enterprises should be the major actors, local governments should play a coordinating role and the central government should provide due support, while the responsibility for making sure that overcapacity reductions happen in a locality will be on the relevant provincial-level 2 CN: What are supply-side structural reforms? 7 Apr 2016 government.”[3] Because political institutions are completely different in the West and China, divergence of reform ideologies can only be expected. An umbrella term In sum, “supply-side structural reforms” is an umbrella term for China’s pragmatic approach to solving its structural problems. Without a solid theoretical foundation as an anchor, it could mean different things at different times, and the temptation to rely on demand-side management remains overwhelming. Bound by existing political institutions, the leadership’s approach to solving economic problems has not fundamentally changed. Bold institutional reforms are required to effectively push through the structural reforms that China urgently needs. Sources: [1] “The Laffer Curve,” The Laffer Center, http://www.laffercenter.com/supplyside-economics/laffer-curve/ [2] Report on China’s Economic, Social Development Plan, delivered at the Fourth Session of the Twelfth National People’s Congress on March 5, 2016 [3] Report on the Execution of the Central and Local Budgets for 2015 and on the Central and Local Draft Budgets for 2016, Ministry of Finance, P.20-21 3 CN: What are supply-side structural reforms? 7 Apr 2016 Recent Research CN: root causes and remedies for overcapacity 6 Apr 16 CN: how to end the vicious cycle 21 Jan 16 Global crude: still spilling onto the floor 20 Jan 16 TW: after the election 19 Jan 16 IN: back at fiscal crossroads 19 Jan 16 CNH: “Taken” – the RMB episode 15 Jan 16 Rates: UST curve: belly’s too big 15 Jan 16 US: what is driving core inflation and when will headline follow? 31 Mar 16 EZ: watching Brexit risks 28 Mar 16 SG budget: balanced and transformative 28 Mar 16 ID: investment eludes 24 Mar 16 Rates: SGS premia compression 21 Mar 16 18 Mar 16 CN: services and manufacturing are codependent 14 Jan 16 JP: rising direct investment in Southeast Asia SG: a winter budget 14 Mar 16 IN: prepared, not immune 16 Dec 15 Qtrly: Economics-Markets-Strategy 2Q16 10 Mar 16 Qtrly: Economics-Markets-Strategy 1Q16 10 Dec 15 IN: fiscal discipline trumps growth 1 Mar 16 Holiday Heresies 2016 7 Dec 15 Rates: G7 bonds - tantrums brewing 1 Mar 16 ID: manufacturing still a drag 3 Dec 15 Global growth: what is potential and where is it going? 25 Feb 16 ID: BI easing bias persists 19 Feb 16 EZ: negative rates not a cure 17 Feb 16 US: how strong is consumption? 12 Feb 16 SG: the next growth driver 4 Feb 16 JP: BOJ into uncharted territory 2 Feb 16 CNH: will capital controls help? 2 Feb 16 FX: Not just about CNY 1 Feb 16 IN: RBI to await budget cues 1 Feb 16 Rates: Global rates roundup/ chart-pack 29 Jan 16 CN: when is a trillion not a trillion? 29 Jan 16 IN: fading boost from low oil prices 28 Jan 16 CNH: billion dollar baby 16 Nov 15 EZ: will more QE help? 4 Nov 15 Rates: regional rates rundown 2 Nov 15 FX: monetary policy divergences intact 2 Nov 15 Rates: UST Curve - the next flattening leg 30 Oct 15 JP: deciphering the BOJ 23 Oct 15 ID: no room to cut 12 Oct 15 IN: the lowdown in exports 9 Oct 15 SG: technical recession 6 Oct 15 SGD: a lower policy band 6 Oct 15 CN: resolving the known unknowns 5 Oct 15 G4: who’s winning the currency wars? 25 Sep 15 IN: RBI – another window opens 22 Sep 15 Disclaimer: The information herein is published by DBS Bank Ltd (the “Company”). 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