Last week Macquarie Research hosted a presentation, China’s economy and politics: a strategic view, by Arthur Kroeber, Managing Director of Dragonomics, which is a highly respected research and advisory firm specialising in the Chinese economy. He noted that the Chinese policy agenda of economic growth at all costs has changed. Macquarie provided this overview.

The China Era of Economic Reform (1978-2006), in which structural changes were the driver of the economy, is over. The focus of the Chinese administration is now on governance reform, although Kroeber was quick to point out that governance reform does not extend to reforming the political system from its current state (he expects gradual but significant political reforms – not democracy, but increasingly effective administration). The aim of the Era of Economic Reform was to “replace the old planned economy with something else,” and Kroeber argued that this aim has been achieved. The government is now looking to move from the old way of doing things – Deng Xiaoping’s ‘Development is the only hard truth’ – to a system in which development is one of many objectives, such as environmental and social objectives.

To illustrate this, Kroeber pointed out that only two of 10 new Politburo members and only one of 25 provincial chiefs appointed by Hu Jintao are engineers. Since 1980, China has been governed by engineers; however, the new staffers have backgrounds in history, law, economics and politics, reflecting the fact that problems now require governance solutions (not construction).

The Chinese government and businesses have significant financing power now, and, as such, foreign investors will be increasingly expected to bring things other than financing capability to foster growth, i.e. technology or management skills. Furthermore, the focus now appears to be on building powerful domestic corporates, making it likely that it will be tougher for foreign investors going forward.

Three key slogans have been developed by the Chinese national government that government officials (at all levels) are being rewarded for following, although not following the philosophy normally does not result in any disciplinary action.

The scientific concept of development: highlights the move from developing the economy at any cost to placing a greater emphasis on the rule of law (social welfare) and on efficiency of factor use (environment).

Harmonious society: An increasing focus on education, health care and pensions (social welfare and the environment).

Intra-party democracy: Stamping out corruption and sharing power, becoming more accountable. Kroeber argued that the communist party realises that a stable regime is achieved by a peaceful transfer of power, and, as a result, there has been more consultative leadership selection, age limits and term limits at all levels and a variety of other regulations put in place.

Although this sounds like the same aims/reforms we have been hearing about for some time, Kroeber noted that the National Development and Reform Commission (NDRC) really has moved from not having the environment, welfare and efficiency as major policy objectives to having these objectives “at its core.”

Commenting on the Chinese taxation system and personal income tax, Kroeber did not express any shock that the Chinese government collects only 20% of what it could in personal income taxes. He believes that this is unlikely to change because workers would demand more representation as taxes paid increased, and the government does not want to change the political system.

Turning to the economic outlook, and looking first at China’s economic growth, Kroeber believes that China will remain in a growth ‘sweet spot’, with changing demographics (urbanisation means being insulated from external shocks) and productivity (means being insulated from inflation). He expects that to result in GDP growth of around 10% through 2010 (GDP growth is forecast to be 11.5% for 2007 and 10% for 2008).

On the US slowdown, Kroeber believes that slower exports in 2008 will take 1 percentage point (ppt) off GDP growth and that another 0.4ppt will be lost from a related fall in investment (he assumes that Chinese export growth will slow from 26% to 18%). Falling export growth would imply a slowdown in investment; however, this is likely to be offset by an expected ongoing boom in Chinese construction investment.

Kroeber noted that a slowdown in Chinese exports would have no effect on Chinese demand for iron ore because investment is driven by Chinese domestic growth.

Kroeber is not concerned about consumer price inflation (productivity > wages) in China, but is modestly concerned about asset inflation (over investment and capital misallocation). He argued that consumer price inflation has been driven by supply shocks to food inflation (not by a demand shock).

Macquarie Research reports its view from all this is that a possible US recession and a slowdown in the (other) main developed economies would likely have a negative effect on the Chinese economy. “However, we think that any effect would be very limited. In fact, a mild slowdown in China would be positive in the eyes of Chinese policymakers.

“The effect of any slowdown on the main developed economies is likely to be reduced (and perhaps completely offset, in our view) by strong domestic Chinese growth. Furthermore, if it is necessary, an abundance of Chinese government finance could be utilised to prop up the economy and reduce cyclical economic fluctuations.