International Department of the CPC Central Committee       BEIJING REVIEW
Friday, March 31, 2017       MONTHLY
A guide for supply-side reform
By Xu Hongcai 

Workers of Northern Heavy Industries Group Co. Ltd., based in Shenyang, northeast China's Liaoning Province, disassemble a tunnel boring machine to transport it to Sao Paulo, Brazil (XINHUA) 

Since the global financial crisis broke out in 2008, one of the major challenges for the world economy is dealing with inadequate effective demand. The Chinese economy is facing this issue as well, but the essence of the problem is that the quality of the supply does not satisfy the demand. The supply side's poor quality has impeded China's plans for economic transformation, upgrading, and growth.

To address these problems, attention must be paid to the following issues when continuing supply-side structural reforms this year.

Correct understanding 

Supply-side structural reform is a term that must be well understood. Some people mistake "cutting excess capacity" as "cutting output." Government orders to cut excess capacity could be meaningless under certain circumstances—when prices rise because of drops in output, industries will naturally put their shut-down production capacity into operation again. 

For instance, cutting excess capacity in the steel and coal sectors in 2016 had mixed results mainly because steel and coal prices kept rising since the third quarter of the year. In major steel-producing provinces such as Hebei, Jiangsu and Shandong, output of crude steel increased rapidly amid price surges while in Shaanxi, Xinjiang, Inner Mongolia and Shanxi, China's major coal-producers, coal output also grew. 

The government should instead formulate standards concerning energy and resource consumption, pollution, and workplace safety. It should also ensure that everyone adheres to the same standards, order the termination of firms which fail to obey the standards and let the market play its role. 

It is hard to demonstrate fairness through compulsory overcapacity reduction. Many people have complained that when ordering firms to cut overcapacity, the government offers aid and subsidies only to state-owned enterprises (SOEs), which have more difficulty in dealing with the ensuing layoff issue, while private firms have to solve these problems by themselves. This ultimately leads to an unfair market environment and competition. 

To ensure fairness, the government must formulate rules concerning safety, quality and emission reduction standards, and then ensure that these standards are obeyed by all. 

During the reform process, administrative measures are emphasized because they can produce rapid results and are easy to use. But without market-oriented schemes, these measures will soon lose effectiveness. 

We must stop using administrative intervention on microeconomic affairs as a way to advance supply-side structural reform. It is reasonable for the government to guide and nurture market schemes in order to solve problems caused by poor quality of the supply side. However, the ultimate goal should be to make the market play a decisive role in resource allocation. 

Shifting leverage

Debt-for-equity swaps will be promoted in 2017 because the corporate debt ratio is too high, which may intensify potential financial risks. Corporate leverage ratios must be lowered. However, as China strives to stabilize growth, the leverage ratio of the entire economy will inevitably rise. Therefore, the transfer of leverage is needed.

On one hand, the public sector, the government and residents need to increase leverage; on the other hand, businesses will be better off through debt-for-equity swaps, as the scheme will help introduce new strategic investors, improve the ownership and corporate governance structure, and establish medium and long-term incentive mechanisms—all of which are key areas for reform in 2017.

In brief, the supply-side structural reform should focus on improving quality, reducing ineffective supply, and making the supply structure more adaptable to demand.

Reducing ineffective supply helps eliminate poor-performing companies, squeeze the market for low-quality products, strengthen oversight of product quality and crack down on counterfeit commodities. Focusing on higher-quality production helps companies establish core competitiveness, realize innovation-driven growth, and nurture more time-honored brands.

The author is deputy chief economist of the China Center for International Economic Exchanges

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