Scalpel in hand, Chinese Premier Li stirs reform hopes

By Koh Gui Qing

BEIJING (Reuters) - Investors getting stung by China's worst financial market rout in years should find solace in the fact that the government, in particular Premier Li Keqiang, is willing to play hardball to force through much-needed policy change.

The central bank's refusal to intervene last week to ease an unprecedented cash crunch, where interest rates in the interbank market shot as high as 30 percent, was the clearest sign yet that China's new leaders are willing to stomach economic pain for the long-term good.

The People's Bank of China (PBoC) takes its cue from the government under China's communist system. It has allowed interest rates to stay high to slow runaway credit growth and to punish banks for reckless practices that include using short-term funding for long-term lending.

In a country where 30 years of double-digit economic expansion has created a culture of prizing growth above all else, Beijing's decision to let the money market seize up even at the risk of choking China's slowing economy is a milestone.

"Clearly we are now in a different ball game," said Louis Kuijs, an economist with RBS in Hong Kong.

"Even though people are reducing their (economic) forecasts, the government is comfortable with a policy stance that emphasizes reform."

SHOCK AND AWE

Accustomed to China's previous government where leaders bent over backwards to produce stellar rates of growth, Beijing's new stance has shocked investors.

China's stock market dived to 4-1/2-year lows on Tuesday as investors worried that steep money market rates, by raising the cost of borrowing, might be a defacto tightening of monetary policy that could stifle investment and consumption.

Some investors said the central bank's brinkmanship could backfire if it triggered a banking crisis.

Others lauded Premier Li's tactics as tough love that could gird China for other challenging economic reforms such as further slimming down giant state firms to make them more efficient.

Li took office in March, along with President Xi Jinping. As premier, Li is responsible for managing the economy.

His grit is reminiscent of former Premier Zhu Rongji, credited for leading China's previous round of major economic reforms in the late 1990s when he sacked more than 50 million workers at state firms to trim the bloated sector.

"Welcome to Doctor Li Keqiang's surgery," analysts from Standard Chartered said in a note.

"We had suspected that Premier Li would want to drive significant reforms. We underestimated, however, his apparent willingness to make policy choices that would risk putting further downside pressure on the economy."

In May, Li said there was limited room for policy stimulus because such measures carried risks and were not sustainable. China has a debt hangover from spending 4 trillion yuan ($650.9 billion) at the height of the global financial crisis in 2008/2009 to boost the economy.

The cabinet also said this month after a meeting chaired by Li that credit had to be used for real business needs.

A ZHU RONGJI REVIVAL?

Beijing's standoff with banks in the interbank market - where banks lend to one another -- began in the first week of June and climaxed last week when rates tore to record highs.

Rates had climbed through June on strong demand for cash during a three-day holiday from June 10, and ahead of the month-end when banks need more funds to meet regulatory requirements.

However, unlike in the past when Chinese authorities often stepped in, they resisted doing so this time.

Not only did the PBoC ignore complaints from traders about its failure to add cash to the market as rates surged, it summoned bankers to a meeting last week where it bluntly told them that plentiful liquidity could not last forever, sources with knowledge of what was discussed said.

The PBoC told bankers that economic problems could not be papered over with monetary expansion, taking aim at outstanding credit which is twice the country's $8.6 trillion economy.

The PBoC relented a bit this week, saying it had given cash to some banks facing temporary shortages and would continue to do so if needed, although overnight rates, at 5.5 percent, are still above average levels.

Analysts said Beijing's unwillingness to cave last week was a way of forcing banks to resolve their own cash crunch by pulling funds from riskier businesses such as an informal loans market, where money is lent for speculation in high-yielding wealth products.

Some said the attitude was a sign Li had no qualms angering others to put China's economy on a more sustainable growth path.

The aggressive Zhu Rongji-style of governance means China may sacrifice growth in the short-term to achieve more balanced expansion, analysts said.

And with Zhu's former lieutenants holding top jobs in China today, including Central Bank Governor Zhou Xiaochuan, hopes for change are high.

"We believe there is likely to be more economic pain down the road," said Zhang Zhiwei, an economist at Nomura.

Growth in the world's second-biggest economy, already suffering from falling exports and sluggish domestic demand, could keep cooling to miss the government's 7.5 percent target this year and hit a 23-year low, he said.

Indeed, China faces its biggest challenge in at last a decade to change the way it does business: depend less on exports and investment for growth and more on consumption.

Policymakers, investors and analysts all agree on what needs to change, but there are few concrete ideas on how to enact reforms, especially if they hurt the interests of state firms.

Some are optimistic.

"While the reform outlook today remains unclear, we believe the current administration seems to have taken a step in the right direction," Zhang said. ($1 = 6.1453 Chinese yuan)

(Editing by Dean Yates)

Source: http://news.yahoo.com/scalpel-hand-chinese-premier-li-stirs-reform-hopes-053316826.html

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