China's future: Part one The Great rebalancing
In October, the Great Hall of the People on Tiananmen Square will host the National Congress of the Communist Party, a meeting held every five years to reshuffle the higher-ups in the Chinese government. The lavishly-appointed building will host thousands of delegates from across the country, mostly middle-aged men whose ideological conformity is symbolised by their dress: unfussy suits, plain ties and identical black hair dye.
For all the pomp, the Congress is a glorified rubber-stamping exercise. The real political work takes place in the months leading up to the event, at Zhongnanhai, a secluded compound located a few hundred yards north of the Great Hall. Here, in government buildings set amid tranquil gardens, President Xi Jinping has been honing his team in preparation for his second five-year term, promoting allies and casting rivals into political oblivion.
After the Congress is finished and Xi’s decisions are given the imprimatur of the top party committees, the president will emerge with more power than any Chinese leader since Chairman Mao. But will he take advantage of his strengthened position to push for reform, or continue to tighten the government’s grip on the economy?
“The political transition will give Xi Jinping more power to do what he wants to do; the question is what he wants to do,” says Jonathan Anderson, principal at Emerging Advisors Group, a consultancy. “There’s a debate over whether Xi is at heart a ‘go-for-growth’ guy or a reformer. He’s delivered the usual liberal reform mantra, but he is also very much about strengthening the stability of the state.”
Xi’s political career may hold clues as to his priorities. Like Vladimir Putin in Russia, Xi’s ascent from unremarkable bureaucrat to powerful strongman took many by surprise. Although he was born into communist royalty – he is the son of Xi Zhongxun, vice-premier in Mao’s government – he had to work his way up through provincial Party structures after his father was imprisoned as a reactionary during the upheaval of the Cultural Revolution in the 1960s.
Xi Zhongxun was rehabilitated under Deng Xiaoping in the 1980s and became governor of Guangdong, where China was undertaking its first free-market experiments. Meanwhile, Xi Jinping climbed the political ladder to become Party chief of the affluent province of Zhejiang in the 2000s, where he promoted private business and supported the rise of Geely, the car company that later bought Volvo.1
After he became president in 2013, Xi initially presented himself as a Deng-style reformer. That year, the Third Party Plenum – a meeting of the Communist Party’s Central Committee – laid out an ambitious reform agenda dubbed ‘Reform 2.0’ in the state media, a deliberate allusion to China’s original round of market reforms in the 1980s.
The official title of the policy document that came out of the meeting was more long-winded: ‘Decision on Major Issues Concerning Comprehensively Deepening Reforms.’ It pledged to allow market forces to play a ‘decisive role’ in the economy and to encourage the development of non-public sectors. The intention was clear: to rebalance the economy away from state-led, debt-fuelled investment towards a more consumer-driven growth model.2
However, this reform programme took a back seat over the next few years as Xi set about centralising political power – mainly through a massive anti-corruption drive – and prioritising vigorous, state-led growth. He signalled his intention to fulfil his predecessor Hu Jintao’s pledge to double the size of the economy between 2010 and 2020, unleashing massive fiscal stimulus packages whenever growth looked set to slip below its target of 6-7 per cent.
The question now is whether Xi will belatedly attend to the Third Plenum reform agenda once the Autumn conference is concluded and his political hand is strengthened. “I think we can all agree that Xi will emerge from the Party Congress with more political capital,” says Evan Medeiros, Asia director at Eurasia Group and former special assistant to President Obama at the White House’s National Security Council (NSC).
“Top of Xi’s agenda is economic management. And I use the term ‘management’ very deliberately. It doesn’t mean a complete embrace of the Third Plenum programme. It will basically be a mix of embracing supply-side structural reforms while also using the state, especially when it comes to industrial policy,” Medeiros adds.
After the Congress is finished, the president will emerge with more power than any since Chinese leader Chairman Mao
Tackling the debt mountain
Whether Xi is willing and able to push ahead with reform will become clearer as his revamped administration addresses the key issues facing the Chinese economy over the next five years. Beijing will need to tackle an enormous debt mountain, reform sluggish state-owned enterprises and spur consumer demand if it is to successfully rebalance the economy.
China’s debt-fuelled growth model is looking increasingly fragile. The country’s overall debt has risen by 130 percentage points of GDP since the global financial crisis, much faster than in other large economies. In its latest Global Financial Stability Report, published in April, the International Monetary Fund (IMF) drew parallels with the conditions that caused the crises in Japan in the late 1980s and the US in 2007-’09. In May, Moody’s Investors Service hit China with its first sovereign debt downgrade since 1989 by knocking the country’s long-term local currency and foreign currency issuer ratings to A1 from Aa3.3
If China is to curtail the flow of new credit and reduce the debt load, it is likely that Xi will have to sacrifice his growth targets. Yanmei Xie, China policy analyst at Gavekal Economics, a consultancy, believes the government may indeed refocus on deleveraging and allow growth to slow once the Autumn conference is concluded.
“It is quite possible the government will be willing to see GDP growth slow to attend to its supply-side restructuring, including deleveraging, reducing excess capacity, and cutting inventory, as well as managing and controlling financial risks,” she says. “There has been ample evidence that the latter has become a top priority for Xi.”
In fact there are signs the credit cycle has already begun to turn. One of the few market reforms Xi’s government has enacted thus far has been to partially liberalise the financial sector, with a view to extending credit to more businesses and boosting overall growth. But this also led to a rise in shadow lending, as banks and other financial institutions started marketing so-called wealth-management products to shift loans off their balance sheets and circumvent rules over credit ratios and capital-adequacy requirements.
Initially relaxed about this activity, Beijing is now taking steps to crack down on it. In its quarterly monetary-policy report published in February, the People’s Bank of China (PBC) drew attention to the risks associated with banks’ shadow-lending activity and introduced new rules on the sale of wealth-management products linked to illiquid assets. The PBC has also been raising interbank rates since January to stem the flow of credit: the benchmark overnight repo rate in Shanghai has risen from 2.2 per cent at the beginning of January to 2.9 per cent as of August 25.
These measures appear to be taking effect. Approximately RMB 1.1 trillion flowed out of commercial-bank investments with mutual funds and brokerages between April and July, according to PRC Macro, a consultancy. Meanwhile, the ‘credit impulse’ – a measure of broad credit growth – is estimated to have fallen by an amount equivalent to 17.5 per cent of GDP over the first quarter of 2017. A drop of this magnitude has only previously been recorded in 1994, 2004-’05 and 2010.4
The PBC will aim to strike a delicate balancing act to ensure the growth slowdown is gradual, and it is likely to continue to extend credit to commercial banks through its Medium-term Lending Facility while putting pressure on financial institutions to rein in shadow banking. This is a necessary process, even if some asset classes are likely to suffer in the short term as the credit cycle turns, according to Will Ballard, Head of Emerging Market Equities at Aviva Investors.
“Over the long run, deleveraging is vital. By cutting its massive debt load, China will make its economy safer and more resilient, and remove the Sword of Damocles from above investors’ heads. But there will be some negative consequences. Chinese equities are likely to suffer as cheap credit becomes more difficult to come by, and bond yields will probably rise as interbank rates are pushed higher,” he says.
After the Congress is finished, the president will emerge with more power than any since Chinese leader Chairman Mao
Although Xi may be willing to let growth slow while China attends to its debt burden, this is not necessarily a sign he is ready to use his power to enact deeper economic reforms. Indeed, some argue Beijing’s crackdown on the financial industry is actually more about reasserting government control over private institutions that had grown too big and too greedy – and threatened to form alternative power bases.
If the government is serious about cutting the debt burden, it will have to start putting more pressure on state-owned enterprises. Xi has promised to do this. Speaking at the National Work Conference in July, a meeting of China’s top financial regulators convened every five years, the president said “deleveraging at SOEs is of the utmost importance”. He urged regulators to “get a grip” on “zombie” companies fuelled by cheap credit.5
Xi’s administration recognises the continued preponderance of unwieldy and uncompetitive SOEs is hampering the transfer of capital and resources to more productive sectors and ultimately undermining economic stability. Under Xi and his predecessors, China’s investment-led growth has been channelled through an opaque tangle of SOEs; not just lumbering Mao-era conglomerates but newer local-government entities established to finance infrastructure projects, of which there are tens of thousands.
“These entities were only created two or three years ago in many cases, but many of them have disastrously bad balance sheets and are involved in white-elephant projects,” says Anderson. “Reversing course would mean identifying where the problems are, shutting down these quasi-corporate structures and transferring the bad debts to local governments to pay for the residual cost.”
If the government is serious about cutting the debt burden, it will have to start putting more pressure on state-owned enterprises. Xi has promised to do this. Speaking at the National Work Conference in July, a meeting of China’s top financial regulators convened every five years, the president said “deleveraging at SOEs is of the utmost importance”. He urged regulators to “get a grip” on “zombie” companies fuelled by cheap credit.Xi’s administration has already taken steps to privatise state-owned enterprises in non-strategic industries. In 2015, the government began reclassifying SOEs as ‘for profit’ or ‘welfare or public service’ firms; the idea was that the more commercially-oriented enterprises could be restructured, sell stakes and start hiring from the private sector.
Earlier this year, the government sold 50 per cent of Chinese medicine-manufacturer Yunnan Baiyao to a private investor, in a deal that has been hailed in the state media as proof positive it is making headway in pushing so-called ‘mixed-ownership’ of SOEs.6 This follows the partial privatisation of state-controlled oil company Sinopec Corp., which sold a $17.5 billion stake in its low-margin retail business in 2014. The company issued new shares to a group of investors including Harvest Fund Management Co., one of China’s largest asset managers, and technology giant Tencent Holdings.7
Nevertheless, the reclassification process has been fitful and many of the changes implemented during the latest round of SOE reform have actually expanded the role of the state. For example, the regulator has promoted the creation of ‘national champions’ through mega-mergers; joining railway companies, shipbuilders and energy firms into massive conglomerates. This is partly so they can project China’s influence abroad via the Belt and Road programme (see China’s future: part two). Consolidating state entities also makes it easier to track and control them. As an old Chinese management slogan put it: yi zhang zhi – or ‘I only want to see one head’.8
Spurring consumer demand
This is not ‘reform’ in the commonly-understood sense of market-led change. But if you take reform more broadly to mean an economic rebalancing away from inefficient debt-fuelled growth towards a more stable, consumer-led model, Xi’s increasing power over SOEs may offer a way forward.
One aspect of SOE reform that has seen significant change under the current administration is the creation of ‘state-capital investment corporations’, which are extending the government’s reach into new industries such as biotechnology and IT. While there is a risk these corporations will crowd out private companies, they may also be able to direct government investment more efficiently, clear away bottlenecks to private capital and unlock new sources of consumer demand, which will be crucial if China is to rebalance its economy.
“China needs to start making higher-return investments—and such investments will be those that successfully anticipate or create demand from the growing middle and upper classes,” according to Andrew Batson, China research director at Gavekal, who points to healthcare, education and logistics as areas the government should focus on.9
Contrary to the received wisdom, consumer spending is not artificially repressed in China; it has been growing rapidly for the past two decades, albeit from a low base (see figure 2). In order for China’s economy to rebalance, it needs to transfer wealth from the government sector to households to amplify the economic impact of improved consumer spending. And Xi’s centralised model may actually be conducive to pushing through such transfers, says Michael Pettis, professor of finance at Peking University in Beijing.
“There are still people out there who say China has got the highest savings rate in the world because Chinese people save lots of money. It’s nonsense: China has the highest savings rate in the world because it has the lowest household income share of GDP in the world. China has to raise the household income share – and the only way to do that is to transfer wealth from the government sector. The problem is a political one.”
This offers one way of looking at Xi’s massive centralisation of power over the last five years, aided by an anti-corruption campaign that has seen thousands of provincial officials – many of them senior figures, or ‘tigers’ – thrown into prison. Until now, China’s growth model has been based on channelling resources through local-government infrastructure investment, which enabled corruption and enriched local elites. If China is to effect an economic rebalancing towards consumer-led growth, it will need strong leadership to tackle these vested interests and redistribute wealth to households. After the National Congress enshrines his position as China’s ‘core leader’, Xi will be well-placed to deliver such redistribution and advance the agenda of the Third Plenum.
“Back in 2009, before Xi became president, I wrote down what would be the optimal process for economic rebalancing and adjustment in China, and item number one on the list was that the next president would have to centralise power dramatically,” says Pettis. “The historical precedents are very clear; in cases where these kinds of reforms were successfully implemented it was always either in democracies or highly-centralised autocracies, not those in-between. It seems to me Beijing understands it has to centralise power in order to implement reform.”
There is, of course, another perspective on Xi’s centralisation of power: he is simply entrenching his own position in an attempt to cling on as president after 2022. “Xi wants to create favourable conditions so he can extend his term,” says Minxin Pei, professor of government and director of the Keck Center for International and Strategic Studies at Claremont McKenna College in California. “He wants to prevent the appointment of a successor and to gain more control over the Politburo Standing Committee. A third term is almost a foregone conclusion.”
For Xi to stay on as president he would need to change the state constitution, which would be politically difficult. There is, however, no limit on terms for General Secretary of the Communist Party. It is possible Xi may remain as the Party’s ‘core leader’ even after he steps down as president, pulling strings from behind the scenes as Deng – who was never officially China’s head of state – did to great effect.
Whether Xi will use his power to push through the economic rebalancing process over the next five years, or merely to further his own political interests, remains to be seen. Both Pettis and Medeiros believe that, for at least the next five years, China will continue promoting the consumer economy while bolstering the political strength of the centralised Party state. This may be enough to correct China’s economic imbalances in the short term, but the longer-term outlook for the Chinese system is less certain.
China will not become a fully modern economy until it is able to unleash the private sector and encourage entrepreneurial innovation, which would require a loosening of Party control and an enforceable rule of law. While China has a robust private sector it remains subject to political fiat – witness the regulatory crackdown on Anbang Insurance, whose powerful and outspoken chairman Wu Xiaohui has reportedly been detained by the anti-corruption squads.10
Pei believes the case may suggest how Xi’s government will rein in other private companies, such as China’s technology giants Baidu, Alibaba and Tencent (the so-called BATs), as they become bigger and more powerful. “Anbang is tied to Deng Xiaoping’s family. So Xi has accomplished several objectives with one move. It was politically-motivated. With the BATs we are likely to see variations on the same theme; they may be asked to bail out state-owned companies or become minority shareholders in these large state companies,” says Pei.
Under this authoritarian regime, it seems likely that deeper market and political reforms will be limited, and the government will retain control over the renminbi exchange rate and capital outflows. This will deter foreign companies, which are already growing frustrated at protectionist measures that compel them to transfer technology to Chinese counterparts in return for market access.
“Rolling back the emphasis on state-led champions, liberalising the market, allowing foreign participants to compete on an equal footing; these things would help a lot – but I’m not sure that’s where we’re going,” says Anderson. “If you look at what’s happening in China now, it’s all about sidelining the role of foreign ideas, of foreign money, and r e-emphasising the primacy of state-owned capital in the system. Market liberalisation is one part of the reform agenda that is not going to get done in the second half of Xi Jinping’s term.”
Pei believes the contradictions in the Chinese system between the state and a vibrant private sector will result in a political reckoning within the next decade, with economic stagnation convincing the government, business and the public of the need for deeper reform.
For now, however, the fate of China rests largely with Xi Jinping and his inner circle. Xi wields immense power, and whether he uses it to drive reform or to cement his own position, the implications will be felt far beyond China’s borders. When the president takes to the podium to address the gathered cadres at the Great Hall of the People, the eyes of China, and the world, will be on him.
- See ‘Born Red,’ The New Yorker, April 2015
- See ‘The party’s new blueprint,’ The Economist, November 2013
- ‘Moody’s downgrades China’s rating from A1 from Aa3 and changes outlook from stable to negative,’ Moody’s Investors Service, May 2017
- ‘China’s credit squeeze sends warning on global growth,’ Financial Times, July 2017
- ‘China’s Xi orders debt crackdown for state-owned groups,’ Financial Times, July 2017
- ‘Reform of China’s ailing state-owned firms is emboldening them,’ The Economist, July 2017
- ‘Sinopec to sell $17.5 billion retail stake in privatization push,’ Reuters, September 2014
- ‘Big is beautiful? State-owned enterprise mergers under Xi Jinping,’ European Council On Foreign Relations, November 2016
- Don’t wait for consumption-led growth, Gavekal Dragonomics, September 2013.
- ‘Wu Xiaohui: China “detains” Anbang Insurance
The implications for investors
Over the next five years, China looks set to promote the consumer economy and cut the debt load, while bolstering the political strength of the centralised Party state. Growth is likely to decline – if not dramatically – because even if consumer spending increases it will not be able to compensate for the drop in overheated, debt-fuelled infrastructure spending that hitherto drove GDP expansion.
This development will have implications for countries far beyond China. The country was becoming ever more closely entwined with the global financial system before the introduction of the ‘Bond Connect’ scheme in June, which grants overseas investors more access to onshore credit markets, and the incorporation of Chinese A-shares into the benchmark MSCI Emerging Markets Index, which will take effect in 2018.
In its Global Financial Stability Report, the IMF warned: “It is likely China’s spill overs to global financial markets will increase considerably in the next few years”.
So how will other markets be affected? With less debt-fuelled growth among state-owned enterprises, demand for commodities seems likely to fall, and this could affect export-oriented emerging markets in Asia and Latin America.
“Recent history indicates how this may play out,” says Will Ballard, Head of Emerging Market Equities at Aviva Investors. “Many commentators attributed Brazil’s economic travails in 2015 and 2016 to the corruption scandal engulfing former president Dilma Rousseff, which eventually resulted in her impeachment. But the impact of a decline in Chinese demand for raw materials following its economic slowdown in 2015 was arguably more important. It is no surprise Brazil started to emerge from its slump when demand in China – its biggest trading partner – began to rise again towards the end of last year.”
That resurgence also coincided with a recovery in global inflation. Indeed, the return of Chinese demand was arguably more of a factor in propelling a global rebound in commodity prices and inflation than the commonly-cited cause: the election of Donald Trump as US president, which investors hoped would bring less regulation and more fiscal stimulus. This shows China’s credit cycle is of relevance to developed-market investors too.
For the moment, commodities markets are holding up – give or take some softening in iron-ore prices since the beginning of the year. Nonetheless, emerging-market investors should keep a close eye on signs of weakening demand as the government’s deleveraging project proceeds. “These signs will not necessarily be evident in debt and quarterly growth figures, but in less-obvious metrics. Freight movement and electricity-generation patterns, for example, tend to be reliable indicators of industrial activity in China’s rustbelt,” Ballard adds.
Within China, the economic rebalancing process is likely to restrict the flow of credit to businesses that previously enjoyed easy access to financing, particularly those involved in infrastructure construction projects, although the Belt and Road programme (see China’s future: part two) is likely to spur demand for commodities among other Asian countries.
If China succeeds in using its new state capital investment corporations to spur consumer demand, consumer-facing industries such as healthcare, education and logistics – sectors that have obvious bottlenecks that targeted investment could help clear away – could benefit, according to Gavekal.9