The Honourable Kevin Rudd, AC.
President, Asia Society Policy Institute, New York
26th Prime Minister of Australia
Chatham House, London
Conference on China’s Economic Future: Emerging Challenges at Home and Abroad
11 July 2019
To understand where China’s economy is headed in the 18 months ahead, leading up to the centenary of the Communist Party in 2021, it’s important to understand the wider context in which China’s current debates on the future of its political economy have been conducted in the period since Xi Jinping became China’s paramount leader in 2012.
2021 is the first weigh station for the party and the country to evaluate progress in the realisation of Xi Jinping’s “China Dream.” Xi promised back in 2013 that by the centenary of the party’s founding, China will have eliminated poverty and achieved “moderate prosperity”, usually interpreted in the official Chinese literature as middle income status.
Whatever the actual numbers might be, let’s be clear that the party will proclaim that both these tests will be passed with flying colours. That’s because it’s central to Xi Jinping’s legitimacy that China do so. But the truth is that the 2021 target does apply additional pressures in the meantime on China’s economic managers not to allow the country’s growth rate to slow too much, whatever the downside factors may be, either foreign or domestic.
There has been much discussion of why President Trump needs to bed down the US-China trade war, as well as have accommodating monetary policy settings, to support his re-election campaign in 2020 with as robust an American economy as possible. But President Xi also faces his own re-election challenge at the 20th Party Congress in 2022, the year following the party’s centenary celebrations, where despite constitutional change abolishing term limits for the Chinese presidency, he too will face political pressures of his own.
The most important of these pressures will be his government’s ability to sustain economic growth above 6% in order to guarantee continuing increases in living standards and to avoid unemployment. To stumble on the economy, particularly at this most critical of political junctures, would be deeply problematic for Xi Jinping, and, indeed, potentially destabilising.
The Enduring Dilemma of China’s Political Economy
Against this background, my argument is that China is now at a crossroads in the history of its post-78 political economy.
In part this has to do with the US-China trade war, together with the risk of a wider economic decoupling between the two countries, which is bringing new pressures to bear on China’s domestic economic policy debate.
In part, however, and perhaps in larger part, it has to do with the type of China that Xi Jinping wants for the future, how much he is prepared to allow market forces to shape that future at the cost of absolute party control – in particular the future role of private firms.
For China’s post-Mao leadership, the central and continuing dilemma, or what the party would describe as its “dialectic”, has been there since the beginning. This is the tension within a Marxist Leninist party, between a deep predilection for political control on the one hand, and the need for a successful economy which increasingly must yield to the disciplines of a free market on the other.
Indeed for the party to succeed in its national mission, it must achieve two fundamental economic objectives: first, to generate sufficient growth, increased living standards and employment opportunities to entrench the party’s long-term legitimacy in the eyes of its people, and second, through that growth, to enhance China’s national economic capacity to enable the Chinese state to defend its core interests and increase its global power, influence and international standing. Neither of these is possible without a fully functioning market economy. And virtually every single Chinese economist knows it.
The implementation of market economic reforms has, therefore, always been an uncomfortable process for the Chinese Communist Party.
That’s because it has usually meant a relative loss of political control, as the party’s ideological apparatus has had to yield the political ground to a growing phalanx of professional economic and financial technocrats spawned across the various agencies of the Chinese state.
Just as China’s lumbering, Leviathan-like state-owned enterprises have had to yield market share to an army of nimble, entrepreneurial private firms.
And perhaps most critically of all, as the party itself has had to contend with the freer flow of information, ideas and people as China has opened its economy to the world.
Over the first 35 years of the reform process, implementation while uneven, has nonetheless produced spectacular economic results with which the world is now deeply familiar.
It has also, however, produced a number of significant financial and economic vulnerabilities, of which the inefficiency and indebtedness of China’s financial system has perhaps been the most problematic.
Together with a party which, until the rise of Xi Jinping, had become deeply, perhaps terminally, corrupt.
Nonetheless, the trend-line was relatively clear, with an increasingly open economy producing a new generation of private firms at scale, gradually dominating the domestic market, and led by companies like Alibaba, beginning to take on the world.
The Economy Under Xi Jinping
But with Xi Jinping, the political-economy compact between the party and the market began to be re-written. Once again the process has been uneven, but the trend-line has been observably different to what we have seen before. Driven by a range of ideological, political and economic factors arising from China’s stock market crash of 2015, the core organising principle under Xi Jinping has been the reassertion of the centrality of the party.
Over the last seven years since Xi’s emergence as paramount leader in 2012, this process has gone through three, complex and largely unplanned phases.
The first phase from 2012-15 was marked by two core decisions. The first was launching the anti-corruption campaign in 2013. This was the biggest in the party’s 100 year history, and resulted in the incarceration and disciplining of hundreds of thousands of party members, accompanied by the purge of Xi’s principal political opponents.
The other was the party’s adoption of “The Decision” on the implementation of the next phase of China’s economic reform program, defined as China’s “new economic model”, where after ferocious internal debate, the market was for the first time explicitly nominated as the central organising principle for the allocation of resources in the economy.
China’s old model was characterised by labor-intensive, low-wage manufacturing for export, high levels of state investment in national infrastructure, and a significant albeit reduced role for state-owned enterprises, all implemented with scant regard for the environmental consequences.
The new model sought to accelerate the role of domestic consumption as the principal new engine of economic growth, driven almost exclusively by a rapidly expanding private sector, particularly in the services sector, and a more limited role for SOEs restricted to a defined list of critical industries, all tempered by new principles of environmental sustainability
This 2013 “Decision” was accompanied by a detailed blueprint of 66 specific reforms across the entire economy. It was seen as Xi Jinping’s answer to what had generally been called the “ten wasted years of economic reform” under his predecessors Hu Jintao and Wen Jiabao.
The overall political and economic model that seemed to be emerging at the time, therefore, was a party strengthened though the restoration of its moral integrity, but one fully in tandem with a bold program of next generation economic reform.
All this changed with the Chinese financial crisis of 2015, which marks the beginning of the second phase in China’s unfolding political and economic debate in the Xi Jinping period. This was not just a crisis on Chinese equities markets as the authorities struggled with managing a stock market bubble, driven by excessive liquidity and financially illiterate investors who saw investing in shares as the next best thing to the gambling tables in Macao.
It also became a wider financial crisis given the proliferation of margin lending practices as consumers borrowed heavily from financial institutions to make investments in what was seen then as a permanently booming economy.
Both state and private institutions were directed, as part of what become known as the “national team”, to invest heavily to try to stabilise the market, although this resulted in even further losses. Markets were finally re-stabilised at much lower prices early in 2016. But damage had been done – the Shanghai Composite Index collapsed 32% in less than three weeks in July 2015. At its 2015 high, market capitalisation was $10 trillion. By September 2018, it was still only half this high, at $5.73 trillion.
But the more important impact of these events during the second half of 2015 was to enrage the central leadership as millions of citizens lost their savings and blamed the party and the government. As a result, the political appetite for the implementation of further, broad-based market reforms, not just those in finance, was dulled considerably. And a major casualty was the 2013 blueprint as the pace of reform ground to a virtual halt.
Tight capital controls were implemented to prevent capital flight, which also made it more difficult for Chinese firms to expand abroad.
Meanwhile, concern over China’s debt-to-GDP ratio spiked, driven by a largely unregulated shadow banking sector and ballooning local government debt.
The strong regulatory clampdown on shadow lenders that followed, including a large-scale deleveraging campaign, had a suffocating effect on China’s private firms. This was despite the fact that by this time these firms had become the crucial, almost exclusive driver of economic growth.
Conversely, bloated and unproductive SOE’s were given favourable access to credit, easing the impact of the broader deleveraging campaign on them, usually at the expense of the private sector. Indeed, many troubled private firms were either bought up by the state sector, in whole or in part, or else went bust.
The Party’s Policy Response to Slowing Growth
- the Communist Party’s unclear policy signals on how big major private firms should be allowed to grow;
- the increased status of party secretaries within the management of private firms; and
- the ongoing vagaries of China’s legal system, which when paired with the anti-corruption campaign, caused increasing angst among Chinese entrepreneurs for their personal futures.
Re-Embrace the Private Sector
The party’s first policy response has been to politically re-embrace the private sector. This was outlined by Xi Jinping in a major speech in November 2018, when he stated that “private firms are an essential part of our economic system; private firms and private entrepreneurs are of our own.”
Vice Premier Liu He also stressed the need to support the private sector a few weeks earlier in October when he reminded the nation that the private sector was responsible for 90% of new employment growth, 80% of urban development, 70% of technological innovation, and 50% of the country’s taxation.
This rhetorical shift was followed with a number of policy measures to rekindle private sector growth and restore business confidence. Moves were made to channel credit to small private sector borrowers, by reducing the reserves banks are required to hold, along with a directive for large state-owned banks to increase their lending to small private sector borrowers by 30%.
In some cities such as Ningbo in eastern China, regulators also urged banks to expand their definition of collateral to cover a wider range of small businesses’ assets, such as patents and trademarks, beyond typical assets such as real estate, which many lack access to. The State Council echoed these moves recently, calling for IP to be more frequently used as collateral.
According to Chinese regulators, loans to small businesses from China’s largest state-owned banks increased by nearly 17% in the first quarter of 2019. Yet according to other measures, loans to private firms only rose by 6.7%, compared to an overall growth in bank lending of 13.7%.
Meanwhile in fiscal policy, the value added tax for the manufacturing, agricultural, transport, construction, leasing, wholesale, retail and real estate sectors was reduced. Beijing also reversed the implementation of social security reforms, easing the financial burden on private sector firms. Income tax was also reduced, by increasing the personal tax threshold from 3,500 Yuan to 5,000 Yuan per year.
Accelerate Financial Sector Reform
A second line of policy response has been to embrace financial sector reform by liberalising interest rates, changing the exchange rate setting mechanisms, and increasing foreign participation in China’s financial services sector.
In March of this year, PBOC Governor Yi Gang committed to the structural reform of interest rates, rather than further rate cuts, to support a slowing economy. Details were thin, yet his stated desire to increase competition in the banking sector and enforce price transparency was aimed at improving credit access to small and medium private firms by effectively lowering lending rates.
In May, the PBOC also issued plans to reform its exchange rate formation mechanism. Last month, Yi Gang appeared more open to having the renminbi fall below a rate of seven against the U.S. dollar amidst downwards pressure on the renminbi. The stated policy objective here has been to make the currency more responsive to market disciplines rather than a simple administrative peg.
The most significant recent measures adopted by the Chinese authorities, however, has been to allow greater foreign participation in China’s $45 trillion financial services sector.
In April 2018, timelines for allowing majority foreign ownership in Chinese securities companies and mutual funds were announced, along with similar policies for foreign insurance firms.
Foreign ownership limits on banks were removed in August 2018.
Foreign credit rating agencies were given full market access in January 2019, when S&P Global became the first wholly-owned foreign credit rating agency to operate in China.
Foreigners have also been given greater access to Chinese equities markets. In February 2019, MSCI announced plans to increase the proportion of mainland Chinese shares in their emerging markets index by a factor of four, to a weighting of 3.3%. And amidst great fanfare this past June, the London-Shanghai Stock Connect scheme was launched, giving foreign investors the opportunity to purchase shares in Chinese companies, and likewise providing Chinese investors the chance to buy LSE-listed stock.
The Bloomberg Barclays Global Aggregate index also began introducing 364 Chinese fixed income securities this April.
Superficially, this forms an impressive list of reforms. However, we need to be cautious about these announcements until we see how China’s regulatory machinery adapts to these changes.
For example, conversations we’ve had with funds managers are replete with stories of overwhelming bureaucratic red tape. Another example is J.P. Morgan’s ambitions to be the first foreign firm to have majority ownership of an asset management business. Recent reports revealed their bid for a controlling stake in their existing joint venture is at a 33 per cent premium to an independent valuation. Yet this was the minimum bid price permitted by Chinese authorities. And while the sale is not guaranteed to them, it serves as a further reminder that policy announcements need to be weighed with the ability of foreign firms to capitalise on them.
China is not acting philanthropically with any of these changes. Chinese policy makers are driven by a number of clear policy objectives.
First, to make the Chinese financial system more efficient in the allocation of credit where the current system is at best 50% as effective in wealth creation against international benchmarks.
Second, to spread the risks currently alive within the Chinese financial system where bad loans are still rife. For example, the recent, high-profile public takeover of the privately held Baoshang bank highlighted ongoing risks that China’s financial sector faces because of uncontrolled lending. Furthermore, Baoshang doesn’t appear to be an isolated case with a number of other small and medium banks rumoured to be being recapitalised in a quieter fashion. Other areas of risk in China’s financial system include the shadow banking sector’s surging reliance on short-term interbank lending.
A third policy objective underpinning China’s financial reform efforts is the country’s declining current account surplus, with some analysts predicting an imminent current account deficit. For around 25 years, China has consistently operated a current account surplus. However more recently, this surplus has been declining. Fuelling this is rising domestic consumption which is beginning to reverse a tradition of high savings rates amongst the Chinese population. Further erosion of Chinese savings is also expected as their ageing population draws on retirement reserves. Whether China actually soon reports a current account deficit is largely dependent on market prices of imported commodities. With a narrowing current account comes the incentive to attract foreign capital to plug the gap, and therefore an even stronger argument for reformers for continued financial opening.
A Political Recommitment to Systemic Economic Reform
Beyond specific policy support for China’s struggling private sector, as well as a fresh commitment to financial market liberalisation, has come a broader policy response to a slowing economy – namely the re-embrace of “institutional” economic reform.
This was explicitly announced by Xi Jinping himself at a Politburo meeting in April 2019. Importantly this was the very same meeting that rejected the text of the then draft trade agreement with the United States. This was the first time in many years that this language of systemic economic reform has been used by the country’s most senior leadership.
It was reinforced in June by Vice Premier Liu He when he candidly admitted that while Chinas faced “some external pressures”, this would “help us improve innovation and self-development, speed up reform and opening up, and push forward with high quality growth.” Liu also noted that these pressures were spurring the creation of stronger domestic capital markets, and more innovative industrial supply chains, which were welcome trends in China’s transition “from being big to being strong.”
The political message from both Xi Jinping and Liu He was clear: adverse external events were now driving China in the direction of more vigorous internal market reforms. Once again, however, we must await the evidence that the systemic reform program first announced in 2013 is in reality back on the agenda. Or not.
Universalising Trade, Investment and Intellectual Property Reforms
A fourth line of policy response to the slowing of the Chinese economy has been to universalise trade, investment and other economic reforms being offered to the Americans bilaterally in the context of their ongoing trade negotiations.
This was on display most recently with President Xi Jinping at the G20 summit where he announced a range of reforms, including an updated negative list that permits foreign investment into the mining, manufacturing, services and agriculture sectors.
He also announced plans to implement penalties for intellectual property infringement as part of a new foreign investment law in 2020. Details of some of these plans were subsequently fleshed out by Premier Li Keqiang in July at the World Economic Forum in Dalian.
These general commitments to reform have been met with cautious optimism by the international business community having heard similar announcements by China’s leaders before. There has long been skepticism that whatever China announces as a new commitment at the policy level, can easily be undone at the level of administrative practice. Or as the Chinese say of their own system “above there are policies; while below there are counter-policies.”
A Return to Good Old Stimulus
Of course, the final response to slowing growth has been the re-embrace of economic stimulus. As noted above, this has included cuts in the value added tax, cuts to personal income taxes, but also targeted consumption stimulus packages towards electronics, communications, automobiles and construction. There has also been fresh infrastructure investment, particularly in urban rail projects.
China’s leadership has consistently voiced confidence in China’s ability to handle the economic impact of the trade war. Central bank governor Yi Gang said ahead of the G20 that, in his view, “the room for adjustment is tremendous” in China’s fiscal and monetary policy toolkit, with “plenty of room in interest rates and in required reserve ratios.”
Officially, the message therefore is that the Chinese economy remains healthy and there is no major risk to growth for the time being. Or as Liu He put it: “no matter what happens temporarily, China’s long-term growth remains positive, which won’t change.”
All that is code language that China will do what it takes to keep growth above 6%. Including making up for the hit to growth that would come from a prolonged trade war. And if that means adding further to China’s budget deficit or debt to GDP ratios, so be it. China continues to take great confidence in the fact that practically all its debt is domestically denominated and that with a still relatively high domestic savings ratio, there is considerable flexibility at its disposal.
The problem remains, however, despite the political assurances to the contrary over the last six months, that stimulus continues to become the continuing, easy alternative to substantive economic reform. In the end, such a course could prove lethal to China’s long-term economic trajectory.
The Trade War, Technology War and Wider Economic Decoupling
China’s long-standing difficulties with private sector business confidence have been compounded by uncertainties arising from the trade war, the unfolding technology war and the growing debate in both countries about a wider decoupling of the US and Chinese economies. I dealt with these factors in some detail last month in an address to the Lowy Institute in Sydney.
It has long been my view that there will be a trade deal of some kind between the countries before the end of 2019. The reason is that both countries need a deal to stabilise their markets and economies going into the politically critical seasons that lie ahead – a presidential election year in the US, and the lead up to the party centenary in China. There will be much debate about the intrinsic economic quality of the deal. But there will nonetheless be a deal which both sides can politically live with.
But the end of the trade war is highly unlikely to bring about an end to the technology war. Despite President Trump’s ambiguous language in Osaka, it appears that Huawei will now remain listed. The US has also now listed five other entities. China has also announced a retaliatory list for “hostile” foreign firms, although it has yet to nominate individual companies yet.
And beyond the trade and technology war, there is a growing expectation in Beijing that the US is preparing for a much broader decoupling of the two economies. The next domain to be affected, at least in China’s calculation, is the digital payments system, digital finance and e-commerce which China increasingly dominates through Alipay, WeChat Pay and UnionPay.
There is a concern that the US will then move on the finance sector in general, where the US institutions remain globally dominant, drawing on the formidable advantage afforded to the US government through the continuing reserve currency status of the dollar. China has observed closely what it sees as the weaponisation of the dollar and the international financial system more broadly against various strategic adversaries of the United States. Beijing anticipates the US may be considering to do the same to China.
Finally, there is the unfolding impact of both the reality and perception of decoupling on global supply chains as Chinese, American and international firms seek to insulate themselves from a combination of tariffs, technology bans and even the longer term possibility of financial sanctions. Companies that are part of global supply chains in sensitive industry sectors that are currently operating in China, whether they are Chinese or foreign owned, have begun to offshore manufacturing facilities as a precautionary measure. Even if both the current trade and technology wars are resolved, it is unlikely that these decisions will be undone. The continuing geo-political risk will still be significant in the eyes of corporate decision-makers.
In summary, quite apart from the long-term consequences for the global economy of these uncertain decoupling scenarios, the bottom line for the here and now is that all these factors, real or imagined, are further impacting business coincidence in China, and represent yet another contributing element to China’s increasingly complex, near-term growth challenge.
So Are China’s Current Policy Responses Working?
The economic data in response to the Chinese government’s policy actions in response to a slowing economy has so far been mixed.
First quarter 2019 Chinese economic growth was officially at 6.4%, stabilising sliding economic growth from previous quarters, although independent analysts estimate growth to be closer to 6%.
A significant portion of this growth is believed to be fuelled on recent economic stimulus, and remains dependent on this.
The most recent figures from May show industrial activity weaker than expected, and fixed asset investment slowing slightly, although retail sales reportedly increased to 2.1% in May following a 0.6% decline in April. The official unemployment figure remains steady at 3.8% in recent months.
It’s concerning that almost half of Chinese exporters see the trade war as a permanent or long-term fixture of bilateral relations, according to a recent survey. This sentiment, and their perception of its business impact have steadily deteriorated over the past few months.
Conversations with business owners in second and third tier cities also continue to reflect anxiety and uncertainty over the private sector business environment. Private entrepreneurs still don’t trust Beijing. And many are still sitting on their hands, not taking new investment decisions.
And all this is before the full wash-through effect of any future collapse of business confidence in the event of a non-resolution of the trade war.
China’s Strategic Economic Choices for the Future
China’s political economy therefore finds itself at a policy crossroads.
Between the competing demands of party control and the market.
Between the competing demands of sustainable economic reform and continuing recourse to stimulus.
Between an economy which over the last 40 years has integrated itself with global supply chains, technology markets and finance, and a country which now which fears it may progressively be cut off from all three if decoupling becomes a reality.
The question then becomes one of what strategic response is China under Xi Jinping now likely to adopt.
One possibility is that China, in response to its internal pressures on growth, as well as the external pressures on trade, technology and finance, accelerates the liberalisation of the Chinese domestic economy as per the 2013 blueprint.
As part of this approach, China could also embark on an ambitious program of international trade, investment and capital market liberalisation. This could take many forms.
In Asia, China could use the Regional Comprehensive Economic Partnership (RCEP) which includes sixteen Asia Pacific economies to advance regional economic integration if that agreement is signed in 2020. China is also debating internally the desirability of seeking membership of the Trans Pacific Partnership, now known as the CPTPP, a far more ambitious free trade agreement than RCEP involving eleven regional economies, from which the United Sates has withdrawn. Meanwhile in North East Asia, China is seeking to accelerate the negotiation of a North East Asian Free Trade Agreement with Japan and South Korea.
In Europe, the EU-China Investment Agreement is likely to come into force in 2020 which China could use to turbocharge its wider economic engagement with the 28 – soon to be 27, member states. China sees Europe as an important strategic economic partner in the future. This is not just because of the size and technological sophistication of much of the European economy. It’s also because China sees Europe as being much less energised by the security concerns of the US and its allies in Asia.
On technology in particular, China will also seek to advance its engagement with Japan, Germany and Israel where it has already sought to become a significant investor.
Globally, China may also seek to become a substantive champion of the WTO and the global free trading system it underpins, particularly given the systematic assault on the WTO by the United States.
There is, however, a second script available to Xi Jinping’s China. And that is for the country to increasingly turn inwards towards even greater party control, economic self-reliance and more mercantilist practices abroad.
If Chinese leaders conclude that a strategy of systematic economic decoupling has been embraced by the United States, and is indeed underway, then China may indeed adopt a more radically conservative response to its circumstances.
The party may double down domestically against what it may increasingly fear as hostile forces operating within.
China may seek to accelerate the expansion of domestic demand in the hope that domestic consumption can offset some of the impact of a much more adversarial international economic environment.
And rather than open its markets more to the world, or even the non-American world, it may seek instead to expand its selective economic engagement with friendlier BRI states where Chinese goods, services and technology standards are more welcome.
A third and more likely response from China would be an untidy combination of both of the approaches outlined above.
Given China’s uncertainty on the precise contours of future American strategy on trade, investment, finance, tech and broader decoupling, be it under Trump or any replacement Democrat administration, as well as the additional uncertainty of whether US friends and allies will cooperate with an American strategy of this type, China may well proceed cautiously until the strategic landscape is clearer.
China is now in a formal process of deep strategic review internally on the extent to which its external circumstances have changed and what China should do in response.
Xi Jinping’s recent reported remarks are nonetheless telling when he said in an internal speech that China now needs to expect another “30 years of containment and provocation form the United States” through until 2049.
The bottom line for all of us that the global strategic and economic landscape is now in a period of fundamental change.
And the open question for us all is how the Chinese political economy will now respond to its own domestic growth challenges, and both the reality and perception of economic decoupling from the United States.
As a McKinsey report warned us recently, not only has the world changed China over the last 40 years, China, through the sheer size of its economy, its impact on global consumer prices and the significance of its markets, has also changed the world.
Therefore how China now responds to these dual yet mutually reinforcing challenges will profoundly affect us all.
Global geo-political risk is now back with a vengeance. And we should all fasten our seatbelts for a rocky road ahead.