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China and the Dangerous Shoal of Reform

Xi JinpingTwo recent news items out of China have raised expectations that the new leadership in Beijing intends to push ahead with major market-oriented policies.  The first is an announcement that a key Communist Party conclave will gather in November to set out an economic blueprint for the coming decade.  The second is that Jiang Jiemin, the head of the commission overseeing the sprawling array of state-owned companies, has been sacked for corruption.  Since these well-connected firms have stymied key economic reforms in the past, some view the move as an attempt to bring defenders of the status quo to heel in the ramp-up to November’s meeting.

The country is at a significant inflection point, one that the most ardent proponents of the “China rising” narrative (examples herehere and here) failed to see coming.  With the economy decelerating from decades of stratospheric growth, a new assessment by the International Monetary Fund warns that the current investment-driven growth model “is not sustainable and is raising vulnerabilities.  While China still has significant buffers to weather shocks, the margins of safety are diminishing.”  The judgment of Paul Krugman, Nobel economics laureate and New York Times columnist, is blunter:

China is in big trouble. We’re not talking about some minor setback along the way, but something more fundamental. The country’s whole way of doing business, the economic system that has driven three decades of incredible growth, has reached its limits. You could say that the Chinese model is about to hit its Great Wall, and the only question now is just how bad the crash will be.

Minxin Pei, a widely-respected China analyst concurs, arguing that “in the next one to two years, when the full magnitude of China’s macroeconomic risks and structural deficiencies are fully exposed, Beijing will likely face its most lethal economic crisis since the end of the Mao era.”  Other experts warn that the country is about to fall into the same abyss of bad debt and deflation that consumed Japan for two decades, while still others compare it to the United States on the eve of the Lehman Brothers collapse.

It’s a message that top Chinese leaders appear to have taken to heart.  Soon after becoming party chief late last year, Xi Jinping paid symbolic tribute to Deng Xiaoping’s landmark 1992 tour of Guangdong province that re-catalyzed economic reforms which had stalled in the wake of the Tiananmen Square protests three years earlier.  In March, he told a group of party officials that, “We must have the courage like gnawing at a hard bone and wading through a dangerous shoal.”

At the Sunnylands summit three months ago, Xi reportedly told President Obama of his determination to “deepen reforms to promote healthy and sustained economic development.”  And in a speech in July, he emphasized that “China must break the barriers from entrenched interest groups to further free up social productivity and invigorate creativity.  There is no way out if we stay still or head backward.”

New Prime Minister Li Keqiang, who holds a doctorate in economics from Peking University, has been even more vocal.  Last year he sponsored a World Bank report that warned the country’s economic trajectory would be derailed by 2030 if the dominance of clunky and inefficient state-run enterprises in the national economy is allowed to continue.  Highlighting the glaring absence of a vibrant private sector capable of sparking creativity, it bluntly argued that “Innovation is not something that can be achieved through government planning.”

In a press conference this past March, Li talked of unleashing “a self-imposed revolution” that curbed government power and opened up the economy to more market forces.  He pledged to allow private capital “to enter more smoothly and efficiently” in the state-dominated railway, energy and financial sectors.  Such reforms, he acknowledged, “will be very painful and even feel like cutting one’s wrist.”  Li reiterated these themes in remarks delivered two months later to party officials nationwide by teleconference, during which he stressed that “The market is the creator of social wealth and the wellspring of self-sustaining economic development.” Coinciding with these comments, the government released an overview of the policy changes it intends to enact, including consolidation of the state-owned sector and the entry of private capital into sectors previously off-limits.

The new leadership put its new approach into action during the brief liquidity crunch that hit state-owned banks in mid-June when it pointedly refused to allow the central bank to inject more money into the market.  Many interpreted the action as a signal that Beijing is determined to curb the credit binge that in recent years funded massively unproductive infrastructure investments but also raised fears about the stability of the banking system.

Premier Li has also championed the establishment of a free trade zone in Shanghai that is expected to be the test bed for new reforms, including opening up the financial sector, now dominated by massive state-owned institutions, to foreign investors.  At a World Economic Forum conference in China last week, Li highlighted Beijing’s commitment to overhauling the sector.

Still, Xi and Li would not be the first leaders to begin their term on a reformist note only to be frustrated by entrenched interests within the party that are literally profiting (here and here) from the status quo.  Zhu Rongji, the hard-charging prime minister in the 1990s, privatized large parts of the economy but was unable to touch the largest state corporations, which continue to have a chokehold over wide swaths of the economy, from energy, natural resources and heavy industry, to transportation, telecommunications and finance.  Li’s predecessor, Wen Jiabao, repeatedly acknowledged that China’s model of economic development was “unstable, unbalanced, uncoordinated and ultimately unsustainable.”  Yet his numerous reform efforts were thwarted by elements deeply embedded inside the Communist Party and he ended his decade in office this spring by lamenting the “collusion between officialdom and commerce.”

As Xi and Li acknowledge, their own calls for reform are sure to encounter similar resistance – indeed Xi has likened the task before him as “storming a fortification.”  An early sign of what they are up against came with Li’s proposal for the Shanghai trade zone, which reportedly encountered unusually strong opposition even though it was the brainchild of a freshly-installed premier.  The obstruction may account for the lack of detail (here and here) accompanying the zone’s announcement.

The epicenter of the status-quo forces is the most influential families in the party’s power structure, for which control over key state corporations are a goldmine of wealth and privilege.  These so-called “princelings” dominate the upper reaches of the government and economy.  Six of the seven members of the newly-installed Politburo Standing Committee, the top decision-making body, are princelings – including Xi, who is the son of an illustrious revolutionary veteran.   A recent Bloomberg News report found that princelings have amassed sizeable fortunes through their control of state firms.  According to the report, 26 of them ran or held top posts in state-owned enterprises, and that three individuals either headed or still control companies with combined assets amounting to more than a fifth of the country’s annual economic output.  Other media reports (here and here) have detailed the extraordinary wealth accumulated by Wen’s and Xi’s own families, demonstrating that the economic system is so riddled with nepotism that even putative reformers are not without serious taint.

For all of the calls for fundamental change emanating from the top, the power of the vested interests has been evident behind the scenes.  Tellingly, as the economy began to slow down, the Chinese system instinctively reverted to its familiar playbook of profligate capital investments.  Some are heralding the uptick in industrial output over the last month or so as a sign that the economy is stabilizing.  But the rebound is due in large measure to the massive spending directed over the last year at totemic but ultimately unproductive mega-projects.

Moreover, even as Xi and Li were settling into their new positions, the chairman of China’s most profitable state-owned bank, and someone widely viewed as a leading contender for a senior government post, had his career derailed because he put commercial performance ahead of pleasing party chieftains who wanted the credit spigots turned full on in recent years.  According to a central bank official quoted in the Wall Street Journal, the banker should have kept the party’s dictates undermost in his mind.

Similarly, China’s top securities regulator was abruptly reassigned to a provincial governorship after just a year and half on the job.  He reportedly ran afoul of state-run enterprises and banks angered at his efforts to build a robust bond market as well as clamp down on insider trading, poor corporate governance and inflated prices for initial public offerings.  As Reuters observed, the move “casts doubt on the new top leadership’s commitment to politically difficult financial reforms.”

Two recent high-level transactions have raised new suspicions of elite cronyism.  The first is the lightning-fast dissolution of the railways ministry, the country’s last major monopoly, and the sale of its lucrative commercial operations at what some believe is a bargain price to a state-owned entity.  The other is a controversy over the acquisition of several coal mines by a leading state conglomerate.  Critics contend that the purchase was vastly overpriced and defrauded shareholders, and the New York Times reports that:

The disputed deal raises a stark question: Are China’s economy and resources held hostage by privileged state corporations and their executives, who can use influence and gain access to easy credit in ways that undermine long-term growth?

And despite the expectations sparked by the upcoming party meeting on economic policy, state media have been quiet regarding the possibility of major reforms.  Indeed, discussion about how to deal with the problems of state-owned corporations is reportedly off the agenda.

It’s also worth noting that many private entrepreneurs in China continue to say that:

the economic playing field is tilted sharply against them and in favor of the country’s mammoth state-owned enterprises, while the political climate remains treacherous. Although many are undoubtedly still making huge amounts of money, some have begun to complain that they survive only at the whim of a distrustful Communist Party.

Even the high-profile show trial of Bo Xilai, advertised as a strike against the vested interests Xi and Li rail against, is another sign pointing to business continuing as usual.  The charges against Bo, himself a princeling, are far less severe than many expected, illustrating the privileges that attach even to disgraced members of the party’s oligarchy.  And the Wall Street Journal claims that Xi made a deal with Bo’s many supporters among the party elite under which Bo would admit guilt to lesser offenses as long as no further action is taken against his family and allies, or other princelings.  In exchange, Bo’s supporters would line up with Xi as he consolidates his political authority.

A similar story may apply to the corruption investigation of Jiang Jiemin, the now-ousted chief of the state conglomerates commission, along with four of his former colleagues at the China National Petroleum Corporation, the giant state-owned company that is Asia’s biggest oil and gas producer.  On the surface, this appears to be another crackdown on graft and cronyism.  But incoming Chinese leaders have traditionally used corruption probes to take down political rivals, and this move seems aimed at dismantling the patronage network of Zhou Yongkang, the recently retired chief of the vast internal security apparatus.  A former CNPC head, Zhou was a mentor of Bo Xilai, who was expected before his fall to assume Zhou’s security post.  Interestingly, the new security chief has been downgraded in the party hierarchy and does not have a seat on the Politburo Standing Committee.

But the most significant portent that the calls for fundamental economic change will ultimately founder is that they fly in the face of the energetic campaign the Communist Party has unleashed to enforce ideological orthodoxy.  Xi himself foreshadowed this effort during his Guangdong tour last December: Even as he paid homage to Deng’s economic reforms, he was emphasizing to party officials the imperative of ideological discipline and pointing to the collapse of the Soviet Union as a cautionary tale.  Xi has also taken to playing up his Maoist credentials (here and here) and directing huge resources to celebrating the anniversary of Mao’s 120th birthday later this year.

One manifestation of Xi’s campaign is a secret missive the central party office issued in mid-May, warning of the dangers of ideological subversion and banning discussions of such topics as constitutional democracy, rule of law and pro-market “neo-liberalism.”  State media and compulsory study sessions for party members have repeatedly driven this message home.  Private campaigns (here and here) to force government officials into public disclosures of their assets have been quashed, and hundreds of anti-corruption activists and outspoken social-media commentators rounded up (here and here).

Xi runs the real danger of being ensnared in a conundrum of his own making: Attempting to pare back the levers of party control over the economy while reinforcing them in the political sphere.  Whether he manages to negotiate this contradiction will go a long way in resolving the debate between those who contend that China’s global ascent is all but unstoppable and those (like this blog – see herehere and here) who believe America’s underlying power is more durable.

This commentary is cross-posted on Monsters Abroad.  I invite you to connect with me via Facebook and Twitter.



David J. Karl
David J. Karl

David J. Karl is president of the Asia Strategy Initiative, an analysis and advisory firm that has a particular focus on South Asia. He serves on the board of counselors of Young Professionals in Foreign Policy and previously on the Executive Committee of the Southern California chapter of TiE (formerly The Indus Entrepreneurs), the world's largest not-for-profit organization dedicated to promoting entrepreneurship.

David previously served as director of studies at the Pacific Council on International Policy, in charge of the Council’s think tank focused on foreign policy issues of special resonance to the U.S West Coast, and was project director of the Bi-national Task Force on Enhancing India-U.S. Cooperation in the Global Innovation Economy that was jointly organized by the Pacific Council and the Federation of Indian Chambers & Industry. He received his doctorate in international relations at the University of Southern California, writing his dissertation on the India-Pakistan strategic rivalry, and took his masters degree in international relations from the Johns Hopkins University School of Advanced International Studies.

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