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Can Xi Jinping Turn China’s Economy Around?

A ChinaFile Conversation

On Monday, the Shanghai Composite Index fell 8.5 percent, erasing all of the gains it had made in an extraordinary run-up this year. The drop was the second 8.5 percent drop in recent weeks. The first such drop (the occasion for the Conversation below) came on the heels of major government intervention to stem the market slide that began in late June. What happened? What does the latest chapter of the crash mean for China’s economy? And, more broadly, what does it mean for the policies and politics of China’s current leaders? —The Editors [Updated Aug 24, 2015]

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People are starting to question whether the bottom is about to fall out from under China’s growth in the short term, and whether Xi Jinping’s government is really committed to the market-oriented reforms that will create sustainable growth in the long run.

It’s clear that China has just experienced a leverage-driven bubble disconnected from the realities of economic activity and corporate earnings, and that the government has severely damaged its credibility first by encouraging retail investors to join the party and then by its mind-boggling interventions to stem the rout. Yet it is also clear that forecasts of contagion from the bear market in stocks to the real economy via a negative wealth effect among individual investors are wide of the mark. Only about 7% of China’s population is active in the stock market and household balance sheets are dominated by property, bank deposits and wealth management products (most of which are effectively fixed-income instruments). Equity losses will pinch household wealth, but not undermine it.

Other potential economic knock-on effects are comparably modest. Equity financing is a minor funding contributor to corporations, who rely mainly on retained earnings and bank loans. Contagion to the financial system would be a worry if brokers started going bust as a result of reckless margin lending, but this is not happening. Given the continued vitality of trading activity, value added in financial services—which boosted GDP a bit during the bull run—does not look to drop that much.

The stock market fall in itself will not drag the economy down. But the popping of the bubble has forced investors to pay attention to a fact that some were happy to ignore while stock prices rose: China’s short-term economic growth outlook is mediocre at best, and another year or two of deceleration is all but unavoidable.

The really vexing question is whether the government has the intention and the political clout to get the economy back on a sustainable track. Beijing can probably keep the economy growing by at least 6% through next year, but the quality of that growth is poor, depending as it does on rising leverage and state-driven infrastructure spending. Private investment—the key to sustained productivity-driven growth—continues to decelerate. This is both because of the end of China’s long housing boom and of the financial repression that made infrastructure investment artificially cheap; and because the government has been slow to implement its promise to deregulate and open up more sectors of the economy to entrepreneurial private firms.

At several crucial points since it began economic reforms in the late 1970s, the Communist Party has tactically surrendered direct instruments of control (prices, production and supply quotas, state assets) in order to enable more vibrant growth. The calculation was that the Party’s legitimacy and power would ultimately benefit from a stronger economy. Xi Jinping’s Third Plenum reform document of 2013 seemed initially to call for another trade-off of this type: less direct state control, a more market-driven and efficient economy, and enhanced prestige for the Party down the road.

Two years on, it is plain that Xi’s top objectives are a strengthening of the Party’s political mechanisms of control, and carving out a bigger role for China in global affairs. Economic reforms are at best a means to these wider ends. Putting political goals so explicitly ahead of economic ones differentiates Xi from his predecessors, all of whom stressed the primacy of economic development. In China’s present environment, where the beneficiaries of the status quo have lots of money and plenty of ability to resist change, productivity-enhancing economic reforms are unlikely to gain much more traction unless they are moved up the priority list. As the economy inexorably grinds slower over the next 18 months, the thing to watch will be whether the top Party leaders signal a shift in emphasis away from political goals and towards economic ones.

At the very beginning of Chinese stock market crisis in late June, many investors felt there were problems in the stock market, mostly related to liquidity issues. But gradually the concerns have grown to encompass more than the market itself. People have begun to talk about whether the government is capable of to handling the stock market crisis, and whether this may end up as a broader crisis of governance.

China’s leadership doesn’t like uncertainty: Beijing basically wants everything under its control, from the exchange rate of renminbi to the rise and fall of the domestic stock market. Part of the reason why there limits to the depths and heights all stocks traded in Shanghai and Shenzhen are allowed to fall and rise is because the government simply likes certainty—something that is predictable and ultimately can be kept under control.

The same mindset has been at work in the government’s efforts to stabilize the stock market. The central bank has pledged to provide as much liquidity support to the market as is needed, and state-owned commercial banks have jointly provided over 2 trillion RMB in loans to the government-backed margin finance agency, the China Securities Finance Corp. to help it stabilize the market. But despite these rescue efforts, the market has still been in turmoil recording its worst single-day fall in eight years on Monday. More retail investors, who contribute about 90 percent of daily trade in mainland China’s stock market, have begun to be impatient and doubt whether the government, particularly the securities regulator, is capable of dealing with the market crisis.

The securities regulator has made a few missteps in its attempt to rescue the market. First, the it tried to blame the crash on factors such as “malicious selling,” “negative news and rumors,” and “the grey market” and speculations in stock index futures. I’m not sure if there is such a thing as “friendly selling” when it comes to the Chinese stock market. There is also no clear definition of what a “grey market” is in China.

Second, a growing number of commentaries and news articles in state media have blamed “foreign interference” for the stock market crisis in China. “Foreign interference” has become an easy excuse for Beijing on everything from Hong Kong’s pro-democracy Occupy Central movement to the stock market crisis. This really hurts the image of Chinese government and won’t help rebuild investors’ confidence in market.

There should be government interference to some extent when dealing with a market crisis. The U.S. government intervened in 2008. But what Beijing has been doing for the past month, including getting its public security department involved in the arrest of so-called “malicious sellers,” has gone far beyond common sense and international norms.

In April, when the Chinese stock market was doing so well, making it one of the best performers in the world at that time, I remember some Chinese newspapers ascribed its performance to Xi Jinping and the top leadership’s efforts to "create a new opportunity for wealth redistribution for everyone," to narrow the income gap, one newspaper concluded. The People’s Daily even published a commentary to describing 4,000 points as “just the beginning of the Chinese market’s bull run.”

China’s stock market crisis has lasted about a month. It may recover sooner or later. If you think of the Chinese government as a large listed company, I guess what the company has done in response to the stock market crisis has already forced many people to rethink its corporate governance and question the capability of the management. That is the long-term price the company has to pay, even if its share price recovers in the short term.

When things hit their extreme, they can only move to the opposite direction—物极必反 (wù jí bì fǎn)– is an idiom that seems to sum up perfectly punditry about China. Where once Beijing seemingly could do no wrong and China was poised to dominate and conquer the global economy now and forevermore, now words of doom, gloom, and crisis dominate the media and spread their fear far into the non-Chinese world trying to make sense of what’s going on.

Extremism to be followed by inevitable reversal seems to be affecting President Xi Jinping as well. Where once China’s leaders seemed pragmatic and technocratic, Xi has plumped for a full-scale switch into politics-led policy, whether it be the long- needed crackdown on corruption that has become so threatening that many officials seem paralyzed and incapable of even the most sensible decisions, or the misguided, politically-charged “rescue” of the stock market that has thrown Beijing’s commitment to true economic reform into question.

Xi’s “China Dream” threatens to become a nightmare. Like all those affected by nightmares, however, waking up and clearing the head is the most sensible cure.

Both China watchers and (more importantly) Chinese officials need to be aware of the more ancient doctrine of the mean (中庸之道 / zhōngyōng zhī dào).

China’s figurative skies are neither clear as a verdant glade’s nor as black as one of Beijing’s most polluted days. The good and the bad in China today need to be assessed and dealt with soberly and carefully, without unhelpful emotion. The economy itself couldn’t stand the sudden, pure immersion into untrammeled market discipline, but it certainly is not helped by purely political decisions and measures. The ills of the stock market and, much more importantly, the wider economy, need to be fixed by a swift but unrushed march down the well-signaled path of important and necessary structural reforms.

Can President Xi Jinping do it? The answer depends on his assessment of, and more importantly the reality of, the strength of his political position. From the outside, it certainly looks like he should have the confidence to temper his political campaigns with a real dose of economic pragmatism. But as ever, perhaps the move to the dangerous extreme still has some way to go before the reversal can begin.

My esteemed colleagues and friends have already identified some of the pitfalls related to the recent market sell off and subsequent draconian reactions by the government. I agree with Arthur Kroeber that the sell off has had limited impact on the broader economy and that a greater challenge is the government's neglect of genuine reform thus far. The only exception is the government's freezing of trillions of RMB in assets held by major shareholders. I agree with George Chen that the securities regulators have damaged the reputation of China’s capital market by blaming the sell off on a variety of conspiracies. Finally, I concur with David Schlesinger that the government’s reaction to the sell off is symptomatic of the politics of the extremes under Xi Jinping. However, I think for foreign investors in general, but especially portfolio investors, the recent events represent something much more disturbing and ominous in the medium term.

In essence, the Chinese equity market has become a legal swamp in which no cautious investor would want to tread. With the latest batch of rescue measures for the market, investors now face risks that are associated with destabilizing developing countries rather than the second largest economy in the world. Asset seizure, insider trading, and rampant leveraging all now are sanctioned by the Chinese government. Securities regulators also seem to rely increasingly on arbitrary enforcement from which investors have little legal recourse.

At the bottom of the crash on July 8th, China’s stock regulator rolled out the infamous “Announcement 18” which threatened “severe punishment” for any senior management or controlling shareholder—one with a stake of 5% or greater—for selling any shares of a listed company over the next six month by for six months. With a single announcement, trillions of RMB in assets belonging to some of China’s wealthiest investors were frozen for at half a year. Making things worse, the securities regulator announced no concrete plans for how and when major shareholders could resume selling their shares, stating instead merely that rules for future selling would be outlined in “further decrees.” In essence, there is absolutely nothing to stop the Chinese government from freezing the shares of major shareholders for another six months or even longer. It is as if their assets have been seized by the government in order to stabilize the market. This likely will have a significant implication for the economy because some of China's wealthiest investors will need to pay a significant cost to liquidate a major part of their assets in order to invest in something else. Private sector investment likely will suffer from this illiquidity.

For foreign investors, the implications are quite stark. If the Chinese government can freeze trillions in assets of its wealthiest citizens, it certainly will not hesitate to freeze or seize the assets of foreign investors. This logic pertains to both the equities market and the fixed income market.

The other legal morass created by the Chinese rescue effort has to do with the de facto legalization of insider trading. In an effort to encourage major shareholders and senior executives to start buying shares of their companies, the authorities allowed insiders to buy shares of a company during earnings season, which previous regulations had forbidden. To be sure, this exemption only applied to companies whose shares had fallen 30% or more, but the vast majority of companies trading in both Shanghai and Shenzhen had seen their shares plummet by at least that much by the time the regulation was announced. As a result, insiders of most listed companies now can buy shares based on inside information without any legal ramifications. Again, it is unclear how long this emergency decree will be effective. We could see legal insider trading persist for months to come. How can pension and endowment funds in societies with much stronger rule of law justify trading in a market where inside trading is effectively legal?

Finally, Caixin revealed that banks in China had granted the China Securities Finance Corporation 2 trillion RMB in lines of credit, which financed its massive purchases of equities in the market. The China Securities Finance Corporation is a joint stock company owned by all the major exchanges in China with the main purpose of channeling margin financing to the brokers. When the crisis occurred, the Chinese government turned CSFC into a bailout fund, which channeled bank loans into the stock market. It turns out that CSFC’s borrowing is illegal according to a China Banking Regulatory Commission decree from 2006, which clearly states that “no corporation or individual can use bank loans to directly or indirectly invest in the stock market.” In any event, stocks became highly inflated in the first place because investors borrowed heavily to buy, and now the government wants to do so itself. This shows that prudential regulation and laws are worthless in the face of the Chinese government’s imperative to maintain stability.

To be sure, officials in the Chinese government and China optimists may proudly claim that a crisis was averted. That is true for now. However, let us also be upfront with the costs of arresting the crash for the moment—the Chinese capital market no longer has any credibility because every rule, even a fundamental rule like property rights, can be violated in the name of stability. In the face of this overriding imperative, investors have no recourse if their rights are violated or if they made losses due to the rules’ being ignored. Much of the hard work by Chinese technocrats and legal professionals in the past two decades to enhance the credibility of the stock market has gone to waste because of the rescue. Now, only punters who invest by guessing at the size of government intervention on a daily basis would want to wade into this market.

Xi Jinping could, if he acts boldly, arrest the slowdown in China’s growth. But 7% growth over the next decade is extremely unlikely and the figure could be much lower.

My concern about growth partly reflects history. China’s growth is unprecedented, 10% a year for three decades. Everything we know about economic development suggests that growth will slow. The old strategy of simply shoveling underpriced land, labor, and capital at economic challenges doesn’t work forever. China is at that point where workers’ wages go up a lot faster than their productivity and even cheap capital doesn’t produce much of a return.

As Larry Summers has written, we don’t know precisely when or why or how much China’s growth will decelerate, but just as Japan, South Korea, and the other so-called East Asian miracle economies sputtered, so, too, will China. Summers expects annual growth of 3.89% from 2013-2033, little more than half the consensus forecast of 7%. The Conference Board takes a different approach, focusing on productivity, but arrives at similarly sobering conclusions.

Nearer-term, there’s reason for concern that the government simply is not serious about reform. Partly that’s because officials worry about making any changes at a time of slowing growth.

Another problem is a fear of upsetting narrow self-interested industries.

Former Premier Zhu Rongji privatized state-owned enterprises and ended lifetime employment for tens of millions of workers. He and President Jiang Zemin also made the strategic decision to bring China into the World Trade Organization as a way of jump-starting flagging reforms. Would Xi Jinping act this boldly in economic affairs? It seems that he will not—or perhaps politically he cannot.

China has succeeded because the government has enjoyed a high degree of autonomy to make policies for the overall good of the country. That was also the case with many of its East Asian neighbors. Japan, then South Korea, Taiwan, Hong Kong, and Singapore, all pursued high-growth economic policies. Growth gave political legitimacy, and, from South Korea’s Park Chung Hee to Singapore’s Lee Kwan Yew, policies designed to promote economic growth swept away many obstacles. Sure, there were always special interests whose voice was heard, but state power in the service of economic growth was the rule.

Today, reforms in China are flagging. The service sector, especially retailing and distribution, badly needs opening. So, too, does finance. SOEs dominate sectors like telecoms, electricity, and energy.

The short-term solution is to deregulate protected sectors. China has talked for more than a decade about the need to re-balance its economy. Consumers only account for about one-third of the Chinese economy, compared with more than twice that in the U.S. Yet there has been little done to shift the balance to encourage consumption and throttle back investment.

It might seem odd to raise the issue of state capture by special interests at a time when Xi Jinping exercises such political control, but it is an issue that deserves more attention.

If Xi Jinping cannot reform China’s economy, who can? It’s often said that Xi is the country’s most powerful leader since Mao. But in economic affairs he doesn’t appear to be the equal of Zhu Rongji.

Eventually this equity bubble will evaporate and, given the minor role equities play in China’s financial system, its economic impact will be limited. The more important issue is whether China’s leadership will have learned the right lessons. China’s economy is becoming more market driven but, while this offers greater efficiencies than under a centrally- controlled system, it is also inherently less stable. The lesson is that markets cannot be based on the unwarranted faith in the power of government intentions but need appropriate regulatory agencies to protect the public.

The last time there was a bubble was in 2006-7, when the Shanghai Composite Index soared from 1,000 to 6,000, and then, within a year, collapsed to 2,000, where it remained until June 2014. With economic growth slackening, this recent surge was unrelated to fundamentals but the result of two well-intentioned but poorly implemented state-driven policy decisions. Policy makers rightly felt that savers needed a broader array of investment options beyond just parking their money with banks or buying property. Their second objective was to use the equity market to moderate the country’s debt burden by encouraging companies to secure financing through equities. To make all this work, the China Securities Regulatory Commission (CSRC) and others talked up the gains to be achieved by investing in stocks.

With a leadership that was championing equity markets, the average citizen was persuaded of an opportunity for enrichment. The financial community also realized that if China’s request to be included in the MSCI Emerging Market index was approved it would trigger additional global demand. The market euphoria also was boosted as countless retail investors bought stocks on margin with borrowed money. Yet while the CSRC expressed caution at times, it was not firm enough in reining in excessive leveraged buying.

Months before the crash began sentiments were beginning to shift. First was a gradual realization that prices had overshot fundamentals and doubts about the power of government intentions to sustain such increases. When the decision to include China in the MSCI global stock index was shelved in early June, sentiments totally changed. The slide was now in full force but any possibility of moderating it was negated by the margin calls, which triggered even more selling. The same forces that exacerbated the market’s rise made it inevitable that the decline would be amplified. Recent stopgap measures to prevent selling and encourage buying may have temporarily stabilized the market. But statements that the authorities would not be satisfied until the index rose back to at least 4500 was a repeat of previous mistakes in trying to promote higher prices rather than establish a credible floor.

When emotions have settled down, the lesson from this bubble should be that equity markets must be driven by market forces and not by government sentiments. Thus the role of the state as a regulator to protect standards and mitigate risks should not be compromised by conflicting pressures to champion rising equity prices. For this to happen, the role and accountability of senior officials of regulatory agencies such as CSRC need to be clearly separated from China’s party-dominated personnel process to provide assurances that its equity markets are really markets.

I agree with much of what my colleagues have already commented on, particularly from Art, Victor, Yukon, and George. To keep it brief and without being overly redundant with what's already said, I will simply attempt to distill this into what I think is the core tension when it comes to the economy: that of credibility vs. control.

The Chinese government’s credibility has, for a long time, been largely predicated on its ability to manage a complex economy and the government can basically point to a very successful, if imperfect, record on getting the economy to where it is today. That credibility also stemmed from the fact that Beijing believed it usually had things under control, or simply asserted control when it felt the market wasn’t “doing what it was supposed to do.” The tendency to control is so ingrained in the minds of Chinese leaders that if they do not mitigate volatility or perceived instability in the economy, there seems to be a palpable sense (or fear) that their longstanding credibility is being eroded.

But the current stage of reforms requires a different balance between credibility and control. Markets are inherently subject to bouts of volatility and occasional bubbles (and irrational herd behavior), and with proper regulations and legal mechanisms in place, the government then becomes more of a referee rather than an active participant, allowing the market to self correct. For market forces to be more credible, the government has to be able to tame its default tendency to control every moment of uncertainty. And it is also somewhat paradoxical that for about 1.5 years now, the central government has been consistently aiming to cut red tape and reduce the layers of administrative approvals for businesses—in other words, reducing government control—but the recent actions on the stock market seems to fly in the face of that effort.

In short, government credibility under a more fully developed and advanced market requires Beijing to sit out more than plow in with overwhelming force. Without sorting out this tension between control and credibility, it will make ongoing reforms more perplexing and potentially more difficult as it grinds forward.

As for the broader economy, we all await more economic indicators to see what the actual impact of the stock market drama is on growth, though likely minimal as already discussed in this thread. Perhaps one silver lining here is that if growth is lower than the officially reported headline GDP—as many seem to suspect—we may be testing the bottom of near-term growth and how resilient the Chinese economy is to this slowdown. So far, we have not seen mass layoffs or much reported social unrest, which seems to suggest that jobs are generally holding up (whether they’re good jobs or not is another issue). And it also suggests that the old canard that anything lower than 8% growth and social instability will ensue never held much water.