In the first half of 2017, market confidence in the near-term stability of the Chinese economy appears to have been restored. But that confidence may prove fleeting. That is because the newfound calm should not be conflated with long-term optimism. Indeed, it belies a deeper—and growing—market skepticism that China’s economy will simply continue to chug along without running into a financial crisis, a fiscal crisis, or perhaps even both.
The general concern in the markets is that loose monetary policy and rising leverage have fueled growth for the past year or so. This, in turn, has allowed Chinese policymakers to paper over fundamental problems in the economy that could very well trigger instability while managing to stabilize growth—an outcome that markets prefer for now.
But from our vantage point, it is equally true that if many of the economic reforms market participants champion were perfectly implemented today, they would still almost certainly lead to slower growth. That is because many of the reforms require deleveraging and the shedding of bad assets, particularly at the provincial and municipal levels.
So market participants appear to want it both ways: meaningful reforms and continued stable growth. And ironically enough, that is what Chinese policymakers want too.
In the end, neither the markets nor Chinese policymakers are going to be able to have it both ways. They will have to make a choice between tolerating a slowdown or keeping unsustainable growth going amid partial reforms.
What is more, mixed signals emanating from policymakers have reinforced what many observers, especially outside China, believe is a mismatch between Beijing’s confident rhetoric but inaction on reforms. At the heart of that dismal assessment is the apparent contradiction between the political mandate that China “will grow” at about 6.5% a year through 2020 but, on the other hand, deteriorating economic fundamentals that suggest achieving such a growth rate is impossible.
This contradiction accounts for much of the uncertainty that has beset Chinese economic policymaking over the last few years. It has created internal confusion over whether growth or reforms should be the top priority, especially since reforms will almost certainly require tolerating near-term pain and missing numerical growth targets.
Local officials in China are not independent actors: they operate within political constraints and under intense scrutiny, especially in the current political environment, from Chinese Communist Party (CCP) watchdogs and superiors. That breeds an innate conservatism. Local officials need to decide which priority—growth or reforms—carries less risk of political reprisal in the event of failure.
Not surprisingly, most officials opt to emphasize the growth mandate since meeting a quantitative target is generally easier than adhering to vague instructions to “implement reforms.” Since local officials’ performance against the numerical target can be easily monitored, evaluated, and rewarded, they tend to make the straightforward political judgment that privileging growth is the simplest way to avoid career suicide and elicit approval from top leaders.
This is especially true now, when all CCP officials are gearing up for a consequential political transition at this fall’s 19th Party Congress. Avoiding volatility will be the paramount priority of every Chinese official at all levels of government.
During the second half of 2017, then, the Chinese government will likely be more sensitive than usual to any real or perceived efforts to undermine confidence in the Chinese economy. And that is one reason, in our view, that Beijing responded so vigorously and rapidly to Moody’s recent downgrading of China’s sovereign debt. It may even offer at least a partial explanation for the People’s Bank of China’s latest bid to manage a stronger yuan.
We stand, however, on the more optimistic end of the ledger than many observers in terms of the prospects for significant policy change. There are some good reasons to think that, once the political transition concludes this fall, the current stasis and gridlock could yield to a period of economic policy transition.
Several factors explain our view:
- Correct Diagnosis is the First Step to Cure: Pressure is building up in the economy, and Chinese leaders seem to recognize that problems have become worse compared to just 12-18 months ago. Some top Chinese policymakers have conceded that current monetary and fiscal policies have not been especially effective and are merely delaying the inevitable reckoning. In private, they also concede that China will be forced to undertake a cleanup. So whether they want to or not, they are likely to be preparing to tolerate some painful measures.
- Early Adopters Can Drive Change: With the 13th Five-Year Plan (2016-2020), Beijing has already begun to lay groundwork that will weaken its emphasis on the quantitative growth target. Some provinces, such as Shanghai, have in fact already ditched it entirely. It is possible, therefore, that even without an edict from the top, other provinces and localities will begin to voluntarily dilute the growth targets in the Key Performance Indicators used to evaluate local officials and cadres. If most of the wealthier coastal provinces now follow Shanghai in this direction, then well over half of the Chinese economy would no longer be targeting growth for its own sake.
- Xi’s Strengthened Hand: The likely economic outcomes of the 19th Party Congress are of course unknown, but most observers expect President Xi Jinping to emerge near the apex of his power. In theory, this would give him sufficient political clout and capital to shake up the approach to economic reforms, should he choose to do so. That would logically include defending a shift from pro-growth to pro-reform policies. In effect, Xi will be better-positioned next year to give local officials more political cover to abandon growth targets in favor of conducting a thorough cleanup of distressed local economies.
- Reforms Are Happening: The growing consensus that “no reforms” have been implemented in recent years is exaggerated. It is true that state-owned enterprises have barely been touched and, if anything, have been strengthened through mergers and enhanced CCP control. But in other areas, which are important for China but probably regarded as less significant by foreign companies and analysts, more reforms have been implemented since the 2013 Third Plenum than Beijing is usually given credit for. A quick survey of ReformPedia here on MacroPolo shows that, particularly in the realms of energy and pricing, meaningful steps have been taken. Results from these reforms remain insufficient and, in some cases, poor. As such, newly appointed personnel, particularly within the Chinese bureaucracy, could grow into capable, effective, and hard-driving implementers that inject new energy into areas where reforms have clearly lagged.
- Early Opportunities for Change: We will be closely watching one signpost in particular: the annual Central Economic Work Conference (CEWC), which is expected to take place shortly after the completion of the Party Congress. This is an occasion that often yields early signals on whether pivotal political consensus has been reached. It could be the first test of whether the contradiction between growth and reforms has been resolved in a manner that will increase the pace, expand the scope, and intensify the effort behind the Third Plenum’s rhetorical commitment to change. If something meaningful comes out of the CEWC, then it is possible, depending on the state of Chinese politics, that yet another “Third Plenum” in 2018 could prove momentous and reset the table on economic reforms.
The bottom line is that for the second half of 2017, the macro outlook will be essentially neutral, with few if any course corrections until at least the late fall. The months of November and December will be a crucial period that could hold surprises that few anticipate today.
A course correction, however, does not necessarily imply that it will be immediately embraced by markets and investors; in fact, it may do just the opposite as markets adjust expectations and begin accepting that doubling down on reforms will come at the cost of immediate growth. That could bring about some volatility—and a key test will be whether Beijing holds the line on reforms nonetheless.
The task for Beijing, therefore, is to re-establish its credibility by committing to tackle the “higher-hanging fruit” of reforms, not just the “easy to haves.” If Beijing does so, then market expectations are likely to adjust over time as both Chinese and global players adopt a more positive outlook on the Chinese economy’s medium term prospects.
If Xi sticks to the political norms of recent decades and steps down in 2022 after two terms, then surely he understands that only five years are left to realize the “Chinese Dream” and the “rejuvenation” he so frequently invokes. With major anniversaries taking place during his second term (for example, the CCP’s centenary in 2021), that may yet spur his new administration to gin up another round of economic changes.