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The Road to China’s Second Reform and Opening Up

September 27, 2017
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Badly handled market interventions last summer have stimulated doubt that China’s leadership will devote the political capital to push through painful reforms in order to achieve faster growth.

Anxiety over China’s economy reached new heights this summer following the crash of the Shanghai Composite Index and botched currency reform, but these fears may be largely misplaced. The collapse of China’s equity markets and the government’s failed intervention to prop them up seem to have presented little risk to China’s real economy or corporate fundamentals. Likewise, while capital outflows continue to pose risks of further currency devaluation in the months ahead, China’s largest-ever trade surplus in 2015 should prevent declines in the RMB’s global competitiveness.

In both instances of financial volatility, a critical tradeoff between continued progress toward giving the market a decisive role in China’s economy on the one hand while preserving the state’s dominant role on the other hand appeared to be resolved in favor of the state. In doing so, the Chinese leadership called into question the general direction of China’s three-decade-long reform and lost important confidence within the international community that Chinese leaders are committed to pressing forward with this difficult economic transition.

Moreover, for a country that for the past three decades has prided itself on the competencies of its technocrats to generate economic growth and development, the badly mishandled and poorly communicated market interventions in August undermined faith in the leadership’s ability to manage the economy, which could translate into greater risk and volatility in the markets going forward. The crisis of confidence in Beijing’s capacity and willingness to achieve this difficult economic transformation is a new and important dimension of the China transition story.

China’s leadership recognizes that reforms which provide a greater role for the market are the only path for continued growth and development, and they have a detailed and widely endorsed blueprint in the Third Plenum decision to guide them. The question now is one political will: do China’s leaders have the necessary political space, and will they devote the political capital to push through painful reforms in order to get to faster growth? Several important indicators in the months ahead will provide further support and evidence of the general trajectory of China’s reforms.

Despite the tendency to focus on the crises of the moment and the day-to-day fluctuations in the markets, the adroit executive’s eye is concentrated on the mid-term indicators of China’s commitment to long-term political imperatives (reform in order to avoid stagnation) in the face of short-term political needs (meeting growth targets and avoiding instability). Successfully navigating the risks going forward will require an understanding of the changes in decision-making under President Xi Jinping and a government relations strategy that aligns with these new realities on the ground. China remains a critical growth market. With the right approach, executives can manage uncertainty. With resolve, China offers an unprecedented opportunity for multinational companies over the long term.

Summer Shocks

The international community has long admired China’s ability to generate high growth and competently manage the economy – now the world’s second largest. That confidence was challenged in the summer of 2015 by the collapse of China’s equity markets, currency devaluation and weak economic indicators. Through a serious of policy blunders, China’s leadership revealed the inexperience of China’s economic policymakers and the underdevelopment of its financial institutions to manage the excess volatility and the uncertainty of the future direction of Chinese reforms.

To begin, in the first half of 2014, amid a deepening slowdown of the economy, the Chinese government began encouraging ordinary Chinese to buy stocks. Official statements talked up the stock market and media reports suggested that the government would back its dramatic rise. Prices soared more than 150 percent with the introduction of margin trading, and although valuations had become wildly out of line with corporate profits, the Chinese Securities and Regulatory Commission (CSRC) never intervened. The bubble peaked on June 12 after it was announced that a decision on China’s membership in the MSCI’s Emerging Markets Index had been postponed.

Once the bubble burst, the Chinese government stepped in with heavy-handed intervention that included a massive $400 billion program to support stock prices, a virtual ban on short-selling, restrictions on selling by major shareholders and the loosening of margin lending regulations. As many experts have noted, when the government stepped in, the market was still high; the move was poorly timed and was only temporarily effective. In July, Chinese equity markets had lost one third of their total value. Within two months it was clear that the policy had failed to stabilize and prop up prices.

The unexpected devaluation of the RMB and further weak Chinese economic data led to an 8.5 percent drop in the Shanghai Composite’s Index on August 24, later deemed “Black Monday.” China’s market volatility spread to financial markets across the world, causing a global sell-off. The following day, after further dramatic declines, China’s central bank simultaneously cut interest rates for the fifth time since November and lowered reserve requirements for the third time. Officials later announced China had abandoned its large-scale share purchase program. In turn, authorities revved up efforts to blame journalists, traders, and even foreign forces for “destabilizing the market.”

As the Chinese October National Holiday arrived, China’s stock market finally seemed to stabilize at levels more than 40 percent below their June high (but still almost 30 percent above levels one year ago). The fall in Shanghai equity prices by 4.8 percent in September was the smallest monthly price move in either direction since February 2015. Yet, there are signs that equity purchases by the government have resumed. This, along with the arrests of several top securities market regulators and a sharp increase in margin requirements and transaction fees for index futures trading, seem to have prevented further volatility.

Regardless of whether China’s markets can sustain longer-term stability in the weeks and months ahead, investor confidence remains damaged. Communication by the government of its intentions throughout the equity crisis was lacking. President Xi made his first public statement acknowledging the stock crash in a speech during his first state visit to the United States on September 22. Despite causing a global sell off and attracting enormous media attention, the Chinese leadership publicly avoided the crisis and ordered Chinese media not to report on it while it was happening. Furthermore, when Xi spoke about the stock market, he never acknowledged the government’s complicity in bringing about the bubble, only highlighting and justifying the government’s efforts to manage the correction on the way down.

The second botched summer intervention came after the People’s Bank of China (PBOC) abruptly announced a one-off, 1.9 percent devaluation of the RMB on August 11 – the most significant one-day adjustment since the hard peg to the US dollar was abandoned in July 2005. The downward adjustment occurred alongside a change in China’s daily rate fixing policy that would allow the market to play a larger role. Instead of the central bank making the decision unilaterally, as had been done in the past, the opening rate is now determined by the previous day’s closing rate, although it retains some flexibility according to supply and demand conditions and major movements in other currencies. The daily maximum trading band for the RMB was kept at two percent.

The policy move was likely motivated by a number of factors. China was trying to make the exchange rate more market-determined to respond to IMF requirements for the RMB’s entry into its special drawing right (SDR) currency. Against the backdrop of slowing Chinese growth and weak economic data, the RMB had also become overvalued. Other factors such as concerns about a U.S. Federal Reserve move to raise interest rates likely contributed. But, there is little evidence that the Chinese government was attempting to boost exports.

Nevertheless, the poor manner in which the devaluation and rate policy was communicated once again led to unintended consequences for Chinese policymakers. The abrupt devaluation led to strong downward speculative pressure on the currency thanks to already deep-seated nerves about China’s poor economic health. As a result, the central bank has, ironically, been forced to step up its foreign exchange purchases to keep the RMB currency high. The PBOC spent over $90 billion in August alone in currency markets to defend the RMB at a rate of about 6.4 yuan to the dollar. The PBOC appears to have in effect reinstituted a soft peg to the U.S. dollar. Thus, China’s policy change failed on three counts: it did not stem capital outflows, nor did it give the market a larger role in setting the RMB value. Instead, it further undermined confidence in the Chinese leadership.

Two Steps Forward, One Step Back

The series of crises this summer led to a range of reactions by expert observers. The most dire concluded that China’s economy is heading quickly for a hard landing; Chinese growth numbers vastly over-exaggerate true economic performance; and Xi and the Chinese leadership’s political authority is now in question. While serious challenges exist, these conclusions likely are largely overblown. The performance of China’s equity markets is a poor indicator of the health of China’s real economy. Domestically, Xi continues to enjoy high popularity and faces no serious challengers to his power. In the short-term, the government has the capacity to maintain a high degree of growth.

The picture is not altogether bleak. While China’s economy is slowing, it is also undergoing a structural transition away from export- and investment-led growth to a consumption and innovation driven economic model. The slowdown was anticipated and mostly by design. Although certain sectors and regions in China that are most dependent on resources and heavy industry have slowed dramatically, others are taking advantage of new areas for growth. The services sector grew 8.4 percent in the second quarter while the industrial sector grew only 6.1 percent. In 2015, for the first time, services are expected to contribute more than half of China’s GDP, highlighting the passage of an important threshold in China’s shift to a service economy.

Despite weak manufacturing and industrial output, China’s consumer middle class continues to see growing incomes and consumer spending remains high. Financial reforms are making solid headway, including the liberalization of interest rates and reform in the banking sector as a result. Further land and housing registration (hukou) reforms could unleash further urbanization, which has fueled China’s economic growth and development for the several decades prior. For all of the government’s policy missteps, reforms are showing some results.

But the commitment of China’s leaders to economic reform has, for the first time in decades, been called into question by events this summer. China’s stock market crash and currency devaluation exposed the inherent tensions between the leadership’s dual aims to implement market reforms and further opening, and to preserve the state’s dominant role in the economy. When the results of giving the market a more “decisive role” – whether in equity markets or currency valuations – created undesired volatility, China’s policymakers gave in to the temptation to revert back to government control and intervention.

Although the Third Plenum reform blueprint appeared to indicate that China’s leaders were committed to giving markets a “decisive role” in resource allocation, the document also affirmed that the state sector would maintain its “dominant role” in the economy. That contradiction has led to a “two steps forward, one step back” result along China’s path to further reform and opening up in many cases in the years since the November 2013 plenum. Over the summer, the contradiction reached a climax, as confidence in the leadership’s ability to steer the economy lapsed.

Many are now asking: if the government’s political agenda requires the state economy to continue to be the principal component of the overall economy, what will be the driver sufficient to push China’s economy forward beyond consumer spending? In order to ensure sustainable growth over the long-term, a conclusive and consistent embrace of market mechanisms regardless of short-term instability will be required.

Looking Ahead

Several events in the coming months will serve as important indicators of the leadership’s continued commitment or hesitation to a full embrace of market forces. These include the list that the Chinese side brings to the U.S.-China bilateral investment treaty (BIT) negotiations this fall, the seriousness of the State Owned Enterprises (SOE) reform document and the 13th Five Year Plan released in March 2016.

BIT Negative List

At the Strategic and Economic Dialogue (SE&D) in Washington, D.C. in June 2015, China and the United States each exchanged initial negative lists for negotiation toward conclusion of a bilateral investment treaty. The lists detail the industries that are not open to foreign investment, a fundamentally new approach for China adopted in its Third Plenum reforms. While China’s move to this new approach toward market access and investment is welcomed, China remains reluctant to open its economy to foreign investors in a long list of key sectors and industries. Following June’s SE&D, both sides agreed to submit a second round of shorter negative lists in early September before President Xi Jinping’s visit to the United States. During this second round of negotiations, no major breakthroughs were reached ahead of Xi’s state visit to the White House. Many had hoped the BIT would be a major deliverable for the summit, but all that was announced was an agreement to progress work toward the conclusion of a high-standard treaty. While more details will emerge in the weeks ahead, this seems to be a disappointing indication of China’s further opening of its markets to U.S. and foreign businesses.

SOE reform document

On September 15, China’s State Council released a new SOE reform document intended to improve the state sector’s performance, which has long monopolized resources and bank credit, which would arguably be better employed by private enterprises. Private firms in China have long faced high barriers to entering key sectors, and SOEs’ protected positions allow them to keep prices high. The reform of China’s state sector has been held up as a critical gauge of the seriousness of China’s leaders to fundamental economic restructuring toward market forces.

For international observers, the reform package was underwhelming. The plans called for tried, long-standing policies to encourage more private investment in state firms in order to improve corporate governance. Unfortunately, “mixed ownership” of SOEs has been promoted by Beijing for decades and the results have been mixed. Moreover, great doubt greeted the idea of setting up state capital management companies to independently manage the government’s assets. Finally, the reform document devotes considerable attention to strengthening party control in SOEs as a top priority for overall reform.

13th Five-Year Plan

In March 2016, the public will see the final version of the 13th Five-Year Plan (FYP), drafted by the National Development and Reform Commission (NDRC), which outlines the government’s social and economic priorities and goals. The 12th FYP (2011-2015) outlined specific goals, including achieving a GDP growth rate of 7 percent, increasing urbanization by 4 percent, raising incomes by 7 percent each year, and increasing the use of non-fossil fuel energy. An assessment of the 12th FYP is likely to be released later this year. Plans for the 13th FYP began in April of 2013 and based on precedent, the document will be released to the public in March of 2016. The next FYP is likely to focus on maintaining economic growth and realizing the vision laid out in the Third Plenum reforms. The 13th FYP should serve as a helpful indicator of how the business landscape in China will be shaped through 2020. The annual GDP growth target will set the expectations for the government for the next five years and analysts forecast it will be between 6.5-7 percent. The One Belt One Road initiative is expected to feature prominently.

New Realities, New Approaches

It is not just uncertainties over China’s commitment and ability to enact market reforms that pose challenges for executives in China. Xi has unleashed the most far-reaching anti-corruption campaign in the nation’s history, moved the locus of policymaking from the government to the Party and cracked down on the space for political and intellectual debate. Policy missteps this summer brought to light some of the weaknesses and unintended consequences of these changes, many of which run counter to Xi’s ultimate aims and objectives.

To begin, Xi’s sweeping anti-corruption campaign, which enjoys enormous popularity among the Chinese public, has also contributed to reform paralysis. The drive was launched shortly after Xi assumed the role of General Secretary of the Communist Party in November 2012 in response to broad public discontent and resentment over elite corruption and local officialdom. For Xi, corruption is a fundamental threat to the Party’s survival. It also fits other objectives, including eliminating political opponents, shoring up control of the main levers of power including the military, and removing vested interests to economic reform.

Yet, the undefined scope and somewhat arbitrary nature of the campaign has paralyzed decision-making within a frightened bureaucracy. Furthermore, eliminating corrupt leaders in reforms areas that have faced resistance from vested interests, such as the oil boss Zhou Yongkang, has yet to translate into progress toward tackling China’s bloated state owned enterprises. Instead, risk-averse local leaders have stopped making decisions, including approving new spending projects. Xi’s increasing use of Leninist political tactics has compounded the sentiment that it is too risky to do anything. Experts suggest this paralysis is having a real impact on economic growth. Historically, these campaigns produce only temporary effects, as they neglect to strengthen institutions.

Other factors are adding to the decision-making and reform paralysis. As the strongest leader in more than two decades, Xi has concentrated power and decision-making in his own hands. Xi relies less on the formal State Council structure and hierarchy for policymaking and more on a close set of informal advisors and advisory bodies. He has also brought about the rise in influence of twenty-two new party leading groups, six of which he leads, which have assumed great authority within the former policy planning process and play a large role. These bodies now make policy instructions and oversee implementation on issues ranging from economic reform to foreign policy.

With so much authority concentrated with Xi and little movement in the bureaucracies, China’s old system of governance is stuck while the new system is not working yet. The government is pushing officials to spend money but bureaucrats are not spending money because the risks are too high. Meanwhile, over-centralization has constipated the system, caused bureaucratic confusion, and led many to ask if Xi has the bandwidth to be in charge of everything. Few see much likelihood of a serious leadership challenge to Xi, but his authority could suffer if these policy-making problems intensify and the economy continues to sputter. The enormous authority concentrated in Xi’s hands in the short term, with so few checks and balances, also raises questions for the long run.

These changes in the way the leadership is operating and whom decision makers are asking for advice has important implications for how foreign businesses need to connect and deal with the Party and its agencies and people. In many cases, they will require a revision of government relations strategies. In the past, foreign businesses could go to the ministry that oversees their industry or regulatory overseer and have some sense that if that person told them something about the direction of policy, that they could take that to the bank. Now, executives who are interacting only with government ministries will begin to find that suddenly policy can shift on very short notice.

Multinationals will need to expand their strategic networks from government officials to strategic influencers. In many cases, the interlocutors many executives are used to dealing with on the government side have less influence. Understanding new circles of influence in China and building those relationships will be critical and knowing the key “influencers” in the Party, Chinese government and business circles is more important than ever.