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Mar 14, 2018 | 17:00 GMT

8 mins read

The Chinese Leadership's Reform Strategy Comes With a Risk

Chinese President Xi Jinping delivers a speech in September, 2015.
(LINTAO ZHANG/Pool/Getty Images)
Highlights
  • The next few years will determine whether China's leaders have the commitment and ability to adapt to economic changes and follow through with necessary reforms.
  • Chinese President Xi Jinping will need to retain a firm grip on power while at the same time meeting the rising expectations that come with that level of authority.
  • Beijing aims to reshape local governments' behavior and lower its growth target, paving the way for more sustainable economic growth.
  • Trade pressure from the United States and a slowing economy will test Beijing's resolve as it strives to restructure its economy, challenging its deleveraging campaign and its attempts at enforcing environmental reforms.

Four decades ago, China created a political and economic framework that encouraged rapid growth. Those policies' successes have left China substantially transformed, but they also brought about massive changes and problems that the state's governing system is only now beginning to address. The sweeping political and socio-economic reconfigurations that President Xi Jinping helped guide during his first term in office have left the Chinese leadership wrestling with a new set of strategic choices. The next few years will determine whether China's leaders have the commitment and ability to adapt to the changes and to follow through with necessary reforms while at the same time meeting the rising expectations that accompany economic prosperity and juggling the country's competing social, economic, political and security challenges.

The Big Picture

In Stratfor's 2018 annual forecast, we stated that Chinese President Xi Jinping will need to maintain his unrivaled authority as China enters a critical period of restructuring. This year's Two Sessions, often regarded as rubber-stamp sessions, are more significant than usual and will set out the country's socio-economic strategies for the year. Xi's tight grip on power could help remove some of the obstacles ahead, paving the way for the more challenging and politically sensitive reforms he deems necessary. But his authority also creates high expectations, leaving little room to guard against policy inefficiencies or failures.

China's path forward will largely be shaped during the annual meeting of the National People's Congress, the country's legislature, which convened March 5 in the wake of two major events: the decision to remove the constitutional limit on presidential terms and the Third Plenary Session of the Party's Central Committee, known in the past for heralding major reform efforts. The confluence of these developments and the nearly complete Chinese leadership transition, which occurs once every five years, has added special significance to this year's legislative session. The National People's Congress faces key agendas to amend the Chinese Constitution and appoint a group of state leaders, including the vice president, vice premier and director of China's Central Bank. But perhaps more critically, the results of the session, which ends March 20, will set the country's economic priorities and the direction of a new round of bureaucratic reforms, each of which will have a significant effect on China's ongoing economic and political restructuring.

As news of the delegates' decisions surrounding these issues begins to filter out of the National People's Congress, it will point to the government's priorities over the next year and offer clues to the strategies it will take to try to rebalance the economy.

Setting Expectations

Following tradition, Prime Minister Li Keqiang opened the 2018 session of the National People's Congress with the government's work report, which sets out key macroeconomic targets for the country. Notably, this year's report set the country's growth target at around 6.5 percent, well below the official 6.9 percent growth rate the economy achieved in 2017. It also issued key goals for the coming year: to continue efforts to contain financial risks in the indebted economic system, to continue phasing out overcapacity in industries like coal and steel, to improve the environment and to reduce poverty. The report also offered the means by which China would undertake its fiscal restructuring, including a tax cut for individuals and small businesses, and a restructuring of the way underdeveloped regions pay for local services.

 
(Stratfor)

Although these strategies are each aimed at smoothing out different facets of China's difficulties, they are all driven by at least one common sentiment: that the growth-driven economic model upon which the country relied for four decades is no longer suitable. The country's leaders have realized that they must mend the cracks in the socio-economic system left by the stresses of rapid growth and find a more sustainable path. But at a practical level, the patterns laid during those boom years continue to influence policy. They are still used as the core gauge of local politicians' performance and have cemented the overreliance on credit-driven investment that catalyzed the country's massive industrial overcapacity and environmental degradation. Though low-end manufacturing exports and a credit-driven, investment-led economy led to a surge in prosperity, China's unfavorable demographics and declining capital returns indicate that the peak of its high growth years has passed. What's left is a system fraught with surging debt, a deteriorating environment and sharp disparities between the prosperous urban coast and poorer inland regions.

By lowering growth expectations, Beijing is working to reshape the behaviors of economic entities, particularly local governments, and to prepare the ground for its economic rebalancing strategies. Notably, most local governments, notorious for exaggerating their region's economic performance, appeared to be more measured in setting out economic goals or tempering their investment enthusiasm to align themselves with Beijing's wishes. By setting out expectations on environmental protection, curbing financial risks and other aspects of its rebalancing agenda, Beijing is underscoring its commitment to addressing the country's fundamental socio-economic challenges while encouraging local compliance.

Confirming Its Course

Several of the government's economic rebalancing efforts over the past year have resulted in progress. For instance, its crackdown on the riskiest aspects of the financial system such as informal, or "shadow" lending, its restructuring of indebted state-owned enterprises and its efforts to contain capital outflow have all resulted in an overall improved financial picture, even as mounting debt risks pose a concern for the years ahead. Meanwhile, improved environmental conditions have followed the government's directives to curb the coal and steel industry and its coal-to-gas project in the country's northeast, although those efforts have engendered significant social backlash.

(Stratfor)

Buoyed by those victories, Beijing has continued to pursue its agenda by increasing supervision and enforcement at the local level. It is also ramping up government reforms to facilitate its broader economic objectives. The sweeping shifts in the country's political structure and the clampdown on bureaucratic interests over the past five years have paved the way for the impending reshuffling of central government agencies. The government will establish two overarching bodies in an effort to streamline and consolidate the enforcement of financial and environmental regulations. Specifically, the central bank will be granted more power to oversee the entire financial system, while a newly established commission will focus on the details of inspection and policy enforcement.

Separately, the National Supervision Commission will be established and enshrined in the constitution as an enforcer of anti-corruption practices and policies at the local level. Far more than an institutional change, these reshuffles are closely aligned with China's evolving socio-economic priorities and political structures. Beijing recognizes that it needs a more coherent and centralized authority to implement and enforce the nationwide initiatives.

An Economic Opening

But these moves represent just a part of the picture. As China's leaders solidify their political positions, they have wasted no time in ratcheting up public expectations over reforms. On March 5, for instance, the National Development and Reform Commission, the country's top economic planner, announced a raft of changes designed to "sharply widen market access" to foreign investment this year. They include lowering investment barriers for the services and manufacturing sectors; relaxing ownership limits in the financial sector including those for securities and funding businesses; further trimming the "negative list" of restrictions on foreign involvement in other industries; and facilitating the expansion of free trade zones.

In fact, Xi had outlined an ambitious reform agenda in 2013, calling for market forces "to play a decisive role." The progress on plans to further open financial and service markets and increase privatization of state sectors, however, has been mixed at best. Despite limited steps taken to liberalize currency and stock markets, broader changes to the financial system ran up against bureaucratic and regulatory walls. Likewise, instead of real corporatization, the attempts to restructure state-owned enterprises have instead focused on strengthening the businesses and the Communist Party's hold over them. Other issues yet to be effectively tackled include boosting the service sector and domestic consumption, addressing lagging land reforms and industrial production cuts, and more critically, managing a strained business environment for the country's private business.

The economic and political reconsolidation that is taking shape does not mean China is moving away from reform. In fact, it can be argued that it will result in power structures that can more effectively ease the pain of and resistance to further economic reform, a development many had expected as Xi entered his second term. And while Xi might see such consolidation as a critical component of the country's economic restructuring, he also understands that the factors that drive future Chinese development will rest largely outside the state's control. The success of the efforts to correct problems spawned by decades of opening up is neither guaranteed, nor is it free of risk. And one of the biggest risks to Xi and the Party is that if the consolidation strategy does not produce tangible results, it could prove a critical vulnerability to both at a time of sustained economic cooling.

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