Get Full Access:
Save 44% Now
Trusted by over 50,000 readers

China, Where Reform Is Carried by an Iron Fist

Oct. 12, 2017 Will the authoritarian government to which the president aspires be enough to solve Beijing’s problems?

Deep Dive

|December 21, 2017

Summary

Chinese President Xi Jinping is riding high into the pivotal 19th National Congress of the Chinese Communist Party, set to take place Oct. 18. He has sidelined political rivals, stacked the CPC leadership with men loyal only to him, and appears to have already become the most powerful Chinese leader in decades. His reform agenda has been bolder than many anticipated, his efforts aided in no small part by the vitality of the Chinese economy, which continues to grow as the financial system, shocked by a stock market crash in 2015, stabilizes. People are less likely to reject change, after all, if they are convinced that the change benefits them.

Still, Xi has not instituted the sorts of sweeping structural reforms needed to fix China’s economy. One of his biggest reasons for neglecting to do so was that he wanted to maintain economic stability ahead of the party congress. But he won’t be able to avoid more ambitious reforms forever – which raises the question: If Xi’s consolidation of power is formalized at the party congress, will he be freer to undertake even more substantive reforms in the years to come?

The following report explains why China is evolving from a country governed by consensus to a country ruled by a de facto dictatorship – a transition in keeping with China’s historical swings between authoritarian and decentralized rule. The report will also examine how the centralization of power, despite its many drawbacks, could help Xi execute his reforms. More than anything, this report will make the case that China’s path forward won’t get much easier from here.

Crowning the Victors

Congresses tend to be scripted affairs, short on drama but long on pageantry, meant to invigorate the party’s rank and file and convince their subjects of their continued relevance. Officially, the 2,300 delegates at this year’s gathering will select the 200-member Central Committee and approve amendments to the party’s constitution. The Central Committee will then select the Politburo, the Central Military Commission, the Politburo Standing Committee and, most notably, the general secretary of the CPC, who since 1993 has also held the presidency. It’s also a chance for the party to tout its successes and lay out policy priorities for the coming presidential term, which lasts five years.


(click to enlarge)

But very little is decided during the congress itself. Preceding each congress is a season dominated by rumor and speculation about the ruthless power struggles and ideological battles waged away from prying eyes. The congress merely serves as a public coronation of the victors. The run-up to this congress has stayed true to form, marked as it was by sordid rumors of senior officials and by high-profile purges of powerful figures. How it has unfolded, though, points to a profound transformation underway in Chinese politics, a transformation that mirrors changes underway in the presidency itself.

Now entering his second term, Xi began to lay the groundwork for the upcoming reshuffle in 2012, almost as soon as the 18th Party Congress ended, when he launched a sweeping crackdown on corruption. His weapon of choice was the Central Commission for Discipline Inspection, an anti-graft body overseen by Xi’s right-hand man, Wang Qishan. In the past five years, the CCDI has taken disciplinary action against more than 1 million officials, in the government and in state-owned enterprises, at virtually every level of power. (The probe has even netted nearly 8,000 anti-graft inspectors).

Far from an exercise in altruism, the campaign served several purposes. One is fundamental: It helps to solve the problem corruption posed to the ruling party’s legitimacy. China’s economic rise ushered in a similar rise in graft, crony capitalism and conspicuous economic disparities, all of which invalidate the reasons for single-party rule. Another purpose is to reassert party primacy – over every state institution, every provincial government, every branch of the People’s Liberation Army, every state-owned enterprise and every private one – and in doing so to prevent any rival node of power from emerging. By eliminating those who oppose the government, the campaign is also meant to ease the implementation and enforcement of contentious reforms. The final purpose, of course, is to boost Xi’s own power.

High-profile cases (the targets for which are colloquially referred to as “tigers”) show just how effective Xi’s weapon could be. The dramatic fall of then-Standing Committee member Zhou Yongkang, whose political ascension followed a lucrative path through the energy sector and the state security apparatus, brought down a rival political network, reined in state security, and showed all those around him that no one – not even a member of the vaunted Standing Committee, no member of which had ever been tried before – was bulletproof. The arrests of two vice chairmen of the Central Military Commission, Gen. Guo Boxiong and Gen. Xu Caihou, removed acolytes of former President Jiang Zemin. Guo and Xu had resisted the authority of Jiang’s successor, President Hu Jintao, and their removal paved the way for Xi’s sweeping restructuring of the PLA. (Two high-level associates of Guo and Xu were purged as recently as August.) The infamous case of former Chongqing party chief Bo Xilai, a rising political star whose wife was implicated in the murder of a British businessman, was a particularly lurid example of systemic rot.

Xi has been amassing power in other ways too. He has created and chaired several “leadership small groups” – extraordinary committees that Xi tasked with policymaking authority typically reserved for other institutions – to outflank other senior leaders and their loyalists within the bureaucracy. He diluted the power of four PLA headquarters by replacing them with 15 departments. He installed loyalists from his days in Zhejiang and Fujian in posts throughout the political hierarchy. Today, 13 of 31 provincial secretaries are loyal to Xi, according to BMI Research. In 2012, that number was four.

Recognizing the Inevitable

Xi will almost certainly benefit personally from the power he has accrued. But his political maneuvering over the past five years is about more than just self-actualization – it’s a recognition, in the highest echelons of Chinese power, that the next era will require a more centralized model of leadership.

Chinese officials began to recognize as much in 2008. China is a massive state governed by a massive bureaucracy tasked with keeping the country’s massive fault lines from rupturing. The global economic crisis exposed China’s dire need for sweeping economic reform and laid bare Beijing’s inability to enforce its writ. Many officials had enriched themselves in the boom years, and with their wealth came the ability to build powerful patronage networks. Some of them, like Gen. Guo Boxiong, Zhou Yongkang and Bo Xilai, controlled powerful institutions or regional governments. Reform initiatives were routinely blocked by vested interests such as theirs or tied up by factional rivalries extending to the very top.

2008 also underscored that China’s run of guaranteed breakneck growth had come to an end. Its growth had relied on low wages and high global demand. Wages have since risen, and demand has since been unstable. Modern China is based on the promise of prosperity, and so when that prosperity declines, the legitimacy of the Communist Party declines as well. Xi and his elite supporters want to avoid this at all costs.

And he is well positioned for success. In 2012, when Xi became president, the powerful Central Committee was stacked with officials loyal to former Presidents Hu Jintao and Jiang Zemin. Xi loyalists are slated to replace most retiring members of the Standing Committee, largely at the expense of factions that had traditionally dominated the Politburo. Xi is also reportedly considering reducing the number of spots on the Standing Committee from seven to five while expanding the size of other bodies, such as the Central Military Commission. Doing so would centralize power and reduce the risk of political gridlock among Xi’s inner circle while diffusing the power of individuals holding seats in Beijing’s lower-ranking bodies.

Xi has sought to suppress an entire generation of potential successors with ties to Hu and Jiang. Contenders for the Standing Committee from rival factions, those seen as candidates to replace Xi in 2022, have been ousted. Out, for example, is former Politburo member and Chongqing party chief Sun Zhengcai, who was purged on graft charges in July. Sun, a Jiang protege, was expected to take a seat on the Standing Committee. Taking his place in Chongqing and on the Politburo is Chen Miner, a rising star with ties to Xi. Remember his name; if he secures a spot on the Standing Committee next week, he may very well be China’s next president.

Or maybe not. Xi’s political maneuvering has understandably fueled speculation that he is angling for an unprecedented third term, or that he is laying the groundwork to rule after 2022 as party chairman, a position eliminated by Deng Xiaoping after Mao. If the congress ends without an anointed successor, this speculation will kick into overdrive. (Hu was anointed Jiang’s successor a full decade before he took power; Xi was anointed five years out.) There’s also been widespread but unconfirmed reports that Xi’s political philosophy will be enshrined in the party constitution (an honor typically bestowed on leaders only after they retire), possibly mentioning the president by name (an honor previously bestowed on only Mao and Deng). Earlier this year, Xi was named party “core,” elevating him above the other members of the Standing Committee.

Of course, this may all be baseless speculation. Rumors to that effect do nothing, however, to dispel the fact that China is moving away from its traditional consensus-oriented model. The model served its purpose – it helped to keep the peace among elite factions, particularly during the three-decade economic boom that began in the late 1970s – but its drawbacks cannot be ignored. Jiang and Hu, for example, were monuments to compromises made with small power bases. They were choices meant to appease multiple factions, choices that proved easy to undermine. Hu especially struggled to rein in wayward institutions headed by Jiang loyalists and other rivals.

Xi may fare better than his predecessors. In the past five years, he has demonstrated a rare gift for political dexterity. But that doesn’t mean he will consolidate power in perpetuity, or that he intends to. (One prominent rival faction consisting of former members of the Communist Youth League appears poised to gain power during the congress.) After all, it was the need to streamline decision-making, not his thirst for power, that created room for Xi’s political maneuvering in the first place. Still, he’s playing a high-stakes game, and the reforms won’t be accepted without a fight.

Threats to the Economy

If Xi accomplishes what he intends to at the congress, he could become the most powerful leader in China since Deng, if not since Mao himself. But is a strongman model any better suited than a consensus model to solve China’s problems?

Broadly speaking, China has been combating four interrelated issues that threaten the economy from within: overcapacity, debt, financial sector instability and currency risk.

In a country such as China, large and populous as it is, economic disparities between the wealthy coast and the impoverished interior can make or break the central government. Companies with declining profitability are therefore sometimes encouraged to keep capacity artificially high. As a result, the country is awash in large, highly indebted companies unable to respond to changes in supply or demand or to competition from lower-wage countries. The economy needs these companies to stay afloat, so financial institutions have little choice but to extend cheap lines of credit to them. This has created massive amounts of debt for state-owned enterprises, private firms, households, and provincial and local governments alike, as well as an overreliance on housing and fixed-asset investment as a source of growth. According to China’s central bank, total social financing (measuring credit and liquidity in the Chinese economy) had climbed to some 260 percent of GDP by midyear. This figure doesn’t account for China’s ballooning problem of shadow lending.


(click to enlarge)

The bottom line is that since China’s economic problems impinge on one another, downturns in any one sector tend to drag down the economy as a whole. The solutions, therefore, often need to be comprehensive. But since reforming any one area would require unpalatable economic tradeoffs and untenable political risk, most reform efforts have been half-measures and overcorrections. Hence Xi’s urgency in centralizing power.

Settling Debts

One of his biggest priorities has been to restructure local debt. Successes and failures in this regard are instructive. An ambitious reform package introduced in late 2014, for example, was intended to improve the fiscal standing of local governments by capping local borrowing and swapping debt obligations for bonds. It failed because of local-level reticence, risk aversion from banks, and a lack of central government financial support. A subsequent version of the program, however, achieved its immediate stabilization goals by effectively bailing out afflicted governments and forcing banks to play along. There is little evidence, though, that the reforms have compelled them to live within their means.

Similar dynamics have been on display in what is perhaps Xi’s highest-profile initiative: supply-side structural reform. Launched in 2015 to address debt, unsold housing and industrial overcapacity all at once, the program has relied on a mix of central government carrots and sticks to compel participation, punish noncompliance and manage the potential for public backlash in an attempt to close down superfluous companies. But the burden of implementation has remained with local and provincial governments, generating a lot of resistance from those who stand to suffer from capacity cuts – and leading to widely uneven results. Notably, the program’s biggest successes have been in wealthier economies that have more room for experimentation. In poorer regions, the focus has tended to devolve to mere stabilization. Both initiatives demonstrated that high-level intervention and central funding help, and yet, for fear of economic and political repercussions, reforms have often been implemented in ways that treat the symptoms of economic duress but not its underlying causes.

Forget the Titans

To address corporate debt, another fundamental problem in China, Xi’s administration has singled out titans of industry for things like speculative investments and has restricted the types of allowable acquisitions abroad. (Tycoons have routinely been denounced by name in state media; the head of one such titanic firm, Anbang Insurance, was arrested.) State media have also labeled such firms as instruments of systemic financial risk and blamed them for fueling capital outflows. (China’s foreign exchange reserves dropped below $3 trillion for the first time in six years in January.) Political motivations are also at play, as connections between these firms and senior leaders are regular topics of leaks. Private firms appear to be cowed into compliance, at least for the time being, and financial reserves have steadily recovered.

Meanwhile, Xi has been a champion of state-owned enterprises, not because they are particularly efficient – they accounted for a quarter of China’s total assets but only a seventh of GDP last year – but because, if harnessed properly, they can be compelled to participate in commercially dubious One Belt, One Road projects and employ a lot of people. As part of his supply-side structural reform initiative, Xi has urged more profitable SOEs to absorb underperforming ones – and their outstanding debt. This tightens the central government’s control over operations with political objectives, but it conflicts with the second focus of reform: boosting efficiencies by allowing private enterprises to invest more substantially in SOEs. With SOEs receiving compulsory support from banks and facing few budgetary constraints – not to mention a mandate to carry bloat – investors are likely to be motivated by what are effectively state-guaranteed returns, not real profits.

As a result, under Xi, the central government has become increasingly interventionist, leaning on his ability to frighten firms that are not aligned with his political priorities abroad to rein in excesses. In keeping with tried and true historical tactics, he’s cultivated a narrative that wealthy businessmen are to blame for China’s economic woes. But, particularly with SOEs, he’s stopped short of structural reforms aimed at boosting efficiency. He has instead treated state firms as social security vehicles that execute his political priorities.

Ghosts and Consequences

China’s overcapacity issues are also apparent in the real estate sector, in which developers have been encouraged to build at breakneck speeds, consequences be damned. China’s infamous “ghost cities” – empty, would-be urban centers such as Inner Mongolia’s Kangbashi – vividly illustrate this problem. In other regions, however, cheap credit has fueled housing bubbles. (This issue heightens the debt woes facing local governments, which rely on land usage fees for revenue.) Attempts to manage real estate markets have likewise yielded mixed results, featuring swings between heating and cooling measures, increasingly complicated restrictions on homebuying and the occasional protest from dismayed homeowners.


(click to enlarge)

Beijing has several tools to use in this regard. Since the central government technically owns all the land in China, it can manage the supply of land in the market. It’s also been tightening its control over various interest rates, restricting capital outflows to incentivize internal investment, and experimenting with an array of measures to manage credit growth. As with supply-side structural reform, however, Xi’s administration has been forced to delegate powers to local and provincial officials since problems differ so much from one city to the other. This, along with the whack-a-mole policies and lack of progress on reducing the economy’s exposure to real estate, underscores the limits of a top-down system in addressing one of the most pressing issues of the day.

Beijing to the Rescue

The risk all this poses to the financial sector was laid bare during the stock market crisis of 2015, which, having caught authorities off guard, led to belated and extemporaneous responses. The crash accelerated capital outflows, forcing the central bank to drain its foreign exchange reserves to stabilize the yuan. Alarmed by the crisis, along with continued runaway credit growth, Beijing has launched a raft of reform initiatives. Earlier this year, in fact, Xi elevated the importance of financial stability and strengthened the role of the judiciary in combating financial crimes. Here, too, results have been mixed, though they exemplify the limits of China’s emerging model.


(click to enlarge)

For example, authorities have tried to insulate China’s banking system from risk in industries highly exposed to real estate volatility, such as construction and building materials. But banks have skirted this restriction by off-balance sheet investments such as “wealth management products” – opaque, lightly regulated securities that leave banks no less exposed to volatility. An estimated $9 trillion is believed to have been poured into such vehicles. The China Banking Association’s 2017 annual report showed that off-balance sheet assets in the Chinese financial system are 109 percent of on-balance sheet assets (approximately $38 trillion). WMPs have been particularly problematic, since investors often assume that they are guaranteed by the central government and thus risk-free. Notably, Beijing has gone out of its way to make clear that WMPs do not have state guarantees. This, along with new regulations, appears to have slowed their growth over the first half of this year, from 43 percent to around 8 percent, according to official figures. Given the systemic risk some WMPs pose to the Chinese economy, however, Beijing would have little choice but to come to their rescue, so the government’s denial of implicit guarantees rings hollow.

The prospects of modernizing the country’s outdated financial regulatory system likewise remain cloudy. This summer, a strengthened oversight body monitoring China’s banking, securities and insurance regulators was established to eliminate the sort of regulatory arbitrage that has helped fuel the rise of WMPs and other shady investment vehicles. As has become common with Xi’s reforms, the move was accompanied by stern punishments for misbehaving firms, and senior regulators were felled by anti-graft probes. But Beijing has refrained from overhauling the entire regulatory framework, at least for now, in ways that would make it better equipped to handle modern financial instruments. Decisions on the final shape of the new system were evidently delayed until after the congress.

Ultimately, Beijing has learned that where there’s will to invest, there’s a way. Though it has the ability to respond to problems forcefully, the central government lacks the financial oversight to anticipate and deflate bubbles before they become too large. In any case, it may not even have the political capital needed to gain such oversight.

An Orderly Decline

Difficult though it may have been for Xi to implement in his first term the kind of reforms China needs, there is reason to believe it may be easier in his second. With newfound power, rules and regulations could be easier to enforce. The more stable and secure Xi’s administration is at the top – and the more the lower ranks fear its power – the more it can sideline, without fear of recourse, those who resist reform. The more stakeholders stand to lose from contentious reforms, the more important Xi’s impunity becomes. With loyalists in key positions, Xi will be able to shepherd potentially controversial policies through a much more coherent bureaucracy, or at least one that is not actively hostile to his cause.

Reform and power, in other words, are mutually beneficial. Reform can mitigate the risks of economic disruption, which would, in turn, make officials such as Xi politically vulnerable. Well-enforced reforms disrupt rival patronage networks and open positions for loyalists, who are more likely to carry out the reforms.

High-profile reforms, moreover, reinforce the narrative that party leaders alone can keep the country together. And the more popular Xi is among the masses, the more weight the central government can bring to bear in pursuit of reform, particularly when Xi endorses or advocates an issue. For example, Xi has been visibly involved in environmental reform, dramatically cracking down on provincial polluters through environmental inspection teams consisting of high-ranking officials and, critically, enforcers from the now-feared CCDI. (In China, environmental reform is particularly politically important because of public health; officials can’t convince the masses that they are not seeing China’s famously thick smoke when, in fact, they are.)

Finally, a tightly centralized government is, in theory, better equipped to manage the risk of mass unrest associated with disruptions to the status quo. Control of the media, cyberspace and other purveyors of information – this enables Beijing to manage the inevitable fallout generated by ambitious socio-economic change.

The limitations to centralized control, though, are obvious: Authoritarian governments and command economies have a shaky track record, to say the least. And Xi himself wasn’t always successful in his first term. In an authoritarian regime, success is contingent on the talents of the leader and his inner circle. It risks creating a culture that prioritizes loyalty over technocratic talent and expertise. Similarly, it can engender the practice of picking winners based on political favor rather than performance.

Centralization also risks fostering echo chambers that leave leaders blind to realities on the ground and thus looming crises while skewing the performance incentives of lower-level officials. The tragedy of Mao’s Great Leap Forward, when lower-level cadres routinely overreported steel output, is a cautionary tale well-understood in Beijing. More recently, these problems were illustrated by the revelation that several depressed provinces were in effect cooking their books, regularly overstating their growth rates to keep Beijing at bay. The first phase of the 2014 debt swap initiative, meanwhile, failed in part because depressed local entities were incentivized to overstate their debt burdens.

The regime’s slow and uneven response to the 2015 stock market upheaval exposed how rigid, top-down systems, in which power is delegated reluctantly, can become paralyzed in a crisis. There are, simply put, fewer people available to conduct the affairs of state – something that is particularly problematic in a model that infrequently allows market principles to cleanse the system. Centralization, particularly when built around a cult of personality, can also hinder the development of state institutions needed for sustainable reform. Xi’s reliance on leadership small groups, rather than large, established entities, for policymaking and implementation is a risk in this regard.

Most important, the things that prevented Xi from doing anything more than taking aim at easy targets and picking off low-hanging fruit are not going away. The potential for high-level power struggles will not simply vanish once the congress ends. The CPC’s economic and political imperatives will continue to conflict. For reforms to be successful, they need to be rooted in economic reality, yet political imperatives mean the CPC will never be able to tolerate the levels of unemployment such reforms would create.

China’s fundamental problem will remain the same. It’s trapped between contradictory forces, and trade-offs cannot be wished away, no matter how powerful Xi becomes. Measures to deflate the real estate bubble risk worsening overcapacity in construction and ancillary industries, which itself risks inflating corporate and household debt. Measures to keep underwater firms afloat with easy credit encourages continued profligacy. Every leak in the dam you plug risks springing another three. When buoyed by robust growth, these trade-offs are more palatable. (In fact, the most innovative and successful reform efforts to date have occurred in coastal provinces with the strongest economies.) But China has entered a prolonged period of declining growth and remains highly vulnerable to external shocks. In a country of 1.4 billion people, neither a painful U.S.-style correction nor a Japan-style “lost decade” is tolerable for a single-party government that has taken full credit for the boom years. It’s only realistic choice is to try to nip and tuck its way to an orderly decline.

Understanding that this is so, a quorum of Chinese elite has accepted Xi’s unprecedented consolidation of power, which may yet give Beijing some of the tools it needs to muddle forward. The government’s large foreign exchange reserves, an invaluable buffer to shocks against the system, give China some breathing room. But in this environment, Xi’s reform agenda over the next five years will boil down to a single overriding objective: staving off a reckoning.