Does China know it must change?

Authors: Derek Scissors and Dean Cheng, Heritage Foundation

In late 2009, it was widely believed that the apparent effectiveness of China’s response to the financial crisis demonstrated the advantages of statist over market models. Now, it is generally recognised that the PRC must eventually return to the market path.

Part and parcel of this is the belief that the Chinese Communist Party leadership will understand and act accordingly. Market reform will return because it will be accepted as necessary, and the Politburo is reliably pragmatic.

That was certainly true in the past, as seen by Deng Xiaoping’s maxim, ‘as long as it catches mice’, and so forth. But Deng Xiaoping is long dead, and his final designated successor is soon to formally retire. There are now powerful reasons to doubt the Party’s pragmatism, at least as pragmatism is understood on the outside.

The first is the most basic: the Party has already made a pivotal economic decision that did not appear pragmatic and that was certainly anti-market. Not coincidentally, it was tied to a decline in Deng’s influence. At the 16th Congress in 2002, Wen Jiabao replaced Deng’s chosen economic helmsman, Zhu Rongji, as Premier. Economic strategy then shifted. While GDP growth has been rapid under Hu Jintao and Wen Jiabao, the Party’s policies have often been damaging or unsustainable.

In 2001, investment and consumption were comparatively balanced. Hu’s government moved quickly and decisively to spur investment. Now the gap between the investment and consumption shares of GDP is unprecedented outside of command economies. If market reform is to be renewed, the dominance of investment must be reversed, painfully. Thus, it is hard to see the investment surge as pragmatic, though there certainly have been benefits.

The explanation for the departure from pragmatism may be that a good portion of these benefits accrued to senior Party members. Subsidies have enabled excess investment. In 2002, lending — dominated by state financials — surged. Investment followed in 2003. The extent of this program is seen in the rising ratio of loans and money supply to GDP. China’s 2011 GDP was half that of the US but broad money (M2) was 40 per cent larger. Such high leveraging suits the interest of state-owned borrowers, managed by Party members, but few others. This is one way in which some cadres have benefited from the departure of pragmatism.

Investment is also financed from profits ensured by anti-competitive regulation, often described as consolidation. In 2006, the State Council explicitly asserted control of energy, telecommunications and other sectors, to go with implicit control of the banking, rail and others sectors. The guaranteed profits for SOEs since have helped make high-ranking Party members stunningly wealthy.

There was no genuine need to reassert state leadership in 2003 — there were no economic contradictions and little social pressure demanding a change of course. The obvious explanation is that elites representing the state sector seized Zhu’s departure to fundamentally alter economic policy. This was what was best for the bulk of the Party leadership, not for China.

The Party consciously eschewed market reform for self-serving reasons in 2003; now it has billions of RMB more reason to hold on to statism. Deng’s approach will only become more remote, both in time and in terms of the leaders he picked.

The fading of pragmatism is discernable in the security realm as well. Where Deng had emphasised hiding one’s abilities and biding one’s time, the Party now appears to prefer grabbing while the grabbing is good.

Deng had deferred discussions about such thorny issues as territorial disputes, and emphasised maintaining cordial relations with China’s neighbours. The current leadership, by contrast, has created an arc of tension, from Japan (over the Senkakus) and Korea (over Socotra rock) to various Southeast Asian nations (over claims in the South China Sea) and India (over the Indian state of Arunachal Pradesh).

This may be intended to distract the population from the impact of an economic slow-down or income inequality due to corruption. In any case, it has more the scent of avarice, or perhaps desperation, than the scent of pragmatism. Looking forward, Beijing is pushing itself into a corner, as such sentiments cannot be easily abated.

An economic shift also looks challenging. High, investment-led growth has been very good for Party members, while lower, consumption-led growth would be better for the country. This was recognised in state media as early as 2003, but Party leadership put itself first. There is more pressure now to boost consumption but there are also groups that have gained tremendously from surging investment.

Rebalancing will require consumption to grow faster than investment for perhaps Xi Jinping’s entire 10-year term. As consumption cannot match the wildly fast investment gains under Hu, choosing to rebalance is choosing much slower investment. This guarantees slower GDP growth, so both the new national and many provincial leaders will appear to have failed.

Market reform would enable rebalancing and thus be sustainable. Still higher investment shares would push the PRC back toward a command economy. This is only pragmatic if the goal is to abandon the market. Yet the final outcome cannot be assured due to the self-interest of Party members. Similarly, distraction in the form of an appeal to nationalism has been pursued despite containing the seeds of political turmoil. The pragmatism of the Party should be in doubt.

Derek Scissors is a Senior Research Fellow at the Heritage Foundation. Dean Cheng is a Research Fellow at the Heritage Foundation