China’s medium- and long-term economic outlook depends more than anything else on the outcome of the political maneuvering and horse-trading that has dominated 2016 and will culminate in the 19th National Congress of the Communist Party, to be held next year, probably in November. With a majority of Beijing’s most senior leaders retiring next year, China is likely to witness a major shift in the composition of its leadership.
Next year’s leadership shift will be the first since the beginning of Deng Xiaoping’s reforms to occur in the context of deep concerns about the economic future. A growing number among the national and provincial leaders recognize how urgent it is to implement reforms that will take China through the difficult economic adjustment it faces, but because they effectively require the allocation of substantial adjustment costs to provincial governments and elites, it will be politically extremely difficult to implement them. How successfully President Xi Jinping consolidates power will determine how quickly China is able to implement these reforms and how long it will take before the country is able to renew its long-term growth.
To understand the great challenges facing Beijing it is important to understand how we got to where we are. In the late 1970s and early 1980s China implemented a series of major economic reforms under Deng Xiaoping, after which, for the next three and a half decades, China’s share of global GDP grew more rapidly than that of any other country since Argentina in the four decades before the First World War.
Some analysts describe this period as consisting of a unified set of policies, but this approach makes it hard to understand why China needs so urgently to change its economic policies and why these changes will be difficult to implement. It is far more useful to think of this period as consisting of four very different stages, the last of which we have only, and with very great difficulty, begun.
The economic surge
The first period began at the end of the 1970s with the Chinese economy in dire straits. Mao-era polices had imposed a series of constraints on the production and distribution of goods and services which distorted incentives and punished individual initiative severely enough to repress productivity and even induce famines.
This had to change. Beijing under Deng removed many of these constraints, thus allowing Chinese individuals to improve substantially both the production and the distribution of goods. These liberalizing reforms relaxed the laws that governed economic activity, freed workers and farmers from their work units, eliminated prohibitions on private initiative, and reduced the role of central planning in favor of localized planning.
Their impact on productivity growth was enormous, but they came at a price. By relaxing constraints, they sharply weakened the power of the bureaucratic elite, and so, not surprisingly, Deng faced determined political resistance. He nonetheless was a brilliant strategist, and fortunate in that power was highly centralized among a small group of loyal supporters, and so he was successful in forcing his reforms onto a reluctant Party. Even as late as 1992, however, Deng’s famous Southern Tour was organized primarily to deal with continued provincial resistance.
This opposition should have been expected. Liberalizing reforms nearly always draw the ire of the existing elite, and historical precedents show that radical reforms of these types are successful only in countries either with highly competitive political systems, like liberal democracies, or in countries with the highly centralized power of China under Deng Xiaoping.
By the early 1990s after many years of growth unleashed by the relaxing of Mao-era restraints, it became clear that China’s terribly weak logistical, transportation and financial infrastructure was severely constraining continued rapid growth in manufacturing. This is when China embarked upon the second stage of its growth period, which was driven by a new set of policies. These were designed to force up the country’s savings rates by repressing the share of GDP growth retained by households, the intended effect of which was to keep consumption growing more slowly than GDP. This proved immensely successful and China’s savings rate surged to the highest ever seen for any large economy in modern history. Central authorities were then able to direct surging savings into investments that the country urgently and obviously needed.
The new policies were similar to those that had been followed by earlier miracle countries, including most famously the USSR in the 1950s and early 1960s, Brazil in the 1960s and 1970s, and Japan in the 1980s. Chinese savings poured into badly-needed infrastructure, real estate and manufacturing capacity, setting off explosive growth. It is worth noting that distributing ever larger amounts of resources to favored sectors and groups closely connected to local elites simultaneously dispersed power widely and ensured that Beijing’s policies received strong support from local centers of power.
Every case in modern history of a country following similar policies reaches a point at which investment saturates the economy’s ability to absorb it productively, but policymakers prove unable to rein it in, and so as they maintain excessive investment growth well beyond the point at which it is justified, debt begins to grow faster than debt-servicing capacity. In every case the investment growth miracle was followed either by a debt crisis or by a period in which soaring debt forces growth to drop precipitously.
Clearly China has not been an exception. China entered this third stage some time in the early 2000s. As it continued massively overinvesting, however, foreign and Chinese economists found imaginative ways of explaining why historical precedents were irrelevant (citing, ironically enough, the same reasons as their predecessors did), but as GDP growth remained high, the growth in real wealth decelerated and the growth in debt inexorably outpaced both.
China is now attempting to begin the fourth stage of its growth period. It must rein in credit growth and investment, but to prevent a consequent collapse in economic activity it must first increase the household share of total wealth, and this must come at the expense of local governments. It must also pay down debt, likewise at the expense of local governments, and it must reduce or even eliminate the channeling of resources to the groups that misallocate capital and resources.
The policies Beijing must now implement, in other words, require a radical change in the way the benefits of growth are distributed. In a sense China must repeat the first stage of its growth period, in which the needs of the economy and the interests of the elite are in opposition. China must shift from a model whose high growth rates disproportionately benefited the elite to one of slower growth in which their privileges are sharply reduced while ordinary Chinese and small businesses benefit disproportionately. Not surprisingly, the Chinese elite, excoriated as vested interests in the domestic press, strongly resist this shift.
The Chinese outlook
President Xi Jinping seems clearly to understand the political difficulty of rebalancing the Chinese economy, and so it is no surprise that his first steps in government have been to consolidate power and to weaken potential opposition. It took highly centralized power under Deng Xiaoping to implement the liberalizing reforms of the 1980s, and it will probably take a return to highly centralized power to implement a new series of liberalizing reforms.
It is too early to say how things will pan out in the run-up to the 19th Party Congress, but there are some obvious signs to watch for. If the president is successful in consolidating power and can implement the necessary reforms, the likelihood of a debt crisis will recede sharply and the deceleration of GDP growth rates will steepen, but in an orderly way. Beijing will begin to de-emphasize the very unrealistic GDP growth target and we will probably start to see real steps taken to transfer wealth from local governments either to the household sector or to pay down debt. These include programs of privatization or other forms of asset liquidation.
If not, debt will continue to surge as the leadership remains under pressure to maintain GDP growth targets and to stick to a growth model that benefits the vested interests. As this happens, however, China’s balance sheet will become increasingly fragile and capital outflows will remain high. As debt rises to dizzying levels, Beijing will seem more and more determined to rein it in, but GDP growth targets are also implicitly credit growth targets, and any success in reining in one form of debt will be undermined by surging debt in another form.
This is the great challenge that the president faces and it is the reason why the transformation of the leadership that will occur next year is such an important one. China faces a difficult adjustment, one that every historical precedent suggests will dramatically transform both China’s economy and the distribution of the benefits of growth. Fortunately, after years of misstep with the previous administration, Xi’s administration seems clearly to understand the difficult path China must follow, but it will take great political skill to actually follow this path, and the 19th Party Congress will be a key roadblock that he must successfully pass through.
Michael Pettis is a finance professor at Peking University’s Guanghua School of Management and a senior associate at the Carnegie Endowment for International Peace. He is the author of several books, including The Great Rebalancing and Avoiding the Fall. Prior to moving to China in 2002, Pettis spent 15 years on Wall Street and also taught courses in finance, bond mathematics and economic history at Columbia University’s Graduate School of Business.