Can Xi Jinping Turn China’s Economy Around?

When things hit their extreme, they can only move to the opposite direction—物极必反 (wù jí bì fǎn)– is an idiom that seems to sum up perfectly punditry about China. Where once Beijing seemingly could do no wrong and China was poised to dominate and conquer the global economy now and forevermore, now words of doom, gloom, and crisis dominate the media and spread their fear far into the non-Chinese world trying to make sense of what’s going on.

Extremism to be followed by inevitable reversal seems to be affecting President Xi Jinping as well. Where once China’s leaders seemed pragmatic and technocratic, Xi has plumped for a full-scale switch into politics-led policy, whether it be the long- needed crackdown on corruption that has become so threatening that many officials seem paralyzed and incapable of even the most sensible decisions, or the misguided, politically-charged “rescue” of the stock market that has thrown Beijing’s commitment to true economic reform into question.

Xi’s “China Dream” threatens to become a nightmare. Like all those affected by nightmares, however, waking up and clearing the head is the most sensible cure.

Both China watchers and (more importantly) Chinese officials need to be aware of the more ancient doctrine of the mean (中庸之道 / zhōngyōng zhī dào).

China’s figurative skies are neither clear as a verdant glade’s nor as black as one of Beijing’s most polluted days. The good and the bad in China today need to be assessed and dealt with soberly and carefully, without unhelpful emotion. The economy itself couldn’t stand the sudden, pure immersion into untrammeled market discipline, but it certainly is not helped by purely political decisions and measures. The ills of the stock market and, much more importantly, the wider economy, need to be fixed by a swift but unrushed march down the well-signaled path of important and necessary structural reforms.

Can President Xi Jinping do it? The answer depends on his assessment of, and more importantly the reality of, the strength of his political position. From the outside, it certainly looks like he should have the confidence to temper his political campaigns with a real dose of economic pragmatism. But as ever, perhaps the move to the dangerous extreme still has some way to go before the reversal can begin.

My esteemed colleagues and friends have already identified some of the pitfalls related to the recent market sell off and subsequent draconian reactions by the government. I agree with Arthur Kroeber that the sell off has had limited impact on the broader economy and that a greater challenge is the government's neglect of genuine reform thus far. The only exception is the government's freezing of trillions of RMB in assets held by major shareholders. I agree with George Chen that the securities regulators have damaged the reputation of China’s capital market by blaming the sell off on a variety of conspiracies. Finally, I concur with David Schlesinger that the government’s reaction to the sell off is symptomatic of the politics of the extremes under Xi Jinping. However, I think for foreign investors in general, but especially portfolio investors, the recent events represent something much more disturbing and ominous in the medium term.

In essence, the Chinese equity market has become a legal swamp in which no cautious investor would want to tread. With the latest batch of rescue measures for the market, investors now face risks that are associated with destabilizing developing countries rather than the second largest economy in the world. Asset seizure, insider trading, and rampant leveraging all now are sanctioned by the Chinese government. Securities regulators also seem to rely increasingly on arbitrary enforcement from which investors have little legal recourse.

At the bottom of the crash on July 8th, China’s stock regulator rolled out the infamous “Announcement 18” which threatened “severe punishment” for any senior management or controlling shareholder—one with a stake of 5% or greater—for selling any shares of a listed company over the next six month by for six months. With a single announcement, trillions of RMB in assets belonging to some of China’s wealthiest investors were frozen for at half a year. Making things worse, the securities regulator announced no concrete plans for how and when major shareholders could resume selling their shares, stating instead merely that rules for future selling would be outlined in “further decrees.” In essence, there is absolutely nothing to stop the Chinese government from freezing the shares of major shareholders for another six months or even longer. It is as if their assets have been seized by the government in order to stabilize the market. This likely will have a significant implication for the economy because some of China's wealthiest investors will need to pay a significant cost to liquidate a major part of their assets in order to invest in something else. Private sector investment likely will suffer from this illiquidity.

For foreign investors, the implications are quite stark. If the Chinese government can freeze trillions in assets of its wealthiest citizens, it certainly will not hesitate to freeze or seize the assets of foreign investors. This logic pertains to both the equities market and the fixed income market.

The other legal morass created by the Chinese rescue effort has to do with the de facto legalization of insider trading. In an effort to encourage major shareholders and senior executives to start buying shares of their companies, the authorities allowed insiders to buy shares of a company during earnings season, which previous regulations had forbidden. To be sure, this exemption only applied to companies whose shares had fallen 30% or more, but the vast majority of companies trading in both Shanghai and Shenzhen had seen their shares plummet by at least that much by the time the regulation was announced. As a result, insiders of most listed companies now can buy shares based on inside information without any legal ramifications. Again, it is unclear how long this emergency decree will be effective. We could see legal insider trading persist for months to come. How can pension and endowment funds in societies with much stronger rule of law justify trading in a market where inside trading is effectively legal?

Finally, Caixin revealed that banks in China had granted the China Securities Finance Corporation 2 trillion RMB in lines of credit, which financed its massive purchases of equities in the market. The China Securities Finance Corporation is a joint stock company owned by all the major exchanges in China with the main purpose of channeling margin financing to the brokers. When the crisis occurred, the Chinese government turned CSFC into a bailout fund, which channeled bank loans into the stock market. It turns out that CSFC’s borrowing is illegal according to a China Banking Regulatory Commission decree from 2006, which clearly states that “no corporation or individual can use bank loans to directly or indirectly invest in the stock market.” In any event, stocks became highly inflated in the first place because investors borrowed heavily to buy, and now the government wants to do so itself. This shows that prudential regulation and laws are worthless in the face of the Chinese government’s imperative to maintain stability.

To be sure, officials in the Chinese government and China optimists may proudly claim that a crisis was averted. That is true for now. However, let us also be upfront with the costs of arresting the crash for the moment—the Chinese capital market no longer has any credibility because every rule, even a fundamental rule like property rights, can be violated in the name of stability. In the face of this overriding imperative, investors have no recourse if their rights are violated or if they made losses due to the rules’ being ignored. Much of the hard work by Chinese technocrats and legal professionals in the past two decades to enhance the credibility of the stock market has gone to waste because of the rescue. Now, only punters who invest by guessing at the size of government intervention on a daily basis would want to wade into this market.

Xi Jinping could, if he acts boldly, arrest the slowdown in China’s growth. But 7% growth over the next decade is extremely unlikely and the figure could be much lower.

My concern about growth partly reflects history. China’s growth is unprecedented, 10% a year for three decades. Everything we know about economic development suggests that growth will slow. The old strategy of simply shoveling underpriced land, labor, and capital at economic challenges doesn’t work forever. China is at that point where workers’ wages go up a lot faster than their productivity and even cheap capital doesn’t produce much of a return.

As Larry Summers has written, we don’t know precisely when or why or how much China’s growth will decelerate, but just as Japan, South Korea, and the other so-called East Asian miracle economies sputtered, so, too, will China. Summers expects annual growth of 3.89% from 2013-2033, little more than half the consensus forecast of 7%. The Conference Board takes a different approach, focusing on productivity, but arrives at similarly sobering conclusions.

Nearer-term, there’s reason for concern that the government simply is not serious about reform. Partly that’s because officials worry about making any changes at a time of slowing growth.

Another problem is a fear of upsetting narrow self-interested industries.

Former Premier Zhu Rongji privatized state-owned enterprises and ended lifetime employment for tens of millions of workers. He and President Jiang Zemin also made the strategic decision to bring China into the World Trade Organization as a way of jump-starting flagging reforms. Would Xi Jinping act this boldly in economic affairs? It seems that he will not—or perhaps politically he cannot.

China has succeeded because the government has enjoyed a high degree of autonomy to make policies for the overall good of the country. That was also the case with many of its East Asian neighbors. Japan, then South Korea, Taiwan, Hong Kong, and Singapore, all pursued high-growth economic policies. Growth gave political legitimacy, and, from South Korea’s Park Chung Hee to Singapore’s Lee Kwan Yew, policies designed to promote economic growth swept away many obstacles. Sure, there were always special interests whose voice was heard, but state power in the service of economic growth was the rule.

Today, reforms in China are flagging. The service sector, especially retailing and distribution, badly needs opening. So, too, does finance. SOEs dominate sectors like telecoms, electricity, and energy.

The short-term solution is to deregulate protected sectors. China has talked for more than a decade about the need to re-balance its economy. Consumers only account for about one-third of the Chinese economy, compared with more than twice that in the U.S. Yet there has been little done to shift the balance to encourage consumption and throttle back investment.

It might seem odd to raise the issue of state capture by special interests at a time when Xi Jinping exercises such political control, but it is an issue that deserves more attention.

If Xi Jinping cannot reform China’s economy, who can? It’s often said that Xi is the country’s most powerful leader since Mao. But in economic affairs he doesn’t appear to be the equal of Zhu Rongji.

Eventually this equity bubble will evaporate and, given the minor role equities play in China’s financial system, its economic impact will be limited. The more important issue is whether China’s leadership will have learned the right lessons. China’s economy is becoming more market driven but, while this offers greater efficiencies than under a centrally- controlled system, it is also inherently less stable. The lesson is that markets cannot be based on the unwarranted faith in the power of government intentions but need appropriate regulatory agencies to protect the public.

The last time there was a bubble was in 2006-7, when the Shanghai Composite Index soared from 1,000 to 6,000, and then, within a year, collapsed to 2,000, where it remained until June 2014. With economic growth slackening, this recent surge was unrelated to fundamentals but the result of two well-intentioned but poorly implemented state-driven policy decisions. Policy makers rightly felt that savers needed a broader array of investment options beyond just parking their money with banks or buying property. Their second objective was to use the equity market to moderate the country’s debt burden by encouraging companies to secure financing through equities. To make all this work, the China Securities Regulatory Commission (CSRC) and others talked up the gains to be achieved by investing in stocks.

With a leadership that was championing equity markets, the average citizen was persuaded of an opportunity for enrichment. The financial community also realized that if China’s request to be included in the MSCI Emerging Market index was approved it would trigger additional global demand. The market euphoria also was boosted as countless retail investors bought stocks on margin with borrowed money. Yet while the CSRC expressed caution at times, it was not firm enough in reining in excessive leveraged buying.

Months before the crash began sentiments were beginning to shift. First was a gradual realization that prices had overshot fundamentals and doubts about the power of government intentions to sustain such increases. When the decision to include China in the MSCI global stock index was shelved in early June, sentiments totally changed. The slide was now in full force but any possibility of moderating it was negated by the margin calls, which triggered even more selling. The same forces that exacerbated the market’s rise made it inevitable that the decline would be amplified. Recent stopgap measures to prevent selling and encourage buying may have temporarily stabilized the market. But statements that the authorities would not be satisfied until the index rose back to at least 4500 was a repeat of previous mistakes in trying to promote higher prices rather than establish a credible floor.

When emotions have settled down, the lesson from this bubble should be that equity markets must be driven by market forces and not by government sentiments. Thus the role of the state as a regulator to protect standards and mitigate risks should not be compromised by conflicting pressures to champion rising equity prices. For this to happen, the role and accountability of senior officials of regulatory agencies such as CSRC need to be clearly separated from China’s party-dominated personnel process to provide assurances that its equity markets are really markets.