In the year that China celebrated the 40th anniversary of Deng Xiaoping’s landmark economic reform, which lifted hundreds of millions of people out of poverty, the country’s economy seems to have lost steam. Officially, China still managed a growth rate of 6.5% in 3Q18 but manufacturing indicators, as measured by for example car sales, are flashing red. Korea’s exports to China, a reliable bellwether for assessing China’s economic health, fell by 13.9% yoy. Going into 2019, the government, therefore, is taking the ritual steps to address the slowdown: fiscal and monetary easing. For example, the People’s Bank of China, the country’s central bank, has cut its required reserve ratio by 1% to stimulate lending, thereby injecting USD 117 billion in the banking system, whereas USD 125 billion of new rail projects were hastily approved. Tax cuts on personal income have been pushed through to stimulate consumer spending and companies receive 50% rebates on unemployment insurance if they do not lay off staff. Oh yes, and China’s censors have told journalists not the report on slowing growth. The protracted trade war with the U.S. and, more generally, reduced global demand is brought up as the cause for the poor economic activity. However, this is not the only explanation. China’s economic model is also to blame. China’s leadership must embrace reform in order to be able to deliver growth in the future. This is important if the regime wants to maintain social stability (i.e. low unemployment).
China’s CEO…
Since Mr. Xi is in power, he has been talking about the need to reform the economy, moving from exports to consumption and from industry to services (from mining to dining, so to say). To a certain extent this has happened. Consumption increased and services have become a more important component of growth, although we still have to see how real the new jobs in China’s gig economy turn out to be once growth tails off and whether the unbridled appetite to save by the country’s citizens is finally relenting.
But real reform has not taken hold yet. This means addressing overcapacity in a number of industries (by letting firms fail) and liberalizing markets to endow private (and foreign) companies with a bigger heft of economic activity (thereby further stimulating innovation and competition). However, it seems that under Mr. Xi China is moving away from Deng’s reform agenda. We would argue that China has become even more centrally directed since Xi’s ascend to the throne. State companies (SOEs) have not been reformed and take the biggest slice of credit offered by the 4 state banks to invest in unproductive or, at best, low-return projects. Indeed, Mr. Xi has strengthened party committees’ control in both state and private companies, who have the task to ensure implementation of the government’s industrial policies. This centralization drive is exacerbated by the government’s Pavlov response to signs of a slowing economy. Each time the economy softens, the government is instructing banks to fund infra projects for which there is little need, misallocating resources and distorting the economy whilst at the same time chalking up ever more debt in the process (although the increase in debt accumulation has dropped in the last 2 years, the credit-to-GDP gap in 2Q18 was still an uncomfortably high +12.3%, according to the BIS). And, although poverty has been greatly reduced, inequality in China has grown to very high levels. The Gini coefficient is estimated at 50 (compared to 41.5 for the U.S.) according to a recent IMF study by Sonali Jain-Chandra, up by 15 points since 1990. Deng’s claim that “poverty is not socialism, to be rich is glorious” seems to get a whole new meaning. Inequality may threaten social stability, thus reforms in respect of (access to) education, taxation (being more redistributive, for example by shifting from consumption to personal income taxes) and the hukou system (which limits migration to urban areas where incomes are higher) should be sped up. Indeed, transferring wealth from vested interests (SOEs and local governments, for example) to Chinese households and private companies could go a long way to repair China’s economic model.
Some have it all…
Structural reforms inevitably imply a slowdown in growth until the new economy takes shape. Mr. Xi seems afraid to sacrifice short-term unsustainable debt-fueled growth for long-term widely shared growth, brought about by innovative private and foreign enterprises, operating on a level playing field with SOEs. The recommended reforms would also address some of the problems underlying the trade war with the U.S.
Mr. Xi should follow in the footsteps of his illustrious predecessor by bowing to the truth that shared prosperity and continuous economic reforms are essential for both the country’s and Xi’s own future.