The Hunt for a Less Red October

China’s leaders convene the 19^th Party Congress on October 18. Human minds naturally seek out narratives, and one of today’s predominant China stories is that this political milestone will mark the restart of stalled economic reforms.  The argument for an impending sea change has three sources: extrapolation from past Party Congress patterns; constant repetition of the mantra that power consolidation is key to unlocking reform; and analysis of current, preliminary policy moves and the urgency of reform to head off crisis. If the Congress does kick off reform, an epic shift in supply and demand projections lies ahead. If not, or if reform arrives only rhetorically, a different kind of trouble lies ahead. China’s new leadership will likely soon declare that a brave new era of reform is afoot. Will that mean to them what it means to us, and how are we to objectively tell the difference between a real “big bang” and reform in pledges only?

On October 18, China’s leaders will convene the 19^th National Congress of the Chinese Communist Party, a meeting held every five years, where changes to Party leadership and the Party constitution are decided.  This is not a policy meeting, but a political one, to settle Communist Party affairs and positions. No policy statement typically accompanies the end of the Congress, but a new Party leadership will be announced for the 205-member Central Committee, the 25-member Politburo and the paramount Politburo Standing Committee, currently consisting of seven members (ratcheted down from nine at the last Congress).

Often these events mark critical political transitions: the even-numbered Congresses since 1992 have anointed new leaders for the start of a 10-year era, while the odd numbers introduce the heirs apparent likely to lead the next generation. Despite the firm grip of the Party, there is always potential vulnerability in transition for a one-Party state in a culture that has struggled with factionalism and succession politics.

After becoming General Secretary in 2012, Xi Jinping launched an aggressive anti-corruption campaign, which challenged Party norms and rivals alike, while centralizing his position in Party institutions and policy-making leadership groups. These campaigns have toppled powerful vested interests, and threaten to do so further, and thus, the specter of Party disunity from elite-level losers still looms. This has implications for economic policy-making and the prospects for structural reform.

Past Congresses: Reform Let Loose?

Prior odd-numbered Party Congresses took place in 2007, 1997, 1987 and 1977, although the “mid-term” pattern did not fully arise until the two most recent cycles. In 1977 there was not a clear policy direction, or for that matter clear leadership.  After Mao’s death, his loyal retainer Hua Guofeng was ushered into power in 1976 only briefly, before his continued commitment to Maoism sealed the decision of other Party elders to push him aside in December 1978 at the Third Plenum session of that Congress, in favor of Deng Xiaoping. This was the same meeting that marked the start of the reform era.

The 13^th Party Congress held in 1987 did serve as a turning point for reform. Deng orchestrated significant personnel changes throughout the central leadership, both in terms of introducing supporters of his “reform and opening” line and sidelining opponents. In this way, the politics of the Congress foreshadowed the policy moves to come. Those policy changes promoted marketization, but with it hyper-inflation and problems contributing to the Tiananmen protests and retrenchment of 1989-1992 before Deng was able to get his reform policy back on track. While the 14^th Congress in 1992 confirmed Jiang Zemin (a compromise choice) in the leadership role he had assumed on an extraordinary basis after the removal of Zhao Ziyang in 1989, the new Standing Committee reflected the need to balance factions after the recent turmoil, and thus no decisiveness in policy direction was evident: Deng’s “southern tour” that year, in which he demonstrated the primacy of reform, carried more doctrinal weight than the Congress itself.

At the odd-numbered 15^th Party Congress in 1997, the Party leadership did indeed deliver a seminal, doctrinal shift that would trigger much of the growth of the decade ahead: state enterprise reform.  The Congress was made to vote on and ratify a program to sell off shares in more than 100,000 SOEs, in a bold experiment. Plans included the transformation of big SOEs where the state would remain dominant into more normal corporations, while smaller firms were essentially privatized (though that word is still avoided today). “Grasping the big, releasing the small” became the catchphrase. Importantly, in typical form, this endorsement of industrial reorganization lacked implementation specifics, and thus the nature of China’s “marketization” remains muddled even today; but there is no question that the Congress helped signal an era of adjustment and investment opportunities.

The 16^th Party Congress in 2002 handed power to Hu Jintao, a transition believed to have been programmed years earlier by Deng and other Party elders. After the tumultuous late 1990s, with major structural adjustments following the 15^th Congress orchestrated by Premier Zhu Rongji, the Asian Financial Crisis, the Internet equity market bubble, the 9/11 attacks and the drama around China’s WTO entry in December 2001, the 2002 Congress was about consolidation rather than major policy innovations.  The 17^th Party Congress in 2007 was marked by whispering about factions, and a general tendency to maintain the status quo.  The most interesting outcomes seemed to be the clarifications of future leadership alignments. As the Global Financial Crisis deepened and signs of popular upheavals in many societies spread, Beijing was trending risk-averse, and in this timeframe a raft of studies emerged concluding that reform was slowing down in China.

What is the bottom line then in terms of the linkages between Party Congresses – especially mid-term – and reform triggers? There have been strong examples of Party Congresses signaling reform momentum despite their inherently “political” purpose (1987, 1997), but also a reduced pattern of decisiveness in the presence of conservative leadership as the Party hunkered down (2007).  General Secretary Xi, elevated to the top of China’s leadership at the 18^th Party Congress in 2012, surprised observers with a broad economic policy reform manifesto in 2013 at the Third Plenum meeting (the “60 Decisions”), but has demonstrated conservative instincts since. If Xi believes reinvigorating reform is important, the 19^th Party Congress will promote that by way of ratifying important components and tapping reformers for key positions.

Xi has changed the basic mode of Chinese politics by concentrating his position within key leadership decision-making bodies and through his designation as the “core” of Party leadership, rather than simply a member of the “collective leadership” of the Party.  Xi leads at least six of the most significant policy-making Leading Groups, a significant change from his predecessors.  In addition, he has made considerable efforts to personalize his standing within the military, where recently he has been greeted as “chairman” rather than the more impersonal “leader” of the People’s Liberation Army.

But given the shift in the political structure that Xi has overseen – with power based more fully with his executive office rather than in the composition of the Politburo Standing Committee, the outcome of the Party Congress in personnel terms matters less than in the past. There is simply less policy significance in the factional arrangement of representation within the “lineup” of Politburo Standing Committee members to be announced at the Party Congress.  While different factions will still seek representation, the Chinese leadership is in transition toward something resembling a “strong executive” model under Xi, rather than depending upon consensus-building among different factions.

Power Consolidation and Reform

Many observers have argued that a concentration of authority is needed to produce a meaningful shift in economic outcomes in China. But the evidence is clear that Xi Jinping has already accumulated more authority to impose policy than any leader since Deng. He does not need, and has not needed in recent years, a Party Congress to serve as a “threshold” event to facilitate reform. The policy changes needed can be announced between Party Congresses, not just at them (as Xi’s Third Plenum meeting in November 2013 amply demonstrated).

Two areas of reform most important for China’s medium-term economic outlook provide case studies for this point:  reform of the role of state-owned enterprises (SOEs) in the economy in order to bring private capital into state-dominated sectors, and liberalization of financial markets to promote foreign portfolio inflows. These reform efforts target some of China’s longest-standing challenges.

SOE reform needs to boost productivity to increase potential growth, to offset a shrinking labor force and declining marginal returns to new capital formation in an investment-led economy.  The Party has already distilled the problem down to a handful of systemic decisions: Which industries should be left to private, market forces and based on what logic? What role should Party officials play in those sectors where the state remains dominant? And how should the State remain “in the money” in mixed ownership schemes where firm governance is meant to be relinquished to private interests? Beijing has never intended to withdraw from all industries. But it has no interest in remaining dominant across the board only to strangle efficiency either.

Dueling bureaucracies have been competing to answer these questions. Both reformers and conservatives have endorsed the “mixed ownership” concept; but just as with Jiang Zemin’s SOE reform at the 1997 Congress, the concept can mean different things depending upon what one wants it to mean. Reformers want competition and shareholder governance to discipline gigantic SOEs. They have made some headway: all central SOEs are to be corporatized (turned into shareholding companies) by the end of 2017, a long-sought objective. China National Petroleum Corporation will reach this goal by the end of November, major airlines (Eastern, Southern, and AVIC) are selling off substantial shares of their subsidiaries, and China Unicom has diluted internal ownership to 36% and committed to cut redundant administrative offices and employees.

On the other hand, conservatives have been consolidating SOEs and soliciting private capital to make them “bigger, stronger, and better”. They emphasize the share price gains fueled by recent state-led supply side capacity cuts to claim a more successful track record for planning, in contrast to declining SOE revenue shares in “normal” industries when mixed ownership was introduced in 2014. President Xi does not need a party Congress to decide which of these camps he should listen to; he needs conviction. The advent of the “Unicom Model” in this year before the Congress is proof that a bigger meeting is not the constraint on more aggressive policy action.

Liberalization of domestic financial markets is also urgently needed, to balance the organic growth in outbound investment patterns with correspondingly large foreign investment inflows. Outflows from Chinese residents, including households and corporates, are estimated at around $550-600 billion annually over the past three years (Figure 1), and are only likely to increase as long as China continues expanding the domestic money supply and credit aggressively. Reimposition of capital controls through formal and informal means can only restore balance temporarily, as they are doing now, at an intolerable cost to long-term productivity and global financial power and influence.

Inflows will remain modest without significant financial market reforms to incentivize stronger portfolio investment.  These include the introduction of more transparent instruments to hedge currency and interest rate risks in onshore markets and clearer rules on repatriation.  Investors need comfort that rules governing investments in China will not change overnight, as they did during the equity market crash of 2015.

We know that Xi can make the decisions needed on this front, because…he already has, only to reverse course in the aftermath of implementation missteps.  The past five years offer multiple examples, ranging from exchange rate liberalization in 2015 to outbound FDI liberalization, to the rapidly abandoned effort to cap local government debt levels led by the State Council in 2014, only to see local officials’ prerogatives reassert themselves less than six months later.  The record of political commitment to follow through with reforms, rather than simply initiate them, is one of the key questions surrounding Xi’s administration.

Empirical Evidence

There is a final argument for why the 19^th Party Congress could trigger renewed reform: because the signs are clear that time is running out to do so without a crisis.  There is a growing body of evidence that China’s leaders understand the urgent necessity of breaking from the current growth model and associated policy mix, which has targeted stable GDP growth above all else. One can argue that a policy correction has already begun. The strongest signal for this has been the deleveraging and monetary tightening campaign waged this year, despite its proximity to the Congress.  Overall bank asset growth has slowed to only 10.3% y/y, the weakest pace in recent history, as China’s central bank has taken steps to limit the availability of wholesale funding and opportunities to speculate in informal financial markets with borrowed money. Throughout this year, leadership has stayed focused on limiting systemic financial risks, and regulators have competed to announce steps to squeeze the informal banking system.  Many of the fastest-growing banks in 2016 may show no asset growth this year.

This change in the pattern of credit growth may be the single most fundamental precondition for shifting the growth model, but it is only the foundation.  A far broader and profoundly deeper array of companion policy reforms will be needed to steer China through a transitional recession that would follow if reforms stay the course. The case for Xi to push ahead now is bolstered by two factors. First, a stronger global economic environment and a relatively stable domestic economy presently offer the leadership more buffer to push ahead. Historically, economic instability has had the effect of reducing China’s appetite for difficult reforms rather than prompting reform, contrary to the typical pattern in the rest of the world. Second, even with all his consolidated power President Xi is aware that before the remainder of his new five-year term is complete his colleagues will start turning attention to the next Congress, and the next, and so on.

In an interview published October 9 in Caijing, PBOC Governor Zhou Xiaochuan reiterated the importance of maintaining momentum toward financial liberalization, as well as the incompatibility of financial reforms and controls on foreign exchange over the long term.  Zhou commented, “There is no country in the world that has an open economy and strict controls on foreign exchange, just as there is no country in the world that has achieved meaningful integration between foreign and domestic markets with an exchange rate seriously deviating from equilibrium.”  Zhou similarly described the inevitability of financial reform, explaining that given the growing foreign demand for access to China’s markets, the costs of reversing this process were extremely high.

As a result of this and other PBOC statements calling for widening the yuan’s daily trading band earlier this year, one area where prospects for meaningful reform may be far more favorable following the Party Congress is liberalization of China’s exchange rate regime.  The recent period of US dollar weakness has seen the yuan appreciate in 2017 contrary to typical market expectations at the start of the year, and there are signs of genuine “two-way” expectations of the yuan’s movement at present, along with limited speculative positioning offshore.

This market environment makes it far easier for the PBOC to potentially step away from persistent intervention in the foreign exchange market without a significant adjustment in the level of the currency, as the PBOC is not facing strong outflows at present.  Zhou’s impending retirement similarly increases the urgency of the central bank’s lobbying for additional liberalization steps while market conditions are favorable, as the next Governor may not be able to take on the issue early in the first term.  One can read Zhou’s interview in Caijing as part of an effort to maintain momentum in financial reform, and as a warning against more conservative voices.

There is a window of opportunity to kickstart the reform process that coincides with but is not contingent upon the Party Congress, but this window is at risk of closing. China’s economy is already decelerating under just the initial tightening conditions already imposed (by choice).  External factors cannot be controlled, and are in fact likely to make reform harder in the future: US interest rates will probably rise over the coming year, potentially accelerating capital outflows from China regardless of whether SOE restructuring and capital market reform have shored up the inflow side of the ledger.

Bottom Line

Party Congresses are about politics, not policy choices.  But what is standing in the way of policy choices today is politics.  This is not the first time that has been the case.  Past Chinese leaders have needed to make strong political signals at the five-year Party Congresses to break through logjams on reform as well.  Expectations for a breakthrough at this week’s gathering in Beijing based on ideas of the need for power consolidation are misleading.  But with five years left on his watch and more than five years’ worth of hard reform work to do, President Xi might well choose this occasion to rekindle momentum on the economic reforms he announced four years ago.