Discussion on Xi Jinping and Li Keqiang’s direction for China’s economy
This article was submitted for course work at my last university on the 7th of November, 2013. It covers the background, importance and historical significance of the Third Plenary Sessions of the Communist Party of China’s Central Committee (CPCCC for short), held in Beijing between the 9th and 12th of November, 2013. Briefly, the CPCCC is the highest representative political body of China’s Communist Party, where successively narrow elective positions can be described as executive or leading groups, but all power essentially is crystallized with- and distributed by the Central Committee.
I have not updated this article as news have came in during the last eleven months, but even though I held a very forcefully reform-minded viewpoint during the time of writing, Xi Jinping in particular has proven to be very much more aggressive in his policies than I would have expected. This applies to both the results of the 18th Third Plenary Session as well as the year following.
This was written to be slightly less academic than the full term project (development needs of capital markets) and as such is slightly lighter on the footnotes and might require the reader to look up major topics in a more independent manner. The structure is as follows:
- Executive Summary
- What is the Third Plenum, and why is it a big deal?
- What influence will history have on the CPCCC’s decisions and power?
- Current Challenges and Opportunities for the CPCCC
- The CPCCC’s willingness to deal with issues
- Likely Policy Directions
- The State Council’s Development Research Centre’s (DRC) recommendations. [“3-8-3 plan”]
- Likely developments
- Quick discussion of market/GDP dichotomy
- Detailed Policy Recommendations
1. Executive Summary
The world financial media has dug into the premise of the third plenary meeting of the China Party Congress’s Central Committee to deliver large, structural reforms. This is enforced by the once-in-a-decade power shift that has brought the “fifth generation” of Chinese Communist Party leaders into control, hoping for reform bringing to mind those brought by Deng Xiaoping during the 11th Third Plenum in 1978, and Jiang Zemin during the 14th Third Plenum in 1993. These were springboards for the respective leader’s economic policy framework, and hopes are elevated by a sense of unrest and lingering dissatisfaction with lack of reform progress under Hu Jintao and Wen Jiaobao during their tenure from 2002 to 2012. This paper is an attempt at using previous economic policies since Deng’s ascent to power in 1978 to evaluate the direction of economic growth that Xi Jinping is likely to stake out.
The approach for this discussion is to first identify what the Third Plenum is, along with a quick review of select major historical events in Chinese post-Mao economic developments that are presumed to influence the CPCCC’s thinking strongly. A brief discussion will then be held on China’s current situation and important political and economic policy drivers and hindrances that it generates. Finally this will be all summarized in a discussion of the most likely outcome of the Third Plenum and the path China will be on after that. A set of detailed policy recommendations will be given that ensures targeted deepening and broadening measures of China’s capital markets to allow for greater utilization of assets and accelerate general money velocity. The hope is that an increased flow of money will be dragging along with it investment cash flows and suppress interest rates which should reduce the net impact on total government debt levels.
A. What is the Third Plenum, and why is it a big deal?
The plenary sessions of the Central Committee – from where the Politburo of the Chinese Communist Party is drawn – occur regularly during the five-year cycles that govern Chinese political process. With the Politburo being central to the formation of ideology to empower the actions of the State, the plenary sessions are essentially meetings to assign direction to China, amend ideological standpoints and launch reform. The interest in this plenum springs from two key factors – it 1) is normally the Third Plenum that deals with economic policy and direction, which is essentially the only aspect of policy that is realistically expected to have foreign direct stakeholders, and 2) it is one of the plenary sessions that occurs following a major power transition, meaning that people are largely looking for policy direction from the new leaders. It will be held from November 9th through November 12th, and include 376 of the CCP’s top leaders.
B. What influence will history have on the CPCCC’s decisions and power?
In assessing the factors needed to answer this question, it is fairly important to show two largely opposing trends: the increasing and ever more real need for difficult structural reform to take China past the middle income trap, and gradual disenfranchising of the powers of the CPCCC and its plenary sessions at large. Both of these processes were largely set in motion during Deng Xiaoping’s rule, and have inadvertently became worse under his successors Jiang Zemin and Hu Jintao.
Deng Xiaoping is credited with starting China on the path to development in the post-Mao era, but in so doing he created power structures that allowed him to become the “Paramount Leader” of China, controlling policy from behind a wall of trusted political allies. He also undermined the role of the Party as such to prevent ideology from becoming a hindrance to the practical political and economic needs of China. However, in choosing this style of politics, Deng created deep resentment among political opponents or just those who tended to disagree with him, forming large Party majorities of opposition that shrank his room for deep, persisting reform and caused him to be seen as a weak leader willing to talk only with the political wind in his back. Errors of going against public opinion culminated in the Tiananmen Square incident where lack of popular support was “exchanged” for military connections, for a long time weakening the legitimacy of the party and Deng’s legacy as a legitimate reformer.
Jiang Zemin came in succession of Deng, and quickly led further market opening, especially in the field of what can be considered financial infrastructure and systems such as introducing exchanges and bank system overhaul. In conjunction with these movements of greater opening and setting China up for greater networks with the rest of the world thereby allowing more export, Jiang however clamped down on what he saw as undesirable social aspects of capitalism and sought to instill greater “redness”, or communist ideology adherence, in the Chinese population. Through the process of governance, he ran up against the wall of political allies enjoyed by Deng, and then had to wait for installing his own cadres into the power structure to create room for forceful reform. The lack of a coherent message from the very leader, coupled with problems of implementation at lower levels of the Party structure and less-than-full adherence to policy even among the top brass means that Jiang was largely seen as highly ineffective. Jiang’s early years of tenure also required greater transparency and honesty in financial reporting, leading to bank system restructuring and bad bank debts generating a large strain on public finances in 1993 that only got worse as Asian growth and trade slowed dramatically (if not going into reverse) during the Asian Financial Crisis of 1997. All in all, crises not of his own doing conspired with some sprung from his ineffective leadership style and hampered his ability to conduct real reform.
Under Hu Jintao, ambitious economic goals coupled with lessons learned under Jiang allowed a steady growth, largely pushing the economic developments that had worked during Deng to the point of instability. “Gradualism” eventually became a term to describe inactivity. Currency reserves were ran up using industrial policy, banks were bailed out and then gradually recapitalized and floated on the stock market to make similar events more unlikely, cushioned further by interest rate regimes that did savers a dis-service and gave banks large interest margins by fiat. Growth and brands were supposed to be built using physical and financial capital alone, not discouraging growth in state owned enterprises (SOE) and politically controlled companies which had access to finance smaller companies could not attain aside from bribery or political connections. (Said activities still being more worthwhile than the exorbitant fees taken at the informal, private lending market known as China’s shadow-banking system.) After Hu’s first term of difficult economic maneuvering, he faced the Global Financial Crisis of 2008, and although handling growth extremely well, the stimulus was largely focused on new lending generation and infrastructure expenditure. At least the first of those policies further promoted inefficient use of capital allocation as banks lent to only governments and politically favored or large businesses.
Xi will thus face an economy in fairly urgent need of deeper economic reform to unleash capital held at all levels – save local governments – from the individual to the company to the central government. This capital needs to be held against unknown liabilities or business and personal risks, and largely needs to be held in cash or cash equivalents due to little access to actual financial markets in rural or migrant families. Politically, the position he is in is no more enviable given a populace tired of lack of deeper reform that has to be governed by politicians that (while not necessarily being aligned against him) have benefited so much from the current system of capital mis-allocation that they present an incredible agency problem and thus need to be rotated out of power or made examples of. Positive signs are at least starting to appear in the last year crackdown on corruption and official conspicuous consumption in everything from representation, travel and gift-buying.
3. Current Challenges and Opportunities for the CPCCC
Structurally, the challenges for Xi and Li are very multifaceted, and as with most cursory glances at China’s inner workings this discussion is likely to be unjustifiably lacking in nuance and insight. Still, the problems of economy and politics intertwine at this juncture and deserve at least a serious attempt at understanding.
China has essentially built economic ecosystems predicated on political favor, allowing politicians to enrich themselves, grow already big companies and SOE’s and use rural land expropriation along with both official and backdoor financing to push infrastructure investment, construction and employment. This has concentrated enormous unknown liabilities in local government ownership if not necessarily on their books, against uncertain cash flows.
Large rural-urban imbalances are present in China not just from an economic perspective but from a regulatory and social security perspective. If people are allowed to move more freely to gain the opportunities of the cities, this alone would over time reduce the problems of China’s rural-urban divide.
Capital is extremely tied up into savings. The lack of capital markets, such as a proper bond market and insurance / pension products to meet savings demand, coupled with repression of equity and property markets to ensure social stability means that the only logical alternative is cash or deposited savings, yielding less than inflation in many cases. As this allows big companies to grow even bigger when needing finance, it is not good when they are naturally profitable as it reduces their investment opportunities for treasury cash, while savers get implicitly taxed and smaller companies are often willing to pay up to 20% interest rates just to get any loans whatsoever. Together with the political-economic ecosystem, there are large incentives for big companies to persuade local governments to spend more so that their existing investments yield more while not having to take the risks of reinvestment themselves. Thus China’s whole capital structure of ownership, yields and productive value of financial capital gets thrown into an inefficient framework.
This leads to general dissatisfaction with the Party and the impression of lacking legitimacy where business and politicians exist for each other rather than the economy and the people. Investments in human capital are thus expected to have lower returns than investments in influence, and a harmonious, morally upright society might be increasingly difficult to accomplish.
Broadly speaking, the biggest opportunities in China exist where the biggest challenges exist, for example in the structure of private investment or saving where the only viable alternative is often cash or property, even though these carry guaranteed losses or high risk thereof. Still, realizing these opportunities requires reform to be undertaken in several areas simultaneously to free the whole circulation of finances internally. The same problem exists with the political-economic ties that there are dependency networks and “fixing” a single part in a piecemeal fashion might just mean that another part of the chain gets broken even worse.
China’s massive savings rates, both privately, in corporations, and on the currency reserves, provide ample opportunities to fund crisis spending or reallocate capital via monetary of fiscal control. (It is not speculated in the legitimacy impact on the Party from said policies however.) Beyond this, the central government has great finances with net indebtedness around 14-15%.
China’s large and diverse pricing ranges and industry mix also allows rural areas (which previously fuelled urban growth with cheap labor) to gradually start enjoying cheap capital as firms move inland and abandon relatively high-cost manufacturing at the seaboard. Successfully managing this transition would mean increased equality of growth across the country and spurring of human capital agglomeration at future strategic locations in China.
Politically, the low satisfaction with the previous establishment might provide a “honeymoon” effect, where change of any kind is seen as beneficial and would give the Party greater latitude to deal with internal Party restructuring and incentive realignment.
C. The CPCCC’s willingness to deal with issues:
The bureaucracy under Xi has already shown some tendencies of accepting the slowdowns and economic/political impacts of reform pushes. Chief among these is the constraints on official conspicuous consumption and lavish representation that has been one of the more visible policies under the 18th Congress so far. The lengths to which this has gone to reduce corruption is unknown to me, but many luxury restaurants have reported markedly dropped revenues when more than one third of the food was expected to be eaten, and ashamed politicians have lost face being reminded to not be wasteful and thus bring remains home with them in a bag (symbolizing having to carry food back to feed oneself, which is very ridiculous on luxury items being ordered).
One more positive indication was the spike in interbank rates that occurred when the regularly cash-strapped summer season in China occurred coupled with actual repurchase agreements being used (draining liquidity from the financial markets and driving interests up even further). Official indications that this would not be reversed and that the stress was good for the financial system sent a strong although not very loud signal to banks that they need to clear their books. Lately, nonperforming loans have increasingly been revealed and revised upwards in quarterly statements by Chinese banks, so the signaling action by the administration seems to have worked.
4. Likely Policy Directions
A. The State Council’s Development Research Center (DRC) recommendations:
The DRC, which is a reform-pushing and reformist agency, has previously worked with the World Bank in the preparation of the China 2030 report, containing many aggressive proposals for how to reform China’s economy. They have delivered a “3-8-3” policy direction recommendation to the Third Plenum, summarized below.
Three key themes:
- Improve the market system
- Transform the role of government
- Build innovative corporate structures
Eight key reform areas:
- Monopoly sectors
- Land system
- Financial sector
- Tax system
- Management of state assets
- Opening of the economy
- Opening up and transparency
- Social security
- Land reform.
B. Likely developments:
One of the main impediments to transformation of the Chinese economy at present is the probability that the entrenched political interests will counteract change due to their personal benefits in the status quo. With that in mind, the wiser path of action would be to “launch” the economic agenda and supporting ideologies on this Third Plenum, attempt to build both broad support in the Party and people, with the goal of “priming” the power structures allowing for more practical, thorough and effective reforms on the 19th Third Plenum in 2018. Otherwise, there is the risk of interparty rivalries and factionalism hindering needed policies and hollowing them out, meaning that reform losses are seen in both implementation and public support because of a gap between advertised and actualized benefits, such as during Deng’s late tenure.
This time of restructuring of the party must be carefully used to root out vested interests or to bring them into line for policy to be successful, but if this is continued in a determined but considered manner while other policy suggestions are on hold, things are likely to work out as there will be few opportunities to hide vested interests in differences over policy. Command and incentives for local development must also be much more aligned to the national strategy of the Party, and transgression or wild inaccuracies in reporting/forecasting must be dis-incentivized further down the ruling hierarchy. Careful consideration needs to be given here however that the ability of Chinese localities to perform pilot programs and release economic trial balloons does not get dialed back.
In slightly more specific terms, the initial reforms broadly need to come in allowing stable sources of local government revenue (taxation) and mechanisms to bring off-balance sheet items back in from Local Government Financing Vehicles (where debt tends to accumulate), and then generally transfer parts of these to the national government. This would have the added benefit of reducing the reliance on confiscatory land sales for rural communities leading to better land use, and allowing urban areas to offer better services with the hope of specific targeting on internal migrant workers to allow them being included into the social life of cities and free up their buffer capital. Tax revenue could be raised in the form of property taxes everywhere, congestion fees for road vehicles in urban areas, overhaul of social security contributions to a progressive rather than effectively regressive system with small tax components included, and likely many others that are likely best evaluated by local governments. Increasing social security functioning would also increase remittances to the inland regions of China since less needs to be held in emergency unemployment/illness cash cushion, increasing the velocity of money in these regions and speeding development in “Tier 3 and smaller” cities.
Broader financing measures are so broadly intertwined with the structures of existing economic-political ecosystems that zero-sum disruptions here (funneling cash from SOE’s to small- and medium enterprises, SME’s) is unlikely to be politically palatable or even possible. A proposal for an integrated long-term financing strategy is provided under Detailed Policy Recommendations. Select private equity funds should be encouraged to start (under both QDII/QFII programs) to provide both funding and management expertise for smaller companies. Due to targeting SME’s and the undesirability of added debt in the system, legislation should be crafted such that larger pools of venture capital are allowed to form, allowing them diversification, network benefits and cash buffers to learn from experience. More mature forms of private equity using loan financing and creative equity-liability hybrid structures should be discouraged where feasible since offsetting financial products for management or securitization of these risks do not yet exist in China. Developing a broader bond market might prove incredibly difficult without massive, liquid players with enormous cash balances to invest in safe portfolios, where said financial institutions would then provide incentives for well-ran businesses to run to market with bond issuance. Again, the order of sequence here is important such that there is an identified and accessible demand for fixed income, to prevent failures in issuance, leaving the issuer with bad rates or in an unfinanced state. Any of these would severely impact the bond market with reduced confidence drying up issuance.
C. Quick discussion of market/GDP dichotomy:
Even though the expectation is for growth to slow somewhat during any economic realignment, there seems to be virtually unanimous support for the deeper market reforms speculated about. This is in stark contrast with any developed world countries where any reform with even slight short-term economic sacrifice gets highly negative market and analysis reactions.
While there is obviously a bias in the foreign reporting on reforms that are beneficial for foreign markets, one other aspect of the reception difference of policy is that the Chinese economy is very fundamentally separated from its liquid capital markets, meaning essentially its stock market. China GDP growth has outstripped listed company earnings, and even with 7.5% or higher annual GDP growth, the stock market is trading on low multiples and also relatively low historic levels. Efforts to suppress corporate profits (in instances when they are not mysteriously “expensed” away) and accelerate wage increases have largely left the broader indexes trading lower even while revenue is growing and people are getting richer.
Another potential reason is that confidence in the majority of (eastern seaboard) business conditions in China, with tangible threats such as wage increases and competition from inland provinces, is trending lower and that increased reform might help alleviate some fears and allow innovations that have already been thought of to leap forwards once they’re no longer held back by regulations. Additionally, as mentioned in the background, confidence in the political system has continuously been eroded, and justified, pragmatic and beneficial reforms might help restore policy trust among the people and the businesses.
5. Detailed Policy Recommendations
In my opinion, China foremost needs to change its’ interest rate structure through gradual liberalization of interest rates, starting with deposit rates and then gradually going along the yield curve from the high yields/maturities to the low ones. Starting at the consumer-bank interaction might however be the wrong way to go and one could instead need to make a deeper inspection into the structure of Chinese financial relationships.
Increasing social security with health and unemployment insurance and effective pension structures would lead not only to the greater availability of capital as it can now be more efficiently deployed, all the covered become better credits. This would ease loan generation at the personal level all the way up into SME’s as now there is less reliance on savings for survival and that an accident, illness or inability to work fully in old age no longer implies difficulties in providing sustenance and care to the point of likely death or disability. High quantities of new cash would enter the economy, increasing the velocity of money and easing investment placement and promoting business and consumer growth.
The central government would need to seed these pension, insurance and social security funds with large amounts of either common equity or preferred equity to allow them to collect premiums, but if these funds are structured on a big scale (each covering geographic areas of +100 million people) these developments should then be self-reinforcing and make money flow in automatically. After a given period of time, these funds then become large enough players to provide a good market for local government liabilities. As both growth will have gotten a temporary push and the interest structure will have become significantly lowered, the local government times-interest-earned relationship will have drastically improved and loans on their balance sheets should look better.
As safety gradually increases confidence in these markets there should be a marked increase in local government liabilities, so assuming that the proposed funds get in early enough, they will also provide benefits to their clients when buying either local government bonds outright or securitized and collateralized versions of LGFV liabilities. After this “filter” of institutional finance has been applied, the bad banks set up in the 2003 bank restructuring can be called in again and partially refunded if need be to take care of destructively ill-conceived local liabilities. If this is known beforehand it would also create a positive effect on the local government bond markets.
Now having created the first parts of a bond market and removed larger risks in the market itself, the next few steps of expansion need to be considered, and at this stage opening up the corporate bond market would seem like a good idea. Most of the introductory gains from accelerated cash flows on local government loan books have probably mostly been had, and this is now, under this structure, expected to be a fairly low-yield market. Now opening up corporate bond markets to provide better yield should in theory be more feasible, when the gains on the market seen on government bonds is likely to have aroused interest. Transparent and competitive prices on an actual market should now have bond market participants doing part of the work that credit analysts at banks would previously do, open up easier venues for bank lending, and crowd out bank loans to major corporations and SOE’s, thus making the SME and consumer banking markets much more attractive for the bank to engage with on a comparative basis.
 The problem is that company-level social security contributions per worker are at 60% of company average wages per worker, meaning that lower wages pay proportionally more for social security and thus there are many incentives to keep low-level wage off-the-books, to great detriment to the often rural workers attracted to work under these conditions.
 Qualified Domestic/Foreign Institutional Investor
 Care needs to be taken that workers fund their own pensions in these systems rather than those of their parents, as is the case in the western world.
 Under assumption of local taxes on economic activity.