China after the leadership change: Continuity and reform

I spent the first week of December in a chilly but snowfree Beijing. This article presents my impressions from conversations with analysts, economists and academics, among other things at a Stockholm-China Forum seminar with Chinese colleagues. My main conclusion is that not only is the Hu-Wen era drawing to a close, but that the entire growth strategy that has dominated the past 30+ years must be reformulated. China’s new leaders also face the task of dealing quickly with the corruption that threatens the legitimacy of the Communist Party. My assessment is that at first, the new leaders will prioritise continuity and stability, but that starting next autumn they will gradually push through economic reforms. Implementing the entire reform agenda that is necessary will take time, however. One important crossroads is the next party congress in five years, when most of the recently appointed top leaders will be replaced. This may provide an opportunity for younger, perhaps more reform-minded leaders to move up. The legacy of Deng The People’s Republic of China has existed for more than 60 years, with two clearly distinct phases. During the first phase, lasting nearly 30 years, Mao Zedong ruled as an autocrat. The Great Helmsman created a peasant-based centrally planned economy and caused chaos during the Cultural Revolution. The next generation of leaders decided to break with the planned economy and the whims of an autocratic leader. Their two main goals were to build economic prosperity and to preserve political stability under the control of the Party, with collective leadership. They have achieved both goals, but in ways that make it impossible to use the same methods in the future. Growth must become more inclusive and consumption-based. Meanwhile the regime must listen to growing protests against corruption and increasing demands for freedom of expression. Since China under Deng Xiaoping chose the path of market reforms, the country’s GDP has grown by about 10 per cent annually for three decades (averaging 9.7 per cent annual growth during the 1980s, 10.0 per cent in

MONDAY DECEMBER 17, 2012

the 1990s and 10.3 per cent in the 2000s). Only two nations have come close to these figures: Taiwan (9.6 per cent annual growth in the 1950s, 9.0 per cent in the 1960s and 10.1 per cent in the 1970s) and South Korea (8.1 per cent annually in the 1960s, 10.1 per cent in the 1970s and 8.6 per cent in the 1980s). Both Taiwan and Korea saw their annual growth rates drop somewhat lower during their fourth decades of growth: Taiwan to 7.7 per cent in the 1980s and Korea to 6.7 per cent in the 1990s. Now China seems to be heading towards a similar slowdown. In 2012, GDP growth will probably be somewhat below 8 per cent, and the country’s Twelfth Five Year Plan (2011-2015) aims for 7 per cent annual growth. Official statements mention a target of doubling China’s GDP in 10 years, which in fact would require about 7 per cent annual growth. This deceleration is partly due to cyclical and external factors, such as the impact of the global financial crisis and a hangover in key sectors following the country’s 2008-2009 stimulus measures. But more important in the long run is that the existing growth strategy – based on enormous capital spending and rapid export growth – is no longer sustainable. Massive investment initiatives have led to chronic overcapacity and low capital productivity (i.e. waste). Now that China has become the world’s largest exporter, there is simply no longer room in the world market for the same rapid export growth. The strategy has also resulted in growing income gaps and terrible environmental destruction. This is why it must change: growth must become greener as well as more equitable, resource-efficient and consumptionbased. The goal of political stability has been achieved, although the system was shaken in 1989. The confrontation with Maoism almost reached the point where the supremacy of the Communist Party was being questioned and spontaneous calls for democracy could be heard. Deng decided to crush the protest movement, and in the eyes of party leaders the subsequent collapse of the Soviet Union confirmed that they had acted correctly by not allowing the same breakdown of authority to occur in China. During the following two
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Economic Insights

decades, political stability truly seemed to go hand in hand with growing economic prosperity, just as the party intended. But in recent years the system has once again become shaky. China’s growing middle class is increasingly well educated and verbal, has access to the Internet and has started to become accustomed to a certain (though limited) freedom of expression. There is widespread outrage at conspicuous corruption. Farmers are furious about unfair expropriation of land. Entrepreneurs and academics want greater intellectual freedom. More and more people in China are travelling abroad, gaining new impressions and returning home with a feeling that the rigid Chinese system is incapable of providing adequate responses to the challenges ahead. There is no large-scale democracy movement in the Western sense. Instead, there is a desire for freedom of expression, a clean-up of rampant corruption and a more attentive, inclusive leadership. It is obvious to more and more people that today’s rigid top-down control must be replaced by greater dialogue and partnership, but how to get there is far from self-evident; different commentators mean different things when they speak of “political reform”. My conclusion is that the cornerstones of Deng’s strategy are crumbling. The Chinese model has to be updated. In his day, Deng broke with the centrally planned economy. Today’s leaders face the task of updating Deng’s model, which was so successful for decades. According to a new debate anthology, the task is to build a “China 3.0” after 1 Mao’s “China 1.0” and Deng’s “China 2.0”. In the following sections I will discuss what this means, especially for economic strategy, but also for the battle against corruption. Demographics, security policy and environmental issues are highly important but have been omitted from this account, since I primarily discussed economic issues during my Beijing visit. The new leaders In November the 18 Congress of the Communist Party of China elected a new Central Committee and a new Politburo. At the top of the power pyramid is the Politburo Standing Committee, which was reduced from nine to seven members – presumably signalling that the party leadership wants a firmer decision-making process. Of these seven, only two were members of the previous Standing Committee: those who are ranked No. 1 and No.2: • Xi Jinping has apprenticed as vice president for the past five years and has been groomed as the next
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party leader. The choice of Xi as party general secretary was thus completely expected. He is the son of a prominent revolutionary leader, has served as a provincial governor, organised the Beijing Olympics and has good contacts with the military. He appears more charismatic than his predecessor, is a better speaker, is more well-travelled – and is married to one of China’s most famous singers. In political terms, Xi has not stood out in any way. He thus appears to be a person capable of keeping the leadership together and uniting different factions. • Li Keqiang has apprenticed as first vice premier in the same way. He has a more humble background and comes from the Party’s youth league, like the retiring party leader (many claim he was Hu’s personal favourite for the top position). Li is the most explicitly reformist member of the new leadership. He has occasionally faced criticism – he is said to have been slow in dealing with the SARS epidemic in his province – and Li’s detractors accuse him of having inadequate leadership qualities.

Some of the five new Standing Committee members were relatively unexpected by Western pundits. Commentators in the West have generally expressed disappointment that more reform-minded leaders, such as Guangdong provincial governor Wang Yang, did not reach the top. But it is hard to avoid the suspicion that some of their displeasure is a kind of “sour grapes” reaction. Some of the new Standing Committee members have a de facto track record as economic reformers, though not as political reformers. • Wang Qishan helped tackle China’s banking crisis of the 1990s. He is thus called the “fire-fighter” – the person sent in to clean up and solve difficult problems. He is regarded as capable and reformminded. Many observers thought Wang would be given responsibility for economic matters, but on the new team he will be in charge of the Party’s discipline commission and will thus responsible for fighting corruption – a signal that a tougher approach can be expected. Zhang Gaoli comes from the post of party chief in the major port city of Tianjin. He was previously party chief in Shenzhen, for many years the most dynamic city in southern China and something of a test-bed for market reforms. Zhao has kept a low profile, but his background puts him in what might be called the pro-market camp. He is the favourite to become first vice premier in charge of the economy.

1 Mark Leonard (ed): China 3.0, European Council on Foreign Relations, 2012.

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Economic Insights

Yu Zhengsheng is an engineer and party chief in Shanghai. He is regarded as supporting privatisation and judicial reforms, i.e. giving more power to the courts. Zhang Dejiang worked in Beijing as one of China’s vice premiers until last spring, when he succeeded the ousted Bo Xilai as party chief in Chongqing. Zhang is reputed as wanting to preserve the strong position of state-owned enterprises. Liu Yunshan stands out among the others. He is not a governor, but instead has worked as the director of the party’s propaganda department and has thus been in charge of the regime’s increasingly tough policies towards dissidents on the Internet.

conservative force, and it is probably true that he is not eager to make growth greener. However, he has clearly shown his displeasure that the economic reforms of recent years have seized up and that growth has decelerated. In light of this, I think it is too early to make sweeping judgements about the new Standing Committee being “conservative”, as some Western observers have done. Instead I foresee a leadership that will gradually show great interest in the economy, tougher competition and technical development – but that is not so interested in political reforms. A politically traditionalist leadership, yes, but at the same time a technocratic and “business”oriented group of managers who will want to update at least parts of China’s economic strategy. When will the reforms come? Recently, Xi Jinping made a symbolic trip to southern China, exactly as Deng Xiaoping did in the early 1990s when he wanted to push through reforms. Xi visited Shenzhen, where his own father helped build up the first special economic zone, and declared that “far-reaching reforms” are necessary. His trip was a clear signal about long-term strategy. But we should not expect any rapid shift. During the Weekend of December 15-16, the party leadership held its annual “Central economic work conference” to decide the direction of economic policy during 2013. The statement issued after the meeting said reforms should be pursued with “greater political courage and wisdom”; investments, domestic demand and taxes will be guided “proactively” to secure steady growth, and urbanisation will continue. While commitment to reform thus was affirmed in general terms, no major new initiatives were launched. This was not surprising. In this initial stage, the new leaders are prioritising continuity. Furthermore, China’s government posts have not yet been allocated. This will not occur until this coming spring, after the second plenary session of the new Central Committee and the meeting of the National People’s Congress (China’s “parliament”). Once they are formally named president and head of government, respectively, Xi and Li will probably hold policy speeches and signal the direction in which reform work should proceed. After that, newly appointed technocrats and planners in ministries and public authorities, state-owned enterprises and think tanks will be put to work shaping and devising the details of the new strategy. This is why I am guessing that not until next autumn, at the time of the 18th Congress Central Committee’s Third Plenary Session, will the government launch any major reform initiatives. Economic developments during the

One should be careful not to make too much of these brief evaluations. Firstly, collective leadership is more important than individual personalities nowadays. Secondly, please note my deliberately vague language: “is regarded as”, “is reputed as”, “appears to be”. The reason is that what has been happening behind the scenes in the party leadership is hidden to us. We can nevertheless state that a majority of the Standing Committee consists of the sons of earlier prominent party cadres. Six of them have worked in large, fastgrowing coastal cities and four (including both Xi and Li) were sent out to perform manual labour in the countryside during the Cultural Revolution. They are thus firmly rooted in the party apparatus, with a background that is likely to make them sympathetic towards gradual economic reforms – but sceptical towards major political shifts.

The new Politburo Standing Committee being introduced at the 18th Party Congress in November 2012: From the left: Zhang Gaoli, Liu Yunshan, Zhang Dejiang, Xi Jinping, Li Keqiang, Yu Zhengsheng and Wang Qishan. Most of these new top leaders are protégés of the now 86-year-old Jiang Zemin (who served as Communist party leader before Hu Jintao). Only Li belongs to Hu Jintao’s circle. Jiang is described in the West as a

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Economic Insights

intervening period will influence how extensive these reforms are. This implies risks. One risk is external: China may be hurt by a deeper euro zone crisis or the failure of US federal budget negotiations – with negative consequences for confidence, investment appetite in US financial markets and Chinese exports. Another risk is internal: earlier overinvestments and real estate bubbles along with excessive debt may suddenly force China into an unexpected, abrupt cutback in debt and capital spending. While the external threat is connected to America’s “fiscal cliff”, the domestic threat is connected to what might be called China’s “investment cliff” – excess capacity that must be cut back. Pessimists have been warning of such a Chinese hard landing for years. So far they have always been wrong. Nor were the observers I met in Beijing overwhelmingly concerned that such a crash might occur now. Earlier high inflation and overheating in the real estate market have decelerated. Annual GDP growth seems to have bottomed out at around 7½ per cent. Short-term indicators like industrial production, electricity consumption and purchasing managers’ indices have all rebounded. But Chinese statistics are not the best, and the latest trade figures were weak. So although the economy has probably bottomed out, it is still too early for any raucous celebration. Short-term economic developments are important to long-term policies, since they influence policymakers’ ability – and desire – to tackle long-term strategic problems. If China, contrary to expectations, should experience a major slump during the next six months, economic planners will mainly focus their attention on stimulating the growth rate. In that case, there is a great risk that they will again do so via “more of the same”: increased lending using the old channels and expansion of old-fashioned infrastructure investments. This would worsen the existing imbalances and postpone necessary innovations. The reform agenda in 2013 Assuming that this will not happen, my main scenario is that a reform policy will be initiated next autumn and that the launch will occur at the Third Plenary Session. Today we do not know what this policy will include, but if I may make a few bold predictions, the following main ingredients seem likely: • Reforming China’s financial sector is high on the agenda. The current system is so obviously wasteful that it has become an obstacle to efficient capital allocation. Today the Chinese save a very high proportion (about 40 per cent) of their income at low interest rates. Their savings end up largely in

banks, which send them onward without sufficiently businesslike thinking. In this way, state-owned enterprises enjoy a cheap supply of capital. They are also protected by various regulations. Their productivity growth is thus generally weak and their profitability is often poor, despite the abundance of cheap capital. The financial sector must consequently be made more efficient. Banks must conduct better credit evaluations to ensure that the price of capital is fairer. There will thus probably be some sort of decree on freer interest rates and more professional lending practices. This would kill several birds with one stone. State-owned enterprises would become more exposed to market pressures, while private entrepreneurs would no longer be subject to obvious discrimination. All borrowers – enterprises as well as local investment companies (which are usually owned by provincial or city governments and have been responsible for a large proportion of the enormous infrastructure investments of recent years) – would be forced to manage their capital better. This would force a shift towards higher quality capital spending, which in turn would mean that the volume of such spending will not have to be so high to have the desired effect on the economic growth rate. • China will take cautious steps towards modernising its labour market. Today there is an underclass consisting of 200 million migrant workers who have moved from the countryside into cities, but who have lost their civil rights along the way. The domestic passport (hukou) system, a relic of the Mao era, ties farmers to their soil. Those who move to cities often temporarily lose access to government social welfare benefits, health care and the right to an education for their children. Yet the domestic passport system cannot be abolished overnight; China would then risk a flood of farmers pouring into cities, while urban planners and builders would be unable to keep up. The authorities could, however, at least give migrant workers a more decent life by guaranteeing them the right to publicly provided health care and education. This would improve the functioning of the labour market while radically narrowing some of the gaps in society and thereby reducing the risk of social unrest. Steps towards land reform will be announced. The government owns all land, and farmers only lease it. This opens the way for local party bosses to drive away farmers, annex their land in the name of the government, lease it again

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Economic Insights

to industrial companies or infrastructure facilities and take their own cut of the profits. This is the most common form of corruption in China, triggering violent protest in many villages. Farmers must be guaranteed reasonable compensation and expanded land tenure rights. Recently, farmers have benefited from protective laws aimed at forcing party bosses to pay them market value for expropriated land, and nowadays developers must also demonstrate that proposed projects are of great macroeconomic value. In practice, however, these rules are often circumvented. Stricter enforcement is desirable, both for social reasons and to strengthen the rule of law. Long-term reforms Through experiments and gradual steps, this reform agenda will be expanded. In a more long-term perspective, one crucial question is what will happen at the 19th Party Congress in 2017. That is when – once again – all members of the Politburo Standing Committee except for Xi and Li will retire, having reach the current maximum age.2 Thus five new members must be appointed. There are numerous upward-bound party officials now in their 50s; they are even better educated and more well-travelled than their elders in the party leadership. The Chinese speak of four generations of party leaders since the People’s Republic was founded. Mao was the first, Deng the second. The third generation was led by Jiang Zemin and the fourth by Hu Jintao. Using this definition, the recently appointed party leader Xi Jinping represents the fifth generation. My point here is that his leadership period, which according to current practice may last ten years, will consist of two distinct five-year periods with different colleagues. During the first period, Xi will rule alongside the above-mentioned protégés of Jiang Zemin; as the second period approaches, he will enjoy decisive personal influence on the structure of the party leadership. One could argue, a bit speculatively, that the Politburo that recently took office is a bridge to a more far-reaching rejuvenation. In that case, the next five years might be a kind of preparation for “China 3.0”, with the decisive steps being taken by a new leadership in 2017-2018. If this should occur, the decade of leadership by Xi and Li may result in far-reaching changes and the “fifth generation” as a whole would be a reform generation – unlike what today’s more pessimistic Western commentators believe.

Those who wonder what long-term economic strategy shifts may occur should study China 2030, an extensive document (more than 400 pages) co-produced earlier this year by the World Bank and the Chinese government’s own leading economic think tank.3 It lists the points I mentioned above – financial reform, tougher competition for state-owned enterprises, relaxation of the internal passport system and land reform – but also numerous other areas in need of reform. Among these are the following: • The social insurance system must be expanded, both to provide a social safety net and to reduce high household saving. This, in turn, presupposes an extensive tax reform and the creation of insurance solutions in order to finance the safety net. Innovation policy must be shifted away from direct government support for R&D at large companies to more general improvements in conditions for entrepreneurs and small businesses. If China is to avoid getting stuck in the “middle income trap”, the entire economy must become more sophisticated and dynamic. China’s currency should continue to be internationalised, and pricing should become more market-based. The goal is to eventually turn the renminbi (yuan) into a functioning global reserve currency. Strong action must be taken to stimulate energyefficient, environmentally friendly production. A carbon tax should be introduced, and eventually also a carbon dioxide tax and an emission trading system. Technical development in “green” sectors should be stimulated. Worth noting here is that the World Bank does not view this as a cost, but rather as something that can generate competitiveness and jobs, since China could take a huge leap and immediately embrace the latest technology.

This is undeniably a massive list. It will not only be difficult to achieve in reality and in the right sequence, but it also collides with powerful special interests – especially in traditional industries that have benefited from the existing strategy. Implementing it will thus take time and require a lot of manoeuvring.

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The existing practice is that members may not turn 70 until the second half of the next term of office.

3 World Bank and Development Research Center, China State Council: China 2030: Building a Modern, Harmonious and Creative High-Income Society, World Bank, 2012. It is remarkable that a central government agency has collaborated for several years with the World Bank on such a large-scale project, also sanctioned by Vice Premier Li, who will be promoted to head of government this coming spring. Worth noting in the meantime is that the report has not yet been published in Chinese.

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Economic Insights

Corruption For natural reasons, China’s economic strategy attracts great interest in the West. For average Chinese – Mr. and Mrs. Wang – the economy, jobs and a rising standard of living are top priorities. But after that comes corruption. A series of fairly reliable public opinion surveys indicate that the Chinese people are largely satisfied with the direction their country is moving – except for corruption, which is increasingly intolerable. In their speeches at the November party congress, both the departing Hu Jintao and his successor as party leader, Xi Jinping, stressed the importance of a clean-up. Corruption is the foremost threat to the legitimacy of the party. Making “fire-fighter” Wang Qishan responsible for the battle against corruption is a sign that this may be more than rhetoric. In one of Xi’s first speeches as party leader, he attacked the excessive number of costly ceremonies during appearances by party officials. It is time to get rid of the red carpets, flower arrangements and motorcades, he declared. This admittedly has no direct connection to corruption, but it resonated with many people, who viewed it as the first volley of an attack on bureaucracy and the desire of some party bosses for status and luxury – which of course can be drivers of corruption. Corruption fighter Wang Qishan is certain to be granted extraordinary authority. The Central Commission for Discipline Inspection will become more powerful. Numerous investigations will be carried out, and the guilty will be exposed, dismissed and imprisoned, but few Western observers believe that such campaigns will eliminate the root of the evil. This will require an independent press (not just Internet microbloggers) entitled to ask unpleasant questions and independent courts with the right to examine the conduct of senior party bosses. And these are not on the radar today. Many challenges China’s new leadership will face many difficult challenges. In this travel report, I have also deliberately omitted such issues as the environment, security policy, demographics and the long-term role of the party – which require separate in-depth analyses and were not discussed during my visit to Beijing. My conclusion after this trip to the Middle Kingdom is that at least on paper, the shift in economic strategy will actually not be so difficult compared to some of these other challenges. As indicated above, personally I believe that these reforms will eventually come – and that their level of ambition will gradually be raised. However, I am more uncertain about the Chinese leadership’s strategies for dealing with corruption, security policy, the environment and other crucial future

issues. There is every reason to return to these issues in future reports.

Klas Eklund Senior Economist klas.eklund@seb.se +4670 763 8088

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