The Year the Training Wheels Came Off China
Economic reforms are transforming this burgeoning superpower, but Beijing needs to get used to the world watching and judging its every move.
A mini-milestone is upon China: It is likely to end 2014 with a $10 trillion economy, making China only the second country after the United States to join the league of double-digit-trillion economies. Ironically, that milestone will be met with muted reaction from Beijing -- similar to the way it dismissed the recent projection from the International Monetary Fund that in 2014 China would eclipse the United States as the world’s largest economy in purchasing power parity (PPP) terms. “No matter if China wears the biggest economy hat or the number-two economy hat, the Chinese public doesn’t feel comfortable wearing either hat,” read an article published in Xinhua, China’s state media conglomerate.
A mini-milestone is upon China: It is likely to end 2014 with a $10 trillion economy, making China only the second country after the United States to join the league of double-digit-trillion economies. Ironically, that milestone will be met with muted reaction from Beijing — similar to the way it dismissed the recent projection from the International Monetary Fund that in 2014 China would eclipse the United States as the world’s largest economy in purchasing power parity (PPP) terms. “No matter if China wears the biggest economy hat or the number-two economy hat, the Chinese public doesn’t feel comfortable wearing either hat,” read an article published in Xinhua, China’s state media conglomerate.
But the preoccupation with the size of the Chinese economy seems beside the point. Whether it’s PPP or exchange rates, GDP clearly fell from its exalted perch in 2014. It was, in the words of President Xi Jinping, the beginning of a “new normal,” a notion invoked to prepare markets, policymakers, and the public to adjust to a reality in which quality of development, employment, and structural reforms supersede that of (decelerating) growth. The curtain is closing on the era of rapid growth.
In fact, with its much larger economic base, China now doesn’t need to grow nearly as fast to add substantially to its economic output. This is probably why, for much of the year, Beijing withheld the kind of economic stimulus that the markets hoped for, despite a slew of indicators showing that the economy was decelerating. The People’s Bank of China, the country’s central bank, only modestly cut interest rates in November, while also liberalizing deposit rates slightly, striking a balance between shoring up short-term growth and committing to financial liberalization.
Still, China is capping off 2014 with a roaring stock market, riding one of the most bullish runs in recent memory. And Beijing looks on pace to meet its jobs target of about 12 million, having created 9.7 million new jobs through August, 100,000 more than over the same period last year.
Beijing’s relatively Zen-like attitude on the slowing economy didn’t compute with investors and market participants expecting the Chinese government to ride to the rescue with another massive stimulus. But that shouldn’t have been the expectation at the outset. In January, I argued in Foreign Policy that in 2014, China would see a soft landing and that “macroeconomic policies will tilt ‘pro-reform’ rather than ‘pro-growth.’”
Now, as 2014 draws to a close, it’s time to revisit what else I got right and wrong, and assess what might preoccupy China’s economic planners in the new year.
Caging tigers and unleashing reforms
Throughout 2014, Beijing showed no signs of relenting on the anticorruption front. Its methodical pursuit of officials led to the latest bombshell in December: expunging former security czar Zhou Yongkang from the ruling Chinese Communist Party and handing him over to the judiciary.
This marks the culmination of a more than yearlong process in which the top leadership moved toward formally purging one of the highest-ranking officials ever from the party. And as if the Zhou arrest wasn’t enough, the anticorruption machine also swept into the Chinese military, an institution that is usually inoculated against such capricious political winds, arresting top general Xu Caihou. In late December, the campaign also snagged Ling Jihua, a top aide to former President Hu Jintao.
Expect the anticorruption maelstrom to percolate at least through 2017 — when another major political transition takes place — including the expansion of an overseas effort called “Operation Fox Hunt” to extradite unsavory officials from abroad.
While the politics of anticorruption demanded considerable government capacity and resources, these did not completely sideline economic policymaking. Beijing managed to take modest steps forward on its ambitious reform agenda.
For instance, China’s grandiose urbanization strategy saw a little more clarity on hukou (residence permit) reform — an issue as contentious and difficult as the immigration debate in the United States. More details were released about how migrants can apply for a local hukou, though acquiring a permit to live in large cities of more than 5 million still remains verboten.
Beijing also progressed toward a gradual energy transition by raising the cost of coal consumption and restricting industry’s expansion. The central government began levying a higher resource tax on coal to raise its cost, a move that simultaneously adds a revenue stream for local governments. These actions were pushed forward in the name of battling air pollution, which in reality is a proxy justification for refashioning the economic and energy landscape into one that is more efficient and much less carbon-intensive.
One area that did not see a sense of urgency was cleaning up local debt, which stood at just under $3 trillion, according to the last official audit in 2013. Beijing seems to be projecting confidence that its current actions, combined with decent growth prospects, can reduce the debt level over the next several years. Creating a legitimate municipal bond market — a policy option being discussed — should help alleviate the debt problem. And Beijing may even be prepared to let a few small, local state firms collapse — in order to reduce moral hazard. But none of this will have an immediate impact on public debt levels that hover around 50 percent of GDP, which analysts have likened to a time bomb that could further depress the property market.
For many observers, one of the biggest economic reform disappointments of 2014 was the Shanghai Free Trade Zone (FTZ), which was created as a test bed for financial reforms, including the free flow of capital, currency convertibility, establishment of foreign financial institutions, and ease of investment and doing business, among others. It is also was meant to prepare China to complete a bilateral investment treaty with the United States by opening up more sectors to foreign investment.
Did the FTZ lead to transformative financial reforms in a single year? No. But the declaration of its failure is premature, for several reasons.
For one, the purpose of the FTZ is larger than simply piloting a few financial reform initiatives. The Shanghai party secretary, Han Zheng, vigorously defended the FTZ as a laboratory for experimenting with better governance. In other words, the zone was designed to experiment with how to transform from an interventionist government to a more hands-off regulatory state. Therefore, as Han insists, notable achievements will take longer than a single year — in fact, Beijing apparently gave Shanghai a three-year time frame to show comprehensive results.
And as I speculated in January, whatever seeds sprout successfully in the FTZ will be spread nationally as best practices, meaning there is a good chance that similar FTZs will be replicated in other parts of China. That happened in December, when Chinese Premier Li Keqiang announced the establishment of three more FTZs, in the provinces of Guangdong and Fujian and in the city of Tianjin.
Talk softly and carry a large purse
A notable omission in my 2014 forecast was what a banner year it was for Chinese economic diplomacy. Regional tensions took a backseat to a more proactive, forward-leaning Chinese strategy of pursuing global interests.
Xi ditched former paramount leader Deng Xiaoping’s dictum of “hiding one’s brilliance” in favor of more aggressive “great-power foreign policy with Chinese characteristics.” At the core of this new brand of diplomacy — whether it’s Li stumping around Europe trying to sell China’s bullet trains or Xi signing free trade agreements — is economic engagement and providing carrots in the form of money.
One of the main ideas behind Xi’s vision is what he calls the “New Silk Road,” which seeks to construct an economic belt that stretches from Europe across Central Asia, stitching these regions closer to the Chinese market. Beijing has backed this idea with considerable financial muscle, including the $40 billion Silk Road Fund and the China-led Asian Infrastructure Investment Bank (AIIB), a multilateral institution that will start with a $50 billion capitalization — and be largely capitalized with Chinese money.
Dropping billions of dollars and leading new multilateral financing institutions may not buy enduring allies and friends, but it certainly turns heads. It has caught Washington’s attention, as Beijing’s institution-building game, particularly the AIIB, has already led to pushback. But the bottom line is that Beijing has ostensibly decided to further leverage its roughly $4 trillion foreign exchange reserves — a sum larger than Germany’s GDP — to create new economic linkages and open markets.
Domestically, Beijing may in fact loom larger in 2015, as China’s cabinet prepares for the release of its five-year economic blueprint toward the end of the year. Several key areas deserve close attention.
Smaller growth targets, little fanfare
In setting its macroeconomic course for 2015, Beijing won’t deviate much from its current prudential monetary policy, using targeted fiscal stimulus when necessary to make sure growth doesn’t collapse. The central bank will adopt a more flexible posture to give it room to pump money into the economy. While some have speculated that Beijing may not release an explicit GDP target for 2015, that seems unrealistic.
Not announcing a growth target may spook markets into believing that Chinese growth is tanking. Instead, Beijing is likely to set a 7 percent growth rate, a soft target properly qualified with “more or less.” Such a target sends the consistent message of doubling down on reform while managing stable growth.
That message was reinforced at the recently concluded Central Economic Work Conference, an important annual high-level meeting, where Beijing made clear that it desires a stable macroeconomic environment in which it can pursue reforms — even if those reforms could hurt immediate growth.
Beijing’s increasing support for capital outflows also deserves watching. As a once capital-starved developing country, China has long been a leading recipient of foreign capital. Now, a capital-abundant China is prioritizing outbound investment, leveraging its deep pockets and ample foreign exchange reserves.
The “go out” strategy isn’t new, but Beijing is now pursuing it at a more ferocious pace and larger scale than ever before, in part tied to the new foreign-policy initiatives announced. Xi has said that China could see up to $1.25 trillion of outbound investment over the next decade; 2013 saw $108 billion in outward investment, up a whopping 23 percent from the previous year. According to estimates from the Chinese Ministry of Commerce, the country’s outbound direct investment could soon surpass the amount coming in, which was about $117 billion in 2013.
Reforms still lack credibility
Many observers have suggested that a year since the Third Plenum in November 2013, the momentum behind economic reforms is already sapped. But that assessment may be premature, as Beijing intends to forge ahead with some of the major planks in its reform agenda.
Two of those planks are the financial and fiscal systems, both of which are likely to see deeper reforms in 2015. On the financial side, a formal, explicit deposit insurance is expected to become reality, setting the foundation for liberalizing deposit rates.
Meanwhile, the Shanghai-Hong Kong stock connect, an investment channel that makes it much easier for mainland and Hong Kong residents to buy and sell stocks in the respective markets, marked an important step toward integration with global financial markets. It was likely also partially responsible for the late-2014 rally in the Chinese stock market. This linkage, aimed at facilitating the freer flow of capital between Hong Kong and the mainland, will likely deepen in 2015. Shenzhen and Hong Kong could be next in implementing similar stock market integration, further embedding the mainland stock markets into global capital markets.
The fiscal system, too, will continue to be overhauled to enhance local coffers and increase budgetary transparency. Dwindling fiscal revenue and the misallocation of capital at the local level are some of the thorniest issues for Beijing to address. Without fixing this admittedly complicated problem, Beijing will perpetuate local development based on debt finance and heavy bias toward investment and infrastructure.
The financial and fiscal systems are closely intertwined. Reforming them aims to achieve dual objectives: raising efficiency and improving the allocation of capital, and encouraging investment to flow into preferred areas such as social welfare, services, innovation, and environmental improvements. More significant movement on these fronts will increasingly convince the market and the Chinese public that Beijing is not dithering on reforms.
Xi’s five-year plan
Next year will mark the simultaneous conclusion of the 12th Five-Year Plan (FYP) and the unveiling of the 13th (likely in the fourth quarter), of which Xi will have full ownership. As with most final years of the FYP period, 2015 could see a redoubling of efforts to meet central energy and environmental targets. For instance, from 2011 to 2013, China managed energy intensity reductions of 2 percent, 3.6 percent, and 3.7 percent, but will need a reduction of about 4 percent for 2014 to 2015 to hit its overall 16 percent target.
Heavy industry and coal producers ought to prepare for another dismal year: The 13th FYP will further marginalize energy-intensive production. Since a major component of China’s economic restructuring is to achieve an energy transition toward high efficiency and cleaner fuels, it appears that the sun is setting on the previous “golden era” of the Chinese coal industry.
Such a priority is necessary if China hopes to meet the “peak carbon” 2030 timeline that it announced with the United States at the Asia-Pacific Economic Cooperation (APEC) summit in November. The 13th FYP, which takes the country through 2020, will offer more clarity on China’s path toward peak carbon. Either way, the transition from an energy-intensive growth model will likely take place in the context of even slower economic growth. Indeed, potentially a 6 percent average GDP growth rate will be announced in the new five-year economic blueprint.
While the gradual ratcheting down of growth expectations is fitting with the “new normal” paradigm that the top leadership hopes will take root, the actual economic and psychological adjustment isn’t going to be easy or painless. Nevertheless, the message is sure to echo loudly and consistently from Beijing to the rest of the world. For instance, a Google search of xin changtai (new normal) yielded nearly half a million hits.
Already, that message is being delivered by the unlikeliest of vessels. Rarely does the party mouthpiece the People’s Daily quote Bobby Kennedy when it wants to make a point about moving past GDP. In a 1968 speech, Kennedy said, “But even if we act to erase material poverty, there is another greater task, it is to confront the poverty of satisfaction — purpose and dignity — that afflicts us all.”
China agrees with that sentiment. Now indisputably an economic behemoth, it paradoxically no longer wants to be defined by GDP growth. Instead, it is pivoting to focus on a set of post-growth problems — basically, how to meet the changing expectations of a wealthier middle class and how to behave as a legitimate global power.
Indeed, this is the year that the training wheels came off China. But here’s the rub: An active global player will now be endlessly judged in the court of global public opinion. If China wants to play in every corner of the globe, it had better get used to the world watching and judging its every move.
China Photos/Getty Images
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