China's Politburo Standing Committee at the opening session of the Chinese People's Political Consultative Conference. Photo: AFP, Greg Baker

The structural change at the heart of China’s rebalancing out from exports toward domestic taxation and consumption reveals startling challenges fit for a statesman. The current challenge is best evidenced by indications of difficult tradeoffs; should the commitment to structural reform be made at the expense of economic growth? And what of the irreconcilable properties of market-based reforms have on state-led capitalism. For those who bet that China’s leading political class would pursue evidentiary progress are now left bewildered because Beijing’s willingness to pursue liberalization has reached domestic limits. These limits are both cultural, political and social. They also reflect a scarcity of institutions that would midwife the rebalance. How did Beijing’s dominant political class arrive at this cul-de-sac?

Bailouts & subsidies

Any look at past monetary initiatives reveals easing cycles (2014-15, 2011-12, 2008-09) that willfully ignored deeper structural issues that underwrote China’s state-led capitalism. By fielding subsidies for corporate investment, boosting property market valuations, along with subsidies for household consumption, Beijing’s political leadership sought to pursue liquidity, or credit-based growth. By 2018, Beijing became highly selective in its use of monetary and regulatory instruments to stimulate the economy. These new initiatives evidenced caution for intervention. The reason was that Chinese leadership demonstrated a commitment to debt reduction and structural reform.

Chinese ambitions became politicized in that the People’s Bank of China openly sought financial stability through the reduction of excess capacity and debt restructuring

Chinese ambitions became politicized in that the People’s Bank of China openly sought financial stability through the reduction of excess capacity and debt restructuring. This meant the willful construction of policy restraint due to domestic politics. The socio-political backdrop of a weakened renminbi, rising current account surplus and excessive debt prioritized Chinese strategic leadership.

Under this new normal, policy direction would emphasize 6-7% GDP growth with a stabilized currency; effectively permitting reform while addressing favorable trends in factor productivity growth. By securing marginal efficiencies of debt financing, Chinese President Xi Jinping pursued polices preventing the decoupling of the US from China’s supply chain competitiveness, while attracting foreign direct investment.

Promise fatigue

The current state of play regarding US-Chinese statecraft is mixed.  While China has openly addressed the developing world’s criticism of its trade and investment practices, China embarked on tax cuts and the loosening of restrictions on foreign ownership of companies. These statements have been met in Washington with a wait-and-see attitude. US skepticism about Chinese-led market liberalization rests on the premise that China’s new policy initiatives are in direct conflict with market principles. China’s currency, banks and severely underdeveloped capital/bond markets reflect the domestic priorities of Beijing alone. Without reforming these institutions, the distortion of China’s capital allocation process continues.

Turning inward

Throughout 2018, China’s deleveraging sought to openly advance the interests of its private sector. But Chinese state-led banks refused lending, so private companies developed funding relations with venture capital and shadow financing.  A closer look demonstrates both market aversion and market failure.  Even though the private sector continuously outperformed state-led enterprises, it had no implicit fiscal guarantee as do China’s state-owned-enterprises. This domestic political reality demonstrates the current root of China’s problem regarding the pace and direction of rebalancing.  The closure of shadow banking services remains a stop-gap measure that obfuscates an ethical dilemma. With China’s Communist Party ideology clashing with the spirit of market freedom that is economic reform, new monetary and regulatory policy initiatives only serve to reduce the negative externality of deleveraging.  The rebalance toward the taxation of domestic consumption has inevitably led to a difficult impasse, namely the retraction of exports from its GDP growth.

Domestic policy trumps reform

A dangerous reality has emerged. China’s dominant political class in Beijing has lost the initiative in managing US relations and it has failed to internationalize the renminbi. The turn inward may be the only policy option China has. Any reduction in trade would permanently erode any domestic consensus for structural reform.  The derailing of reform would mean that Chinese leadership would be dominated by internal matters, leaving profound strategic consequences for the ambitions of its blue-water navy and Eurasian Belt and Road initiatives.

The closing of China would presage the permanent erosion of any incentive toward liberalization because market signals from foreign competition would cease to exist. However, if Beijing’s leadership refuses to turn its gaze inward and begins joint-venture partnerships with multinational corporations, then Chinese leadership can fortify itself against myopic nationalist sentiments that embody reactionary factions in Beijing.

The promise isn’t just the appeal to market liberalization, but the ability to correct a misreading of China’s contemporary domestic challenge.

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