To Become the Biggest Economy, China Needs to Stop Fighting Itself

China’s leaders are loving—and hating—reform

China Stocks Decline on Disappointing Factory Data

With the yuan floating who knows where and China’s markets looking for a bottom, investors, analysts, and economists worry the country is headed into a time of volatile swings in public policy.

To supplant the U.S. as the No. 1 world economy, China has to overhaul its own. Yet its rulers are caught between the desire for far-reaching reforms and a deeply ingrained instinct to shelve them when things go wrong. So the yuan’s recent surprise devaluation gave China’s exports an edge—even though President Xi Jinping and his advisers have stated their desire to make consumption, not exports, the main engine of the economy. And the government intervened to stem the slide in stocks—while financial reforms were meant to build a stock exchange that responds to market forces. “The leadership is so paralyzed and preoccupied by even a modest downturn that it reacts with the same old fiscal tools of investment and pump-priming,” says David Shambaugh, director of George Washington University’s China Policy Program.

Finance Minister Lou Jiwei in 2014 cracked down on off-balance-sheet borrowing by local governments and ordered them to issue bonds instead. The thinking was that selling bonds to public investors would boost the transparency of local government finances and reduce spending on boondoggle projects. That plan was put on hold as growth sputtered. Regulators reversed themselves by relaxing the curbs on off-balance-sheet financing to keep credit flowing to towns and provinces—so they can create more jobs by starting more infrastructure and real estate projects.

Xi and his economic planners are simultaneously trying to rebalance the $10 trillion economy toward consumer-led growth, liberalize China’s capital markets, and stabilize stocks, which dropped an additional 6.5 percent on Aug. 18. The scale of these problems, along with an economic deceleration from double-digit growth to about 7 percent or lower, has raised questions about whether Xi’s government can meet its economic goals. “There are so many balls in the air, and one of them is going to fall,” says Jian Chang, chief China economist at Barclays. “It is just impossible to achieve so many potentially conflicting objectives at the same time.”

As Chinese stocks gained 150 percent from July 2014 through June 12, state-controlled media urged individual investors to buy. The stock market boom was supposed to offer companies in search of capital an alternative source to debt, and that worked until shares started to tumble. When the bubble burst, the government had to rescue investors.

An active civil service would help in these emergencies by monitoring the markets and watching for excesses in local debt. Yet the anticorruption campaign is also hindering reform efforts. A wave of arrests has made officials nervous about sticking their necks out. At the same time, civil servants whose perks have been trimmed have little motivation to undertake measures mapped out by the leadership. Premier Li Keqiang in his annual work report vowed to expose bureaucrats who “are lazy and lacking in action.” Says Willy Lam, an adjunct professor at the Chinese University of Hong Kong: “Bureaucrats are reluctant to execute the government’s directives. Resistance is mostly a reaction against the loss of income, perks, and prerogatives officials used to have.”

The surprise move to depreciate the yuan triggered a 2.85 percent drop, the currency’s biggest in two decades, and caught most investors and economists off guard. The absence of a clear explanation left the market guessing whether the move was a well-considered step on the road to fully freeing up the currency or a desperate effort to prop up exports. The Aug. 13 comment of People’s Bank of China Deputy Governor Yi Gang—“Trust the market, respect the market, fear the market, and follow the market”—added little clarity.

The Chinese government, as a rule, doesn’t show its cards to the financial markets. Major economic policymakers elsewhere typically either signal big policy changes well in advance or explain once a decision is made. The U.S. Federal Reserve has consistently kept investors informed since it unleashed quantitative easing, says Patrick Chovanec, chief strategist at Silvercrest Asset Management Group in New York. “There was no such thing in China. They just devalued, and you are left guessing at what it is they are trying to accomplish,” he says.

Allowing the yuan to rise and fall more freely is part of China’s plan to win its currency the same prestige as the U.S. dollar. Critics of China in the U.S. and elsewhere have long been calling for the end of fixed exchange rates for the yuan. Yet timing the move to free the yuan up just days after an alarming 8.3 percent decline in exports for July showed a certain tone-deafness to some and fueled views that China keeps its exchange rate weak to help exporters.

Analysts say Xi has failed to make much progress on an ambitious list of promised changes unveiled in 2013. They include shifting the emphasis to services over manufacturing, dismantling state-owned enterprises, and curbing loose spending by local governments. He is reviving the ancient Silk Road trading route to Europe, with plans to build transport and other infrastructure.

Making those things happen, while also running a country of 1.36 billion people, has been complicated by Xi’s top-down management style. Since taking over in March 2013, Xi has centralized power, taking a leading role in eight high-level policymaking committees in areas including military reform and cybersecurity.

He controls short-term financial policies and broader economic planning via two “leading groups.” One is a reform panel of his own creation, and the other is a financial and economic affairs committee customarily led by China’s premier. Xi’s predecessor, Hu Jintao, left the handling of China’s economic affairs to his premier, Wen Jiabao, who chaired the financial and economic affairs committee.

“There has been an overconcentration of power at the very top,” says Lam, whose book Chinese Politics in the Era of Xi Jinping was released in April in London and New York. “Nobody wants to take responsibility for anything unless they get a clear-cut directive from Xi Jinping himself.”

The bottom line: The Chinese government is struggling to adhere to its stated plans for economic reform.

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