President Xi takes “core” leader role as China heads for political turbulence

Xi Jinping Oct16Outside observers often imagine that China’s political structure is uniquely disciplined – unlike, say the US Republican Party, or the UK Labour Party, or indeed, political parties anywhere.  But the fact that most arguments take place behind closed doors, and aren’t reported in the state-controlled media, doesn’t mean that the arguments don’t happen.

Yesterday’s announcement that President Xi Jinping is taking the “core leader” designation, only held previously by leaders such as Mao, Deng Xiaoping and Jiang Zemin, is thus a rare moment when the curtain is lifted and the arguments briefly enter the public domain.  It highlights the intensity of the debate now underway between Xi and Premier Li over the direction of economic policy.

Li has been very active so far this year in promoting Populist policies, at the expense of Xi’s efforts to promote reform through his Princeling faction.  Xi’s move therefore confirms my belief that Xi is determined to “take the pain of reform” before his expected reappointment for another 5 years at the 19th Congress in November 2017.  As he emphasised in a major interview last year, before his US visit:

“Reform steps have upset the vested interests of some people, and caused changes to the career and life of some people. It is only natural that there will be difficulties. Otherwise it will not be a reform. That is why I said that we must be bold enough to crack hard nuts and ford dangerous rapids during reform and that only the daring will prevail at key stages of reform”.

This week’s developments highlight the context within which Xi is operating.  His only option is to try and tighten his control of the government in response to Li’s renewed push to implement Populist policies.  In turn, this confirms that fundamental economic reform depends on the President to make it happen.  If Li is able to continue with his policies, and Xi loses control of the government apparatus, reform may well be abandoned.

The announcement also confirms that China’s economy is reaching a difficult stage as the country enters the critical period ahead of the 19th Congress.  This is when appointments to the Politburo Standing Committee (PSC) – effectively the supreme governing body – will be finalised for the next 5 years:

 As Reuters has reported, Li is currently pushing to appoint 3 Populist allies to the PSC, which would give him a 4 – 3 majority against Xi’s Princeling faction
 In response, Xi’s strategy has been to focus on the appointments to the 25-man Politburo, which in turn appoints the PSC. This currently has a 14 – 11 Populist majority. But many will retire next year – giving Xi the opportunity to replace them with loyalists, and hence control the PSC appointments
 Another sign of the battles underway is that Xi has not yet made any moves to anoint a successor. This has led to suggestions that he may be aiming to remain in office beyond than the standard two-term ten years. But it may instead be that, as yet, he lacks the Politburo votes to impose his will

None of us know how the next 12 months will play out in China.

My personal belief, having worked with Xi’s father, is that his son has inherited his determination and courage. Therefore I suspect he will win through – but it will probably be a closely fought battle.

Prudent companies and investors would therefore be well advised to prepare for other Scenarios to develop, as it will probably be too late to react after the event.

The Deng, Jiang model for China’s economic growth under Xi

China pollutionJan14

Major change is already underway in China, with potentially enormous implications for all of us.

  • Corruption is being stamped out via a policy of ‘shock and awe’
  • Similarly, wasteful lending is under attack in both the official and the so-called ‘shadow banking’ sectors
  • Thirdly, pollution is being tackled by literally ‘sending in the bulldozers‘ to destroy polluting factories under the eyes of TV cameras, and introducing quotas on car sales in the major cities

It is impossible to underestimate the scale of the changes now underway.  Just as under Deng and Jiang, they are being led from the top by a new leadership group headed by Xi himself.  Its key focus is on the “economy and ecology“, highlighting the economic and political crisis that developed during the “lost decade“.

Equally, as the blog has detailed this week, these challenges clearly mirror those faced by Jiang and Zhu in 1993, and by Deng and Zhao in the post-Mao period after 1977:

Today’s challenge is not to restore order after the chaos of the Gang of Four, or after Tiananmen Square.  Instead it is to head off an existential crisis over pollution, coupled with demographic decline.  The Party’s main think-tank, China’s Academy of Social Sciences, has thus headlined the “shrinking demographic dividend, overcapacity, choking pollution, risks from the property sector and local government debt as key threats to be tackled immediately.

Bankruptcy was the key economic challenge facing Deng in 1977.  Whilst as the World Bank noted, the major risk in 1993 was that ”China could have lost economic control and landed in a Latin American-style inflationary spiral”.

This time, as a major World Bank report with China’s National Reform and Development Commission has warned:

China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the ‘middle-income trap’.”

This comprehensive Report was issued to coincide with the 5-yearly Party conference in March 2012 and highlighted 5 key risks:

“The end of export market growth; wasteful infrastructure investment; the need to boost personal consumption via higher wages (which has the downside of reducing profit margins and job creation); managing the transition to a new economic model; and the threat of hitting ‘the middle income trap’ described by Nobel Prize winner Sir Arthur Lewis”

Xi and Li follow the Deng/Jiang model
In response, it is clear that the new leadership is closely following the successful strategies developed by Deng and Jiang in response to similar crises:

  • The return of ‘the man who knows what to do’.  Deng was brought back in 1977, having been purged 3 times, because he was the only person who could manage the situation.  Similarly he returned a second time with his Southern Tour in Q4 1992 to build Jiang’s powerbase.  This time it has been Jiang who returned.  He ensured the removal of the corrupt Bo Xilai, and forced through the leadership changes in November 2012 that meant 6 of the 7 current Politburo members are his men
  • The immediate assumption of control over the military.  The Bo Xilai affair highlighted the risk of military unrest – there were well-reported rumours of tanks moving in Beijing in March 2012.  Xi has followed Deng and Jiang in immediately taking control of the Central Military Commission by becoming its chairman
  • The use of the World Bank to develop a policy framework.  Again, Xi has followed Deng and Jiang in this, with no delay.  In fact, the World Bank began work even before Xi formally took power – highlighting his early awareness of the depth of the crisis that China faces
  • Focusing on the economic challenge immediately.  Deng had premier Zhao Ziyang, and Jiang had premier Zhu Rongji, both entirely focused on the economic issues.  Today, Li Keqiang is taking the same role.  Equally important is that Xi has followed Deng and Jiang in taking personal leadership of the issue via chairmanship of the new “Leading Group for Overall Reform”.  Without his active involvement, reform will inevitably be blocked by those who would lose out as a result
  • Willingness to take tough measures.  China’s new leadership have 10 years of power ahead of them.  Thus they are already sending in the bulldozers to destroy polluting factories over the heads of local government officials.  Whilst Xi’s appointee at the central bank, Zhou Xiaochuan, is taking power back from the regulators who have failed to control the shadow banking sector.  All this has clear parallels with Deng and Jiang’s ‘no nonsense approach’, and their appreciation that a sense of urgency is critical for success

What does this mean for the outside world?
The years after 1977 and 1993 were stormy periods in China’s history.  The period to 2020 is unlikely to be different, and there are no guarantees that the new leadership’s policies will succeed.  But it is already possible to identify some of the likely major impacts on the global economy:

  • Domino effect.  US-centric observers have wrongly assumed that the Federal Reserve’s taper has somehow begun to destabilise Asian economies such as India and Indonesia.  They will now have to rush to catch up, as it becomes clear that this is really early warning of China’s massive policy shift
  • Double-digit growth.   The imperative of political survival means the leadership have to continue to bulldoze polluting factories, and also clean up the one-sixth of China’s farmland currently contaminated with toxic waste. Therefore the days of double-digit economic growth will never return
  • Deflation.  Premier Li made clear last year that maintaining employment was his key priority.  We can therefore expect China to focus on maximising export sales during the transition, effectively exporting deflation – as volume rather than profit will be the priority.
  • Export Demand.  China’s main export focus will no longer be the cheap textiles and plastic products of the past.  Instead it will create jobs via an aggressive drive to sell affordable cars, relatively high-value chemicals and other  products into Asian and developing country markets, based on its vast new capacity.
  • Dollar strength.  China’s economic crisis will come as a shock to most of the financial community, as did the US subprime crisis.  We can therefore expect China’s currency to fall in value, and the US$ to rise, all other things being equal.  This, of course, will also help to boost China’s exports
  • Domestic Demand.  Similarly the focus of China’s domestic demand will change.  Sales of western luxury goods will continue to decline as the corruption campaigns continue.  Instead, the focus will be affordable necessities such as $50 refrigerators for the 90% of the population who earn less than $20/
  • Debt.  China’s record $1.3tn holding of US debt was built up as a form of vendor finance, to support US purchases of China’s products.  But this strategy is no longer relevant, so we may well see China slowly reduce its holdings as it will have more use for the cash at home – putting pressure on Western interest rates

Readers will no doubt have their own insights into the impact of these changes on their own businesses and personal lives.  But one thing is very clear.  China not only has to go down this path, as we described in chapter 6 of ‘Boom, Gloom and the New Normal’ in November 2011.  But its leaders now clearly recognise that they have to change policy with great urgency.

The blog always feared that the recent boom would turn out to be another of the ‘boom and bust’ cycles that have characterised the post-Mao period.  No sane person would ever want to go back to the days of the Great Leap forward and the Cultural Revolution.  It therefore hopes that Xi and Li will not only manage to overcome the current crisis, but also succeed in establishing a more sustainable future for the country.

Deng’s economic policy in China’s post-Mao period

China bikes1976China’s economic policy has gone through 2 complete cycles since Chairman Mao’s death is 1976.  Under new president Xi, it now seems to be about to start a 3rd cycle.  If this cycle follows the pattern of the previous cycles, it will have very major implications for anyone doing business with China, either directly or indirectly.

As yesterday’s post discussed, China’s lending programme since 2009 has been the largest in the world, at least $9.7tn – more than twice the US Federal Reserve’s.  It now has to be substantially reduced, to avoid economic and political crisis.  No country has ever been in this position before.  But we do know what happened in China’s 2 previous economic and political crises, and these provide clear insight into how the new leadership will operate.

Today’s post looks in detail at the first cycle, which ended with very similar problems to today’s.

1977 – 1992, Deng Xiaoping’s return, and its aftermath
Deng returned after the death of Chairman Mao in 1976, following his 3rd purging.  His first task was to deal with the chaos caused by the failed bid for power by Mao’s widow and the Gang of Four.  As the photo shows, Beijing was then a very backward city.  Deng, who had not travelled outside China since the 1920s, was astonished to find on visiting Japan and Europe/USA that China was decades behind them in technology and living standards.  He moved quickly to improve the position, but faced entrenched resistance from those who believed that ‘combating bourgeois liberalism’ via political correctness, not ability, should remain the main criteria for official appointments.

Deng set about opening up the economy during his time as paramount leader – with president Xi’s father, Xi Zhongxun, playing a leading role in the transformation of Guangdong’s economy.  Equally, he developed a close working relationship with the World Bank under Robert McNamara.  This led the Bank to despatch a team of 30 experts in 1980 for a 3 month study period, to develop recommendations on how to rebuild China’s economy.  This was the first time the World Bank had ever undertaken such a programme.  Its purpose was described by Deng as follows:

We are very poor. We have lost touch with the world. We need the World Bank to catch up. We can do it without you, but we can do it quicker and better with you.”

Major reform followed as Deng set out what became known as the philosophy of the ‘socialist market economy’, or ‘socialism with Chinese characteristics’.  At the same time, Deng took bold steps in relation to the army, cutting its budget and manpower dramatically so as to free up cash to invest in the broader economy and boost living standards.  As a former army general, he could see that the prospect of invasion, so feared by Mao, had become most unlikely, and he was able to push through his changes despite strong opposition.

Deng began to set his retirement in motion around 1985, introducing the important reform of a maximum of 10-year terms of office for the senior leadership – a policy which still continues.  But the collapse of the Soviet Union, and the Tiananmen Square protests in 1989, brought him back into a more active role.  Hardliners in the government saw a chance to reverse Deng’s economic reforms, whilst clamping down on political protest.  This prompted Deng to argue instead that the Russian Communist Party had lost power due to ‘too much glasnost (openness) and not enough perestroika (economic reform)”.

This led him to the final act of his career, the famous Southern Tour of 1992, when he summarised his views on economic development in two phrases:

  • “To get rich is glorious”
  • “It doesn’t matter if the cat is black or white, as long as it catches mice’

The tour was at first unreported in official media, but as the blog will discuss tomorrow, new president Jiang Zemin was then able to consolidate his position on the basis of continuing Deng’s policies of economic reform.  At the same time, he kept a tight lid on political protests which risked destabilising Communist Party rule.

The years from 1985-92 were thus a period of considerable uncertainty for the future direction of economic policy.

Deng’s reforms had led to major gains in living standards.  But the privileges of the Special Economic Zones such as Shenzhen were being increasingly abused by corrupt leaders able to buy products and services at advantageous prices for their own personal profit.

Equally, economic disaster was leading Party hardliners to demand a return to the ‘old ways’.  The political turmoil of 1989 had provided the perfect excuse for those who had never supported reform.  They demanded that the reforms should be reversed, on the basis that otherwise Communist Party rule was threatened.

As the World Bank noted afterwards:

China could have lost economic control and landed in a Latin American-style inflationary spiral. If that had happened, the reform process would have halted and China might not have been able to avoid a financial crisis.”

Tomorrow’s post will look at how Jiang adopted Deng’s playbook from 1977, and managed to create the springboard for China to embark on double-digit economic growth.