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China’s Financial Challenge: Reforming a Flying Brick

September 14th, 2015

By Davis Florick – Junior Fellow

The Xi Jinping Administration is facing significant hurdles in its bid to maintain consistent growth in the Chinese economy. On the surface, a number of events foreshadow sweeping changes in the state’s fortunes. More disconcertingly though, many of the recent challenges Beijing has faced, including concerns over unethical and, in some cases, illegal banking practices; a falling stock market; and weakening gross domestic product (GDP) growth figures, are indicative of underlying structural problems. Demographic shifts, public perceptions of senior leaders (in both public and private careers), and the ongoing parasitic role of state owned enterprises (SOE) are just some examples of these far more complex, long term vulnerabilities the Chinese Communist Party (CCP) leadership needs to address. Against this backdrop, the Xi Administration has already made strides toward restructuring the economy, yet the government needs to institute considerably more changes. To be fair, recognition that under previous administrations reforming China’s economy was considered an insurmountable task is warranted. Constant and overwhelming pressure existed to raise standards of living, support key constituents such as SOE’s and the military, and compete on the global stage. These obstacles made altering the status quo profoundly difficult, thereby compounding complications for future leaders. However, the Xi Administration has, through a variety of measures, created the trade space to enact sorely needed restructuring. Therefore, the time is right for Beijing to adopt an ambitious and bold reform package in the pursuit of a more healthy and robust China capable of reaching new heights.

Many of today’s problems in the Middle Kingdom should come as no surprise. Rather, over China’s long history, a number of endemic, structural challenges for which government has not been able to take concerted action have occurred. First, the state has struggled to promote a comprehensive, transparent, and wide-reaching banking system. Due to a variety of factors, the general population has never relied on private institutions to safeguard its wealth. Considering the alternatives available to them for maintaining their savings, many Chinese have turned instead to real estate as the best means of protecting their assets. The emphasis on real estate coupled with the burgeoning economy make the current housing bubble more comprehensible. Second, the conflicts of the last two centuries have made serious private and public reform challenging to say the least. Dynastic, republican, and communist administrations have struggled to survive in the face of external and internal challenges. Even when leaders such as Mao Zedong have sought reform, it has often backfired. In the face of challenges such as managing over a billion people – both a simple and complex problem – the difficulties of structural modernization have become quite stark. Third, to bolster support and manage such a vast territory with so many people, Chinese governments have repeatedly sought local assistance to provide employment and stability. Unfortunately, forfeiture of central control has compounded the difficulties of implementing reform at the state level. Yet, despite these obstacles, the current CCP leadership has engendered an environment where institutional change is more feasible than it has been in years.

Politically, Beijing in 2015 is a far different place from the Beijing of 1975, 1985, or even 1995. The China that Mao’s successors inherited was a compilation of fiefdoms which routinely operated apart from the central government. Mao had enabled this development since the Great Famine period because it denied his political opponents within the CCP the support they needed to oppose his rule. In the 1970’s, the succession struggle between Deng Xiaoping and the Gang of Four served as testament to the factionalism that had emerged following Mao’s death. Similarly, in the 1980’s, internal Party conflict during the Tiananmen Crisis evidenced factionalism within the senior leadership. Specifically, the victory for hard line elements left even the infallible Deng Xiaoping weakened. Following this episode, the Jiang Zemin and Hu Jintao administrations of the 1990’s and 2000’s were more often characterized by their need to build consensus – a clear departure from the absolutism of Mao and Deng. Yet today, experts widely agree that Xi Jinping enjoys far more power than his recent predecessors. With anti-corruption efforts as his instrument, he has removed a wide swathe of the fiefdoms within the state. Targeting corrupt officials, politically dangerous business leaders, and other potential opponents, he has removed a significant segment of the regime’s potential challengers. Summarily, Xi Jinping has engineered an environment whereby far-reaching reform is suddenly within reach.

Thankfully for China, its current political developments have come at just the right moment as reform has never been more urgently needed. Lagging markets and declining growth figures are just the most prominent in a slew of negative barometers. Paradoxically though, the aforementioned problems are arguably among the most reversible. Look beyond the basic metrics and one will find burgeoning questions over the integrity and – ultimately – solvency of the banking system, rising housing prices, increasing wage rates, noncompetitive SOE’s, and more. Unfortunately, no easy resolutions to such challenges exist. If not addressed, the banking system will continue to lose public trust, unemployment may rise uncontrollably, and mismanagement of state-run firms will persist. The Xi Administration has already embarked upon a new approach to the Chinese economy with a greater emphasis on expectation management and a shift from a government investment-based to a consumer consumption-based model. However, to stem the negative tide, the government must undertake more ambitious steps. The following three options described below would all serve to initiate the type of structural change necessary to reform fundamentally the Chinese economy, yet they by no means constitute an all-encompassing program. Tectonic transformation now is vital as today may be the best opportunity for such momentous progress.

First, the CCP should address the nation’s symbiotic problems in the banking and real estate sectors. In particular, serious questions persist over the reporting done concerning the assets various institutions hold. Underreporting allows for more wide spread and high risk lending. Concerns over the integrity of the Chinese banking system have driven the general public to the real estate market for generations. The risk of losing everything due to unsound lending practices is far too significant for Chinese citizens to ignore. By contrast, the real estate market has traditionally been considered a safer gamble. In this particular case, Xi Jinping would do well to examine certain elements of the United States (US) banking system. Specifically, forcing banks to hold a higher percentage of their assets in reserve accounts would be useful. This action would at least reduce investors’ fears over insolvency issues. To further alleviate broader Chinese concerns, establishing a private-public organization that identifies the most ethical and transparent banks would be efficacious. Once institutionalized, this body would benefit banks seeking to reach the broader consumer population. The aforementioned measures are just a start toward improving investor confidence. While they may not eliminate the risk of a housing market correction, they can certainly help alleviate potential market panic. Ultimately, shoring up domestic confidence is vital toward improving marketplace health.

Second, in parallel to improving the financial system, the Xi Administration should adopt a more proactive approach toward the general population. Governing more than a billion people is complex, yet reforming retirement welfare and career transition programs is vital. Since the mid-twentieth century, China’s population has doubled, leading to tremendous pressures on all walks of life. Both the traditional retirement age, fifty for women and sixty for men, and the government safety net have not kept pace with rising costs of living. In a similar vein, the rapid shifts in the demands placed upon labor as firms transition from manufacturing to higher technology projects has left millions unsuited for the evolving economy. Adjustments to raise the retirement age gradually, improve pensions for the elderly, and bolster transition programs will greatly alter the economic outlook. Specifically, two key issues will be addressed. First, even for older workers, the transition from manufacturing positions to other areas of employment would be far less daunting, thereby reducing the risks of public instability. Second, transforming attitudes toward both the duration of workforce participation and retirement safety nets will reduce the burden on younger generations to provide for their elders. The cumulative effects of these changes will be a noticeable reduction in market volatility as the risks associated with its natural ebb and flow are blunted, and the government will have more breathing space as cradle-to-grave assistance will be provided through other means. A pincer-like approach to reducing the problems associated with an aging workforce will significantly alter tomorrow’s environment for Chinese business and government.

Third, reforming the banking sector and welfare system will permit China to seek changes in its SOE structure. Since Beijing began to expose the state to outside influences, government-managed companies have come to represent an archaic way of doing business.  Slow and inefficient, they have lacked the motivation of private firms to modernize. Unfortunately, they remain a necessary means to employ substantial quantities of unskilled and aging laborers. Consequently, Chinese politicians have been averse to overhauling the SOE system, fearing wide spread unemployment leading to domestic unrest. However, at this juncture, with considerable economic hurdles emerging, the Chinese government needs to pursue dramatic, yet responsible and mature reform. Therefore, Beijing must look to privatize SOE’s whenever possible. A progressive approach that looks increasingly to release state-run firms from government supervision will relieve a significant burden on China’s budget. Certainly this will cause major alterations in how many of these companies do business, but the aforementioned programs would preempt some of the risks to the workforce. Specifically, the government can do a better job of providing career transition training to alleviate concerns. Furthermore, the introduction of a more credible banking system and robust retirement construct would further minimize the negative fallout from dissolving the SOE system. Invariably, the Xi Administration must seek separation from the state-run firms if it wants a healthier and more vibrant economy. Resistance to the privatization of so many companies will certainly occur, but it is a necessary cost of moving into the twenty-first century.

China’s economic model is rapidly encountering a variety of challenges that are all too inevitable. From a historical perspective, there are a number of structural flaws that were bound to catch up with the growth of the last three decades. Considering some of the long term obstacles Beijing faces, in many ways it is a testament to the CCP’s leadership, beginning with Deng Xiaoping, that the markets have fared as well as they have. Today though, China is addressing a myriad of issues, yet more should be done. Clearly, those I have listed are just a few of the many reforms the Xi Administration should consider. However, it is incumbent on the senior leadership to make use of the personal support Xi Jinping enjoys to leverage reform.

About Davis Florick

Davis Florick is a Senior Fellow in the HSC Security and Defence division, a Special Assistant to the United States Deputy Under Secretary of Defense for Policy, and a James A. Kelly non-resident fellow with the Pacific Forum. He has completed his Executive MBA at the University of Virginia Darden School of Business, holds a master’s in East-West Studies at Creighton University, and will be starting his PhD in International Relations at George Mason University in Fall, 2018. His foreign relations areas of concentration include East Asia and the former Warsaw Pact and Soviet Union. Davis has been published in International Affairs Forum, the World Business Institute, and the International Affairs Review, the Diplomat and RealClearDefense. He was also a member of the 2015 Nuclear Scholars Initiative with the Center for Strategic and International Studies.