A time of challenges for China’s leadership

A presentation by Claude Smadja for the
Baraboo Growth Symposium, Vail January 2019

The next two years are going to be extremely difficult for China. Just as an anecdotal evidence that the leadership is preparing for a difficult period ahead, the seminar on risks for the senior cadres of the CCP just finished after four full days of discussion on how to manage and mitigate these risks both on the domestic as well, as on the international fronts.

What makes the present situation so particular is that we have a convergence of four crises – or at least major challenges – looming up which will test President Xi Jinping leadership ability, and whose outcome will shape not only China’s trajectory in the coming years but also the global economy and the whole geopolitical landscape.

The first challenge is an economic one: GDP growth has been slowing in China with the 2018 results – 6.6% – being the lowest in the last twenty years, and the fourth quarter of last year confirming that the deceleration of activity is continuing as a result of both structural and cyclical adverse forces. There is here primarily the impact of the deleveraging and the restrictive measures against shadow banking imposed by the government to reduce financial risk which had taken a very worrisome proportion after ten years of debt-driven growth. Significantly, financial risk had been identified as one of the top three priorities by the leadership at the beginning of last year. Adding to that has been the initial impact of the tariffs imposed by the Trump administration. To prevent the slowdown going too fast too far the leadership has been trying to inject additional dynamism in the economy by loosening fiscal policy, reducing the banks reserve requirements, deciding on tax cuts and by launching a new set of infrastructure projects.

The problem is that new funds have so far gone to SOEs – a set pattern given the emphasis put on the preservation of the role of SOEs as a key element of the power grip of the Party – while it is the private sector which generates growth and job creation. The government is now insisting that the banks should reverse their long-held tradition of directing credit almost exclusively to SOEs and provide credit to the private sector – Xi Jinping has personally intervened on that twice in the last month.

It remains to be seen how the private sector – especially the medium-size private companies which had been so demoralized by the inability to get necessary credit from banks and has been forced to resort to expensive shadow banking funds which had dried up – will react if new credits are now available. At the same time, Beijing needs to make sure that the issuance of new funding for infrastructure projects will be well controlled and calibrated to avoid inflating again the debt of provincial and local entities and re-igniting the financial risk that was a major issue in 2018 and that it had fought hard to bring under control.

This will be a very difficult balancing act for the leadership as they absolutely need to put a floor on GDP growth at around 6 to 6.5% but at the same time they need to make sure that the fiscal loosening being implemented will not aggravate the structural imbalances in the economy that the 2009 stimulus program generated. In the same way, it will be also be very difficult to calibrate the much needed support to the private sector while maintaining the primacy of the SOEs despite the very poor performance of many of them. This balancing act between contradictory priorities will have to be managed in the context of a softening global economy and the uncertainties of additional punitive tariffs by 1st March if the present negotiations with Washington fail.

The second challenge is linked to the Belt & Road Initiative. This is one of the two signature initiatives launched by XI Jinping and a trillion dollars project. The idea is to kill three birds with one stone : Help address the issue of over-capacity in some sectors in China, especially in the infrastructure and construction domains, and create a new vector of growth for Chinese companies in Asia, Central Asia the Middle-East and Eastern Europe; create a huge zone of co-prosperity with China at its center ; and build a sphere of geopolitical influence for Beijing. However, the project is fraught with a number of risks from an economic side, as many of the countries targeted are in poor financial and economic shape ; There are also political risks given the very volatile and unstable political situation of most of these countries ; and then there is the reputation risk for China as many of the expectations created by the Belt & Road Initiative might not be fulfilled, generating an anti-China backlash.

So far, Beijing has been unable to entice the private sector in its projects which are almost exclusively undertaken by SOEs, as private sector companies consider that most of the projects represent too much of a financial risk for them. In fact, there is quite a significant concern in China about the fact that some of the money invested in the Initiative will never be recovered. What has also happened is that although Beijing speaks of a win-win initiative, so far 86% of the projects undertaken has gone to Chinese companies, creating frustrations in the countries of destination. Many of these countries are also realizing that some of the projects have a much higher cost than if they had been allocated through bidding processes.

Last but not least, some of the countries targeted by the Belt & Road are now confronted with a huge debt burden with respect to their financial capabilities. This has been the case for Sri Lanka which was forced to grant a 99 year lease to China on the strategic port of Hambantota because it could not repay the funds borrowed for the construction of the port. In the same way, Pakistan is now on the brink of bankruptcy but will not get any loan from the IMF as Washington will block any infusion of money to Pakistan to allow this country to repay some of its debt to China. In Malaysia, Prime Minister Mahathir decided a freeze on all projects initiated by his predecessor in the context of the Belt & Road and an audit of the actual costs involved with the cancellation of some of these projects.

So, some backlash has been building up towards Xi Jinping’s initiative, which in fact has considerably slowed down in 2018 in terms of the number of new projects undertaken. The key question is whether XI Jinping will be able to make the necessary adjustments to his initiative in the course of 2019 to keep it moving and contain the growing reputation risk involved in it. However, these adjustments will, in many cases, go against the vested interests of some SOEs and it remains to be seen whether Beijing will be able to demonstrate the necessary flexibility that will allow the Belt & Road Initiative to continue to proceed in a smoother way.

The third challenge will be for XI Jinping to maintain his position of uncontested leader in Beijing. Over the last six years the president has been concentrating all the levers of power in his hands, eliminating all potential sources of opposition to him, and creating a personality cult not seen in China since the Mao era. His decision to abrogate the two terms limit to the President position has not been well received in many segments not only of the power apparatus but also of the Chinese public at large. He has expanded the number and role of Small Leading Groups which he chairs himself, or have some close associates to chair, and which cover – and shape the decisions on – every single public policy issue in the economic, security, foreign policy domains. In the same way, the restructuring of the Chinese military which has been engineered by Xi was not only aiming at transforming it into an efficient, modern, fighting force but allowing the President to establish his control on it. This is now almost fully achieved. In parallel to that, Xi Jinping is also gradually establishing his full control on the police apparatus – which was not the case until two years ago.

However, in doing so and in using extensively the anti-corruption campaign to neutralize any potential source of opposition to, or contestation of, his power ; by being omnipresent and becoming the ultimate decision-maker on all important decision in any domain and abolishing the practice of collective leadership which had existed before his accession to power, XI has created a lot of ennemies who are just waiting for any opportunity to hit back at him. If the economy slows down too much ; if the confrontation with the US turns out to be too damaging ; if his drive to put China close to the center of the international stage generates a very costly backlash ; even if a natural disaster or calamity is badly handled and generates a strong popular outcry ; then there might be attempts in Beijing to get back to the former formula of collective leadership that characterized the Hu Jintao era.

This does not mean at all that XI Jinping could possibly be removed from power. He is now too solidly entrenched for that. But this would mean that in some policy areas he will have to resort to a more collective decision-making pattern and that some of his pet projects might be put on the back-Burner. This would be a very bad outcome for him as he considers that the Hu Jintao era was a “lost decade” for China as decision-making was too dispersed, leadership was too weak, and the grip of the Party loosened too much. In addition to that, Xi is convinced that it is only under his leadership that China can be – and will be – restored to the status it deserves as a great super-power.

The fourth and presumably the most important challenge is of course linked to the management of the US-China relationship. This relationship is at a very critical juncture. To understand how we got there, and to try understand what will shape the future of this relationship one needs first of all realize what key strategic assumptions from both sides have now proved to be wrong.

  • The US/Western assumptions regarding China that have proven to be wrong:
  1. China’s economy will somehow “converge” towards a a free market, western style model. This was wishful thinking. China is doing what it has always been very clear about doing i.e. build a “socialist market economy with Chinese characteristics” but the Western world was so assured that there could not be any other economic model than its own one that Beijing assertions were wrongly dismissed as sheer rhetoric. In the same way, when Xi Jinping has been speaking about reforms, he always had in mind reforms aimed at strengthening the system, not changing it. This means preserving the strong role for SOEs and the absolute guidance of the Party not only on the economy ,but on every aspect of China’s social fabrics. So, if preserving the system and improving its efficiency, or bending to tactical necessities, means opening up more activities to foreign companies (for instance in the financial services ) this is something that Xi can live with.
  2. The authoritarian nature of the regime will constrain China’s innovation and entrepreneurship capabilities and would slow its catching up process on the Western world. Innovation is booming in China and the country has today what is probably the most vibrant startups ecosystem in the world. China is fast catching up on mastering the disruptive technologies that drive the 21st century economy, threatening the technological supremacy the US had enjoyed so far – especially in the ICT, AI, aerospace domains.
  3. The spread of social media in China and the high penetration of the Internet would compel the regime to move towards some kind of social liberalization. In fact the authoritarian grip of the regime under Xi Jinping has never been so tight since the Mao era. The regime has mastered the art of using social media to watch the mood of the people, to shape it but also to respond to some frustrations when it comes to daily life issues, while ensuring that the key elements of the regime message, and the basis of its legitimacy are always present.
  • The Chinese assumptions about the US policy that have proved wrong
  1. President XI Jinping had assumed that he could break with the traditional approach shaped by Deng Xiaoping – « Lie low, hide your strengths, bid your time » – and initiate a very assertive and ambitious strategy to bring China back to « very close » to the center of international stage without generating a backlash from Washington. He was counting on the fact that past the initial bluster the Trump administration would just continue along the lines of past administration, i.e. oscillating between looking at China as a strategic partner or as a strategic competitor. He did not realize that for key people around Trump China is now a adversary Number One, a strategic rival bent on supplanting the US as the number one super-power, and to be stopped – or at least slowed down to a maximum extent – in its course.
  2. XI Jinping had also under-estimated how his much heralded « Made in China 2025 » initiative – and what it meant in terms of tilting even more the playing field towards Chinese SOEs and progressively squeezing out Western MNCs from key sectors defining the commanding heights of the 21st century economy – had antagonized Western MNCs which had been so far one key base of support, and the most efficient lobbyist, for China in Washington.
  3. Last but not least, XI Jinping had not realized the strength of Donald Trump’s obsession with trade deficits and how this was a key consideration shaping the President’s approach to China, making him lean towards the hard-liners in his administration who – beyond trade issues – have now defined and are implementing a full-scale China containment policy.
  • In this present context, what are the strategic objectives that Beiijing and Washington are pursuing and where is this leading the US-China relationship?

XI Jinping objectives have not changed. They can be summed up as:

  1. Putting China “close to the center” of the global stage and establishing it as the equal to the US. This involves an accelerated push towards expanding fast China’s technological, economic capabilities, creating a modern and sophisticated military apparatus, able to project power beyond the mainland border, and and creating through the Belt & Road Initiative a sphere of geopolitical influence. This means establishing China’s leading position in some key technologies of the future such as AI. However, contrary to the assumption in many circles in Washington, its is doubtful that China aims at “replacing “the US as Number one » but rather dealing globally with it as its equal, while supplanting it in the Asia region. In the same way, In the same way it is a misconception to think that Xi Jinping’s objective is to build a new world order centered around China and antagonistic to the existing US-led international order. More presumably what China wants is an adjustment of the international structures and institutions such as the WTO and the IMF that will take into account its expanding economic weight.
  2. Ensuring the long-term sustainability of the grip on power of the Chinese Communist Party. This means that the Party leads everything “government, military, civilian, academic, north, south, east, west and center », as Xi Jinping pointed out at the National People’s Congress in 2018. This also means making sure that SOEs continue to play their role not only as a key element of Beijing economic strategy but also as a crucial factor in maintaining the grip of the Party on China’s society. This goes with the shutting down of any potential dissenting voice and making sure that the private sector, while playing its role in economic development, operates in a perimeter strictly defined by the state.
  3. Bringing China to the status of a moderately prosperous society by 2030. This entails achieving over the next ten or twelve years the shift towards an economy by technology and innovation, domestic consumption and a prominent position in the technologies defining the commanding heights of the 21st century economy. This requires, at least for the short or even medium term, maintaining some form of interdependence between the Chinese and the US and European economies.

The Trump administration’s strategic objectives:

  1. Containing the rise of China as an economic, technological, military Super-power able to challenge the prominent position of the United States. This translates, among other things, by:

    Slowing down China’s high-tech development through the tightening of the rules regarding Chinese acquisitions of US high-tech companies; restricting access of Chinese nationals to high-tech research centers; imposing a ban on using telecom companies such as ZTE or Huawei which have become very serious challengers to established players in that domain and are even supplanting them when it comes, for instance, to 5G as a technology and business game-changer; and bringing European countries, Japan and Australia to join in the boycott or ban of the Chinese companies most advanced in the crucial technologies such as ICT. (It is interesting in that respect that, so far, the US has not come up with any significant proof/evidence to support its claim that Huawei is a threat to US national security).

    Challenging more forcefully China’s territorial claims in the South China sea, and countering the increasing presence of the Chinese navy in the Indian Ocean.

    Launching a program of investments in development assistance programs in some third world countries – notably Africa – to try to stop or even reverse the spreading of China’s presence and influence in these countries.

  2. Trying to decouple the US economy from the Chinese one, through policies such as tariffs aimed at pressuring US European and Japanese MNCs to restructure their global supply chains and – when feasible – to relocate activities from China to the US.

The problem is that there is scant chance that the Trump administration will be able to achieve its containment objectives, as – with respect to China’s rise in every single domain – the train has left the station quite some time ago. China has already become too much of an economic power with a vast and dynamic domestic market – it has supplanted the US economy in Purchasing Power Parity terms. It is now a technological powerhouse and is fast developing its military capabilities. There are three times more countries that have now China rather than the US as their main economic partner. With China’s huge population, its growing influence in different parts of the world there is no way that the US could replicate with it what its Soviet containment policy achieved in the Cold War era.

The rear-guard battle that the White House is waging might at best delay China’s development in some domains for a few years but no more than that. It will also prompt Beijing to accelerate its drive to become self-reliant in key areas such as semi-conductors or aeronautics. But what it will definitely do is to create resentment towards the US from a country and a public opinion fiercely nationalistic, extremely proud of what China has achieved over the last forty years and to exacerbate the sense of a revenge to be taken over history. This would undoubtedly make even more difficult the much indispensable modus vivendi that will have to be achieved among two super-powers with different systems operating according to different logic but compelled to find ways to engage in business, economic interaction and to collaborate on some key global issues.

The Chinese leadership will not accept or bend to any pressure to change a system that it sees as extremely successful in making China achieve in 40 years what it took almost two centuries for Western countries to achieve. It will not – also – accept any change in its policies or structure that would endanger the grip of the Communist Party as a structure of power (not anymore as an ideological structure). This will mean the continuation of the leading role of the public sector and the SOEs in all strategic economic and technological areas and the reliance on a directive industrial policy. The line one would hear in Beijing from government and Party officials is very simple: « We are not asking any country to change its political or economic system and we don’t see why anybody would feel entitled to ask us to change our system ».

In that context, the most likely development in the present US-China confrontation is that Beijing will offer some good concession to reduce the US trade deficit, additional pledges and measures to protect intellectual property rights and reduce forced transfers of technology from Western companies operating in China. This will not weaken or change in any way the modus operandi of the Chinese system or the basic structures on which its economy functions. But, if tactical concessions are made by Beijing they will presumably be made in a way allowing Mr. Trump to declare victory and tell his electoral base what a strong leader he is, without Beijing conceding anything that the leadership considers essential with respect to its strategic objectives.

This will not address the structural challenge – the most crucial one in the many years to come – of how to make two economic blocs having achieved a kind of parity but operating according to different systems and logic not only to coexist but to interact in a positive way and to be able to join forces in addressing some global challenges.

Western corporations will have to re-calibrate the way they do business in and with China – as the Chinese market is too big – and will get even bigger – to ignore while Chinese corporations will also have to devise less abrasive and offensive ways to get from the US and Europe the kind of technologies they will continue to need in the coming years to sustain their evolution.

There will certainly be some perceptible sighs of relief if the present US-China trade negotiation end up successfully before 1st March and eliminate for the moment the scary prospect of a very damaging trade war. But don’t hold your breath. We are just at the very beginning of a period of deep global structural adjustments from and economic and geopolitical standpoint.

The most likely pattern that we are going to go through in the coming period will be an alternation of phases of low-intensity economic and geopolitical frictions and phases of high-intensity economic and geopolitical frictions. And the most favorable outcome will be to limit the damage of this alternation and maintain the interdependence between the US and Chinese economies as the best safeguard against something worse.

The writer is President of Smadja & Smadja, a Strategic Advisory Firm   

@ClaudeSmadja