China – Battle over Policy Goes Public

A damaging bout of market volatility early in the year was overcome in part thanks to assurances from Prime Minister Li Keqiang that policy makers in Beijing had no intention of relying on a steep devaluation of the yuan to boost an export sector that has been hobbled by slowing productivity growth and rising unit labor costs. However, the acceleration of the gradual pace of yuan depreciation in the wake of the UK’s late June vote to leave the EU, what many have described as a stealth devaluation carried out under the cover of a temporary but steep plunge in the value of both the British pound and the euro, has left investors wondering whether they can trust the official statements coming out of Beijing.
The doubts stem not from a belief that Li deliberately deceived investors, but rather from the concern that the discrepancy between word and deed is evidence of a power struggle over policy within the upper ranks of the ruling CCP. In that regard, President Xi Jinping’s public criticism of the credit-fueled growth strategy pursued by Li’s economic team is particularly worrisome, because it suggests that the president shares the concerns of investors about a national debt burden that has ballooned to more than 250% of GDP.
Certainly there was little indication of any major problems developing when the NPC, the rubber-stamp legislature, convened in March. Li talked of deploying “innovative measures” to avoid mass worker layoffs as China transitions to a consumption-driven growth model and targets a more sustainable growth rate (with a medium-term target of 6.5% per year) following a prolonged period of double-digit real expansion. Among the measures proposed by Li are debt-for-equity swaps designed to shore up the position of struggling state-owned firms whose debts pose a major threat to the stability of the financial system.
However, Xi flatly rejected the plan, and has advocated a more aggressive approach to dealing with the problem of industrial overcapacity. The public spat suggests that Li’s days as premier are numbered, and speculation is mounting that he will be replaced by Wang Qishan, the public face of President Xi’s three-year anti-corruption campaign, at the CCP’s party congress next year.
All of which points to a further concentration of decision-making power in the person of the president, at a time when socioeconomic stresses created by the ongoing economic transition are contributing to an increased risk of social unrest and popular demands for greater government accountability. Meanwhile, Xi’s abandonment of the consensus-based approach to party governance that has characterized politics in the post-Mao era in favor of a more dictatorial style of leadership has heightened concerns related to China’s increasingly assertive foreign policy strategy, in particular, its contentious claim to vast stretches of the South China Sea.
The Permanent Court of Arbitration in The Hague recently ruled that the so-called “nine-dash line” on which China bases its claims has no legal foundation, a verdict that Beijing has angrily dismissed as invalid. China’s flat-out rejection of the court’s verdict, together with its evident preference for relying on shows of military force to back up its territorial claims, increases the danger of heightened tensions and possibly deadly clashes between China and one or more of the several countries with competing claims to the valuable resources contained in disputed areas of the sea. China is currently engaging with ASEAN to come up with a compromise solution, the security concerns and national pride of the numerous parties will remain obstacles to resolving the dispute, regardless of any economic incentives offered by Beijing.
Assessment of China’s ability to achieve a smooth economic transformation remains clouded by suspicions that official data are misrepresenting the true state of the national economy. Measurement errors, such as misreported housing statistics, suggest that China’s growth is weaker than the headline figures seem to indicate. Although the reported growth contribution from consumption and services is plausible, anecdotal evidence of unfinished megaprojects, factory closings, and a mining sector in crisis make it impossible to rule out a hard-landing scenario.
Since 1979, The PRS Group Inc., has been a global leader in quant-based political and country risk ratings and forecasts. For more information on The PRS Group and its wide range of risk products, go to: www.prsgroup.com or contact Michael Burke, Director of Client Relations at (315) 431-0511, extension 311.