While China’s economic fundamentals are solid, the recent market crisis could threaten the country’s reform agenda, writes Christopher Mark, Sr., in this opinion piece.

China’s plummeting stock market and uncertainty about Beijing’s policy intentions and capabilities are forcing global businesses to reassess their exposure to the Chinese economy. At the same time, renewed focus on China’s economic slowdown has prompted deepening gloom about broader growth prospects, given the country’s outsize role in the world economy. These factors contributed to the late-August rout in global equity markets.

The current China conundrum lies in both economic and political dimensions, although much of the alarm about China’s economic downturn appears to be misplaced or overstated. China’s economic fundamentals essentially are solid. Multiple indicators point to a growth slowdown that remains broadly in line with the leadership’s game plan, and the authorities can draw upon enormous financial resources and economic resilience. Particularly if planned reforms go forward, the Chinese economy should be able to continue functioning as a reliable driver of global economic growth.

The recent market turmoil has serious political implications, however. The opacity of maneuvering within the Chinese leadership makes it exceptionally difficult for foreign business and government leaders to gauge risks or prospects. While President Xi Jinping has eschewed a high-profile role during the latest market turbulence, he appears to be engaged in a high-stakes internal power play, trying to drive policy via a top-down power structure while flouting the consensus-based leadership dynamic of the last two decades. In the process, he has consolidated more power in his own hands than any leader since Deng Xiaoping. Xi has taken command of the Communist Party’s primary policy committees and set up new ones under his control to oversee economic restructuring, foreign relations and national security, military reforms, and cyber censorship.

Abetted by a propaganda apparatus bent on burnishing his leadership aura, Xi is now indelibly identified with all major policies. However, over the next seven years of his presumed time at the helm, much could go wrong – involving not only wrenching economic changes and further market gyrations but also environmental degradation, ethnic violence, pushback from attempts to root out Party corruption and reform the military, or any number of foreign-relations wildcards. And conspicuous failure in any of these areas is bound to be identified with him.

“China’s economic fundamentals essentially are solid.”

There is little doubt that Xi’s hardball tactics have earned him powerful adversaries within the Party. Some coalition of these might find it expedient to make him the scapegoat if the current downturn worsens or a major crisis erupts, threatening to cut short his tenure. Still, in any such dire scenario, Xi may be able to make the case that his personal brand of “strong hand at the top” would be the Party’s only hope of forestalling chaos and maintaining its hold on power. A more likely scenario is that Premier Li Keqiang – to whom Xi has left responsibility for day-to-day handling of the economy and associated challenges – could become a lightning rod for public anger over the government’s handling of the market crisis. If so, it could deflect some of the political fallout, giving Xi a freer hand to pursue his main agenda of revitalizing and rehabilitating the Party and thereby preserving its hold on power.

Blowback in Beijing

Following largely ineffectual efforts since June to halt the slide in China’s stock market with a spate of emergency measures –- including a ban on large shareholders selling their stakes and encouraging state banks to buy shares –- Beijing is turning once again to monetary stimulus measures to reassure investors and bolster the economy. In effect, the Xi administration is trying to buy time until China’s economic prospects stabilize. On August 25, the central bank cut interest rates by one-quarter of a percentage point; it simultaneously reduced bank reserve requirements by half of a percentage point, effectively adding roughly $106 billion to the economy.

China’s wildly gyrating stock market has tested both public confidence and the country’s leadership capacity. Following Beijing’s full-court press in July to arrest a precipitous slide in stock prices, the market by late August was down more than 40% from its high point in June. Resumption of efforts to stem the [market] fall could delay a necessary correction and further distort market forces, while longer-term damage to leaders’ credibility will be more difficult to assuage. President Xi and Premier Li were silent throughout the market selloff, despite widespread perceptions that the regime had backed the market’s upsurge during the spring and would stand behind investors on the downside.

The effect of the market collapse on China’s real economy is still relatively muted. Over the past year, investors flooded the Shanghai and Shenzhen stock markets looking for better returns than those in the stagnant real estate market, and since late spring, small retail investors responding to state-media exhortations joined in the surge. Despite the recent prevalence of share purchases based on loans, market analysts judge that the amount of leverage in the Chinese market has been relatively small, limiting the prospects for emergence of a debt crisis.

While its potential magnitude is difficult to gauge, one result of the market selloff is likely to be a reduction in spending by households that sustained significant wealth losses. The market sell-off at one point had wiped out nearly $3 trillion in value, affecting millions of middle-class investors. As a consequence, broader consumer sentiment and spending could be depressed, threatening to upend Beijing’s plans to rebalance the economy by focusing on domestic consumption as a growth driver.

Shaken Credibility

The market turmoil severely damaged public confidence that Party and government leaders can effectively manipulate market forces or meet future economic challenges. Popular anger is simmering over perceptions that Party officials and state-controlled media had pumped up the market this spring with talk of high returns offered by stocks, and fostered a surge in margin lending that drew in millions of individual investors with relatively small accounts, but then appeared inept in addressing the downturn.

It remains to be seen how popular views of Xi will be affected by the stock-market turmoil and the government’s response. While he faces no immediate threats to his authority, Xi’s pledges to limit bureaucratic meddling and to give markets greater scope have been tarnished by the government’s apparently panicked and scattershot approach to the market free-fall.

“Resumption of efforts to stem the [market] fall could delay a necessary correction and further distort market forces, while longer-term damage to leaders’ credibility will be more difficult to assuage.”

Leadership Differences

While Beijing’s effort to stem the stock-market rout has shaken domestic and foreign investor confidence, the leadership remains convinced that China’s longstanding growth model is no longer sustainable and that rebalancing the economy is essential. In the nearly two years since the Party’s economic rebalancing blueprint was promulgated, China’s economic slowdown – the most severe in a quarter-century – has intensified its concerns that lower growth could spark massive unemployment and threaten domestic stability. Faced with intensifying deflationary forces in the industrial sector, Chinese leaders have been looking for ways to contain downward momentum as they seek to shift the economy to a slower but more sustainable growth path while simultaneously working down a looming credit overhang.

Beijing jolted international markets on August 11 by moving to liberalize its exchange-rate management, initially engineering a 1.9% depreciation in the renminbi’s value against the U.S. dollar and even more against the euro and Japanese yen. Although relatively modest in comparison to recent movements in other emerging-market currencies, it was the biggest one-day drop in China’s tightly-managed currency since 1993. And while the move will give a near-term boost to China’s faltering exports – inevitably prompting protests of currency manipulation from trading partners — it could signal a shift to a more market-driven exchange rate needed for broader financial-sector reforms.

Beijing’s use of public funds to prop up the overvalued stock market and its change of tack in currency policy came amidst mounting economic difficulties that could undermine leaders’ efforts to keep overall growth at about 7% for 2015. The threats to growth have revived internal debates over timeworn remedies involving fiscal spending on infrastructure and other projects, while leading to backtracking on reforms aimed at curtailing local-government debt and restructuring state-owned enterprises.

Since last November, Beijing has tried to bolster flagging growth through five interest-rate cuts; several reductions in banks’ required reserves levels and other measures to stimulate bank lending; freeing up local governments to issue bonds, with financing to enable commercial banks to purchase those bonds; and a continuing rollout of announced infrastructure projects. Despite the prospect that such measures could lead to more bond defaults and nonperforming loans, Beijing is once again pushing more money into the real economy through central government backing of infrastructure investment.

“Xi almost certainly will regard the recent market turmoil as confirmation that chronic inefficiencies and distortions in the Chinese economy need to be expunged through fundamental reforms.”

Internal disagreements over economic and financial policy have begun to surface more visibly in recent weeks:

  • As recounted by various Chinese officials, Central bank governor Zhou Xiaochuan and finance minister Lou Jiwei – advocating scaled-back stock market intervention – were overruled by Premier Li and his associates, who demanded forceful actions to prop up the market and assuage public ire.
  • Also reflecting likely policy discord, Chinese state media in recent days have conveyed sharply differing views about future state intervention in the markets. While the official Securities Daily defended interventionist policies to forestall destruction of investor confidence, commentary in the official Economic Information Daily called for retreat from stock-market bailout policies.
  • In a development with possibly profound political overtones, the annual leadership “summer summit” at the seaside resort of Beidaihe – traditionally a venue for Chinese leaders and Party elders to air views and forge consensus on key policy issues – was abruptly scrubbed in mid-August, and commentary in the Communist Party’s flagship People’s Daily subsequently criticized unnamed retired leaders for interfering in government policy and sowing discord.

Implications for Reforms

Beijing’s measures to prop up share prices undermine Xi’s push to allow market forces to drive the economy, but he probably will stay the course on his overall reform agenda. The market crisis has nevertheless exposed vulnerabilities:

  • Internal opposition to Xi’s reforms of the financial sector is likely to stiffen, increasing the vulnerability of the reformists such as central bank governor Zhou Xiaochuan.
  • Further opening of Chinese financial markets to foreign investors – a key element of Xi’s reform agenda – could be jeopardized if those investors’ confidence is shaken by further stock-market intervention.
  • Whereas reforms of state-owned enterprises (SOEs) have been premised on selling shares to the public and converting SOE debt to equity, these plans are likely to be set back by government efforts to stabilize the markets.

Xi almost certainly will regard the recent market turmoil as confirmation that chronic inefficiencies and distortions in the Chinese economy need to be expunged through fundamental reforms. Still, his reliance on authoritarian command-and-control mechanisms, and the concomitant crackdown on dissent within the Party and among the public at large, could ultimately derail his reform ambitions.

Christopher Mark, Sr., is chairman of The Signal Group, a consultancy focused on Chinese economic and political developments.