China's Crisis: The Price Of Change

by Rodger Baker

Last week was an eventful one for China. First, the People's Bank of China shocked the financial world when itcut the yuan's reference rate against the U.S. dollar by nearly 2 percent, leading to a greater than 2 percent drop in the value of the yuan in offshore trading. The decline triggered a frenzy of speculation, including some expectations that the Chinese move would trigger a race to the bottom for Asian currencies.

Beijing said the adjustment was designed to fix distortions between the trading rate of the yuan and the rate it should have been at according to speculation, and that subsequent large shifts were unlikely. The International Monetary Fund, however, noted that the move could lead to a freer floating yuan - something the IMF has asked of Beijing before the organization considers including the yuan in its Special Drawing Rights basket of currencies. In comments made on the sidelines of its annual report on the Chinese economy, released later in the week, the IMF also noted that the yuan was not undervalued, despite the decline.

Also last week, Chinese state media issued a warning to retired officials to stay out of politics and not misuse their former networks and prestige. The warning followed reports in state media suggesting that the annual unofficial gathering of current and former Party officials at Beidaihe was canceled and would not serve as a policy-making venue in the future. The reports noted that Party officials had already held several additional sessions in Beijing and that decisions were being made in the open, not in some secretive gathering of Party elders. Other reports circulating in Chinese media warned that former Party and military officials were involved in real estate speculation along with other economic mismanagement and needed to stop.

Finally, last week China dealt with one of its worst industrial accidents in years - a series of explosions at a chemical short-term storage facility in the busy port city of Tianjin. More than 100 people were killed in the explosions and aftermath, prompting the government to launch an investigation into illegal storage and improper safety procedures at that and other facilities around the country. Citizens have begun small-scale demonstrations in Tianjin to demand government reparations for damages as a result of the blast. In response, Beijing stepped up its media campaign against rumors, using state media to remind the public that the government publicly charged a Politburo standing committee member with corruption, so the public can trust the government to be open and not hide a conspiracy surrounding the Tianjin blast.

If there is a common theme running through these events, it is the way Beijing is emphasizing its openness in decision-making, in reporting and in explaining its actions. This is not the China of the past that tried to hide the truths of major natural or man-made disasters from its citizens. It is not the China that operated by secret agreements made only after a consensus of Party elders, or the China that tried to protect Party officials at the expense of the public. Nor is it the China of tight currency controls, amid fears that the vagaries of global markets could affect China's economic regulation. Or at least that is the message Beijing is trying to send. It is a message perhaps meant more for domestic than international consumption, but one that recognizes that neither abroad nor at home is there a lot of trust in the Chinese Communist Party or the government to pursue a transparent policy. The taint of corruption, collusion and nepotism remains strong and is perhaps even reinforced by the breadth and depth of the ongoing anti-corruption campaign.

Old Systems Become Obsolete

The reality is that China is in the midst of what may be its most serious crisis since the days of Deng Xiaoping. And the model of government and economy Deng put in place is no longer effective at managing China, much less shifting it in a new direction.

As China emerged from the chaos of the Maoist era, Deng initiated three basic policies for China's future growth and development, starting around the early 1980s. First, allow the economy more localized freedom, accepting that some areas would grow faster than others but that in the long run the rising tide would lift all boats. Second, prevent any single individual from truly dominating the Chinese political system. No longer could a figure like Mao Zedong exert so much personal influence that the entire country could be thrown into economic and social upheaval. Instead, China's leaders would be locked into a consensus-driven model that limited any individual source of power and eliminated factions in favor of widespread networks of influence that overlapped so much they could not be truly divisive. And finally, walk softly internationally, be ruthless in the appearance of a non-interference policy and avoid showing any military strength abroad. This latter point was intended to give China time to solidify internal economic and social cohesion and strength while avoiding distraction or inviting undue military attention from its neighbors or the United States.

In retrospect, Deng's model worked exceptionally well for China, at least on the surface. While the Soviet Union collapsed, the Communist Party of China held together, even after Beijing's mismanagement of Tiananmen Square. Although at times slow to respond or initiate proactive change, China's leaders managed the country's rapid economic growth in a way that avoided extreme social or political destabilization. The Party managed not only the leadership transitions set in motion by Deng, but also, amid intra-Party scandal, the latest transition to Xi Jinping. China's leaders even managed the impact of the global economic slowdown and appear capable of maintaining order even as economic growth rates slow considerably.

But the relative calmness on the surface belies disturbing deeper currents. The dark secret of consensus rule was that, while appearing to provide stability, by the late 2000s it was doing more to perpetuate underlying structural problems that could delay or even derail actual reforms or economic evolution. The lack of radical shifts and turns, the avoidance of major recessions and the ability to defer significant but potentially destabilizing reforms made China look like an unstoppable juggernaut. China's economy climbed past Japan's and seemed destined to surpass the U.S. economy. And if economic strength translated into total national strength, then China was emerging as a significant global power. Beijing even began breaking from Deng's cautions on overt military power and started amore assertive foray into the East and South China seas, both because of a perceived need to protect its increasingly important sea lanes carrying natural resources and exports and because it was feeling more powerful and capable and wanted to act on those strengths.

However, all economies are cyclical. As they grow through different stages, the deadwood needs to be trimmed and funding provided for the new shoots. Recessions, slowdowns, bankruptcies and sectorial collapses are all part of the natural economic process, even if they are disruptive in the short term. As China claims to be climbing the value chain in manufacturing and exports, it is not simultaneously trimming away older components of the economy or effectively weaning itself from the stability of large state companies that are disproportionately locking up available capital compared with total employment. Parochial interests by local and provincial governments - themselves keen to avoid any sense of instability - have left massive redundancies intact across China's manufacturing sectors, particularly in heavy industries, the backbone of early Chinese economic growth. Consensus politics allowed China to grow, but not in a healthy manner - and the global economy is no longer giving China the freedom to just keep pouring on the fertilizer and hope no one notices the rot spreading through the trunk and branches.

Xi's Crisis Management

The leadership transition to Xi in 2012 was also not nearly as smooth as it first appeared. It occurred amid the Bo Xilai scandal, in which it appeared the former Chongqing Party Secretary was making a bid not only to reshape the direction of Chinese politics but also to usurp Xi's rise to central Party and state leadership. What has emerged amid the ongoing anti-corruption campaign is that the challenge was much more serious than it may have appeared, including an alleged assassination plot against Xi.

The recent pronouncements regarding former Party leaders and officials staying out of politics suggests that challenges to Xi's position are still emerging. Xi's decision to build a national security council and economic affairs advisory body, to which he belongs, has aroused opposition from former officials used to playing a role in shaping policy. Publicly canceling the unofficial Beidaihe summit was an overt strike against former officials. The consolidation campaign continues.

While China faces some of its toughest economic challenges, and after it has stepped out into the South China Sea and international military affairs in a way it cannot easily pull back on, it is also contending with internal dissent and intra-Party fighting. Xi's consolidation drive, closely linked to the anti-corruption campaign, is all about tightening the reins of control to allow more rapid policy adjustments, force macro-policies on localities and accelerate the Party and state's response time to changing circumstances. But that challenges decades of tradition and entrenched power and interests. It also creates a contradiction: The economic policies are moving toward liberalization, but the political and social policies are moving toward autocracy.

To manage the next phase of China's economic opening and reform - something that changes in the global economy and decades of internal ossification are forcing upon Beijing - Xi is simultaneouslycracking down on media, information, social freedoms and the Party itself. The fear is that significant economic reform without tight political control would lead to a repeat of the Soviet experience: the collapse of the Party and perhaps even the state.

Each event, each headline, should be assessed in the context of this internal crisis. The currency dip - an important step in liberalizing yuan trading, gaining a role in the Special Drawing Rights basket and continuing China's path toward yuan globalization (freeing the country at least a little from the dominance of the U.S. dollar) - has auxiliary risks, not least of which is that a freer currency can move in directions far from those the government would like to see. The explosion in Tianjin is reinforcing the fears of rampant mismanagement and corruption. It has sparked a new round of conspiracy speculation and is placing the government in a position where it must deal with protesters in a major city as well as foreign investors and traders - again raising uncomfortable questions about safety and security in China. The warnings against retired officials interfering in politics may be more than just public relations attempts to highlight some newfound transparency.

This is not to say China is on the verge of collapse, that the government and Party is about to fracture along internecine battle lines, or that economic reform is simply impossible in the face of entrenched interests. But none of these are out of the question. China has entered a stage of the uncertain. The transition to an internal demand-driven economy will not happen smoothly, nor will it happen overnight. The reduction in exports and the drain on investment is already under way. And with all of these issues sitting squarely on his shoulders, Xi is preparing for his September visit to the United States, where the litany of concerns about China expands daily.

The transitory period is the most chaotic, the most fragile, and that is where China sits right now.

"China's Crisis: The Price of Change is republished with permission of Stratfor."