China's Inevitable Changes

By Rodger Baker and John Minnich

Tuesday, November 5, 2013 - 04:06     


The Central Committee of the Communist Party of China will convene its Third Plenum meeting Nov. 9. During the three-day session, President Xi Jinping's administration will outline core reforms to guide its policymaking for the next decade. The Chinese government would have the world believe that Xi's will be the most momentous Third Plenary Session since December 1978, when former supreme leader Deng Xiaoping first put China on the path of economic reform and opening.

Whether or not Xi's policies will be as decisive as Deng's -- or as disappointing as those of former President Hu Jintao -- the president has little choice but to implement them. China's current economic model, and by extension its political and social model, is reaching its limits just as it had prior to Deng's administration. The importance of the upcoming meeting is that it comes at an inflection point for China, one that its leaders can hardly afford to ignore.

A Fundamental Challenge

It is worth recalling just how extraordinary Deng's 1978 meeting was. Mao Zedong had died only two years earlier, taking with him what little remained of the old pillars of Communist Party legitimacy. China was a mess, ravaged by years of economic mismanagement and uncontrolled population growth and only beginning to recover from the trauma of the Cultural Revolution. Had the People's Republic fallen in 1978 or shortly thereafter, few would have been truly surprised.

Of course, in those tense early post-Mao years hardly anyone could foresee just how rapid China's transformation would be. Nonetheless, battling enormous institutional constraints, Deng and his colleagues quickly set up new pillars of social, political and economic stability that guided China through the fall of the Soviet Union and into the 21st century.

Although Xi presides over China during a time of economic prosperity, not disrepair, perhaps not since Deng has a Chinese leader faced such formidable challenges at the outset of his tenure. Former Party general secretaries Jiang Zemin, and to a greater extent Hu, could largely follow the lead of their predecessors. Jiang, emerging as a post-Tiananmen Square leader, was faced with a situation where the Party was rapidly losing its legitimacy and where state-owned enterprises were encumbering China's economic opening and reform. But internationally, China's position was relatively secure at the beginning of Jiang's term in office, and by the time he took on the additional role of president in 1993, the decline of the Japanese economy and the boom in the United States and the rest of Asia left an opening for China's economy to resurge.

These conditions enabled Jiang's administration to enact sweeping bureaucratic and state sector reforms in the late 1990s, laying much of the groundwork of China's post-2000 economic boom.

When Hu succeeded Jiang in 2002-2003, China's economic growth was seemingly unstoppable, perhaps even gaining steam from the Asian economic crisis. The United States, which had seemed ready to counter China's rise, was instead fully focused on Iraq and Afghanistan, and though the Communist Party of China was not exactly seen as the guiding moral compass of the state, the role of print and social media in raising criticism of Party officials had not yet exploded.

As Xi prepares his 10-year plan, China has reached the end of the economic supercycle set in motion by Deng. Public criticism of officials and thus of the Party is rampant, and China's military appears much more capable than it actually is, putting China is a potentially dangerous situation.

Once again the United States is looking at China as a power perhaps to contain or at least constrain. China's neighbors seem eager for Washington's assistance to counterbalance Beijing's influence, and long-dormant Japan is awakening once again. Xi may not have to rebuild a fractured Party or state as Deng did, but in some ways he faces the same fundamental challenge: redirecting and redefining China.

China can no longer follow the path it has in previous decades. Deng emerged as China's paramount leader out of the struggles and chaos of the Gang of Four era and the Cultural Revolution. He redefined what China was and where China was going, not out of a desire to try something different or an infatuation with "Western" economic models but out of a fundamental need to change course. 

Whether Xi wants it to be or not, China is at another crossroads. He has little choice but to make consequential decisions, lest he leave China scrambling from one quick fix to another at the expense of long-term opportunities.

The Perils of Rapid Reform

Reform, with "Chinese characteristics," is not about Westernizing the Chinese model. Rather, it is about reshaping the relationship between the Party, the economy and the people in a way that will maintain the centrality of the Party. This may require improving the efficiency of the Party and governing structures, changing the organization and rules of business, and deferring to the rights and responsibilities of the citizenry. But while this will likely entail selectively scaling back the Party's power in certain areas, it does not mean the overall reduction of Party power.

Since the founding of the People's Republic in 1949, the Party has been constitutionally at the center of Chinese leadership. Mao's authority stemmed from his role as chairman of the Central Committee of the Communist Party of China, a position he held from 1945 until his death in 1976.

Concerned by Mao's concentration of power, Deng never adopted the same titles, though he still managed China through the Party, drawing strength and authority through his careful balancing of retired and serving Party officials. In 1993, the Party general secretary took on the parallel role of the president. Jiang served in both roles, as did Hu and Xi.

The consolidation of Party and political leadership was made clear in the formula. It is matched by the general secretary and president also holding the dual roles of chairman on the two parallel Central Military Commissions, one under the Party and the other under the state.

Under Mao, the Party and the state were united in the figure of Mao himself. In the 20-year transition from Mao to Jiang, the Party remained synonymous with the state, but the consolidation of power in a single individual was replaced as Deng sought to initiate a system of group leadership to avoid the rise of another strongman. Jiang's accession to the presidency formalized Party-government leadership, but consensus leadership constrained his power.

Jiang may have technically held all the key posts of power, but other power brokers in the Politburo could counterbalance him. The system ensured that the paramount leader remained constrained.

This group dynamic allowed the Party to avoid the rapid and far-reaching policy swings of Mao, but it created stagnation in the bureaucracy and state sector. Ensuring the right web of connections often became more important than fulfilling the responsibilities of the Party or the state. Deng's machinations helped eliminate strongman politics and degraded political factions like the Gang of Four, but these were replaced by more complex and widespread bureaucratic and industrial patronage networks. The result was more a web than a set of individual strings. No longer could any one interest press entirely against another without risking the entire structure. The intertwining threads were just too complex. Rapid policy swings were impossible and factional battles that threatened the fabric of the state were effectively eliminated, but the cost was a decision-making process that was increasingly cumbersome and timid. Radical reform would never make it through the process of consensus building, and any policy deemed harmful was met with resistance.

This worked well during China's boom. Though China was corrupt, beset with a cumbersome regulatory environment and prone to violations of intellectual property rights, it was fairly predictable overall, unlike so many other developing economies.

The consensus model was also more attuned to social stability, constantly making tiny adjustments to appease or contain the demands of public sentiment. In times of slowed economic growth, China's leaders would stimulate the economy. In times of apparent overheating, they could cut back on credit. If people were frustrated with local officials, the central government would alternately remove the accused leaders or crack down on the protesters. But when the foundation of China's economy began to shake after 2008, when China's very success drove up wages and prices as its biggest consumers faced serious economic problems of their own, China's consensus leadership proved unequal to the task.

During China's rise, Beijing needed only minor adjustments to maintain stability and growth. But now that the country is in a far different set of circumstances, Beijing needs a major course correction. The problem is that consensus rarely allows for the often radical but necessary response. And for good reason: The success of radical change is not guaranteed. In fact, history suggests otherwise, as it did notably with the case of Mikhail Gorbachev and the Soviet Union.


To overcome the limitations of consensus leadership, Xi apparently is trying to strengthen the role of president. He wants to redefine the presidency so that it is not merely the concomitant title for the Party leader but also a post with a real leadership role, similar to the presidencies of other major countries.

This is a way to compromise somewhere between consensus and strongman. The presidency should not exceed the Party, but as the head of state, Xi is hoping to use his position to have a greater say in how the Party is restructured.

The first target is the bloated bureaucracy. Already there are signs that several of the reforms are about removing layers from China's bureaucratic structures. This should add efficiency to the system (its stated goal), but it may also confer greater central oversight and control by cutting through the webs of vested interests that have taken hold in many of China's most powerful institutions.

The reforms slated for the economic sector are similar. They will introduce more market and competitive mechanisms while giving Beijing greater control over the overall structure.

Consolidation, efficiency, transparency, reform and restructuring are all words that possess dual meanings -- one regarding more efficient and more flexible systems, the other regarding systems that the center is better able to direct. At a time when China needs radical change, it first needs to change the mechanism through which policies are decided and enacted. 

The government hopes that by disengaging from constant, restrictive intervention into certain sectors, it will have greater capacity to intervene selectively, focusing on enforcement and compliance rather than dictating every move of state-owned enterprises. There is no guarantee that these reforms will work or that they can be implemented effectively or smoothly. China has seen three decades of economic growth, and in turn three decades of more tightly woven relationships and knitted interests. Unraveling any thread can rapidly degrade the entire structure, unless stronger central replacements are already in place.

China's leaders are facing the difficult task of adjusting once again to changing circumstances. Political legitimacy and control remain closely linked. It is Xi's position as head of the Party that ostensibly gives him legitimacy as head of the state. But to create a more nimble and adaptive government, Xi is seeking to harness the people in a slight reversal, using his role as president to rebuild the legitimacy of the Party, and in doing so take stronger control of the Party mechanisms.

This is a difficult balance. But China is at a turning point, and without nimble leadership, a system as large and complex as China can move very rapidly down an unpredictable and uncontrollable path. The leadership can attempt to take control and hope for success, but the consensus system and entrenched and bloated bureaucracy are reaching the end of their effectiveness as China enters uncharted economic and social waters.

Editor's Note: Writing in George Friedman's stead this week are Rodger Baker, Vice President of Asia-Pacific Analysis, and Stratfor Asia-Pacific Analyst John Minnich.

11/05/2013 12:00 PM

Economic Doghouse

Complaints about German Exports Unfounded

By Alexander Jung, Christian Reiermann and Gregor Peter Schmitz

Photo Gallery: Is Germany Too Focused on Exports?

The US government and European Commission are complaining bitterly about Germany's hefty trade surplus and export orientation. But such criticism fails to consider how much the country's partners benefit from its competitive strength.

Marco Buti, the most senior member of EU Monetary Affairs Commissioner Olli Rehn's staff, isn't exactly viewed as a friend of Germany in Brussels. The chief economist of the European Commission, a native of Italy, has a tendency to blame many euro-zone ills on the nature and effects of German economic policy.

Sometimes he is troubled by austerity dictates from Berlin meant to clean up the finances of crisis-ridden countries. And sometimes he feels that Germany is too stingy because it's unwilling to spend more to jump-start the economy.

Buti is especially irked by the imbalances within the euro zone. In his view or the world, countries like Germany are partly responsible for the turbulence in southern countries because they flood them with goods.

Buti will have yet another opportunity to call the Germans to order next week when, on Nov. 15, the European Commission releases its early warning report. The report identifies those countries whose deficit or surplus is particularly large in relation to economic output.

Germany will be among those at the top of the list. If the European Commission sees this as a problem, it can subject the country to an "in-depth analysis," which could be followed by a reprimand. The office in charge of the procedure is Buti's Directorate-General for Economic and Financial Affairs.

An old debate is returning with a vengeance. The German government has been pilloried for years because Germany's exports allegedly disrupt global economic peace. The complaint was voiced by Christine Lagarde, then France's finance minister but now head of the International Monetary Fund (IMF), as well as a long line of US Treasury secretaries. Current Treasury Secretary Jacob Lew took the same line only last week. According to a report from his department, Germany was identified as a top threat, even ahead of China.

The charge is always the same: The Germans have acquired an unreasonable advantage by one-sidedly focusing on exports, and now they are flooding foreign markets with their products. At the same time, this view holds that the Germans live and consume below their means, which is detrimental to foreign companies because there is less demand for their products in Germany.

At first glance, the numbers seem to prove the critics right. Last year, Germany's export surplus amounted to 7 percent of annual economic output. It is expected to be about the same this year and only slightly lower next year. This forces the European Commission to intervene because the average value over the course of three years cannot exceed 6 percent.

Germany's account balance surplus

Germany Bridles at Criticism

The only question is: Whose fault is it?

German government representatives turn the argument around, saying that the problems in Southern Europe are not Germany's fault. On the contrary, says Berlin, countries like Greece, Italy and Spain have only themselves to blame for their troubles because they spent years living beyond their means and at the expense of their own competitiveness.

This explains the harsh rejection of worldwide criticism by German Finance Minister Wolfgang Schäuble, a member of Chancellor Angela Merkel's center-right Christian Democratic Union (CDU). According to a Finance Ministry memo, "The German current account surplus offers no reason for concern for Germany, the euro zone or the world economy." Berlin is pursuing a course of "growth-friendly consolidation," the memo to Schäuble continues, and there are no imbalances "that would require a correction of our economic and fiscal policy."

In their expert opinion, the Finance Ministry officials note that the German current account surplus relative to those of euro-zone partner countries was cut in half between 2007 and 2012, from 4.4 to 2.2 percent. By comparison, trade surpluses with the United States and other world regions grew. The euro zone's foreign trade balance is generally balanced. Indeed, Schäuble's experts believe they deserve praise for this rather than rebuke.

But that is unlikely to happen. When IMF First Deputy Managing Director David Lipton met with German Finance Ministry officials last week, he proposed that Germany make a commitment to reduce its current account surplus. He also wanted the German government to set a fixed target that could not be exceeded in the future.

For Finance Ministry officials, this approaches the sort of hubris one would expect from a planned economy. They also like to point out that there isn't much they can do about the surpluses because they simply lack the necessary leverage. No one in the world is being forced to buy German cars or machines, they note, so should the German government ban exporting? "This is the sort of thing that didn't even work under socialism," says one official.

Suggestions that the Germans stimulate imports are no less unrealistic as the government also lacks important tools to influence them. Germans will buy more foreign goods if they earn more money. But this isn't something the government can dictate since, in Germany, employers and trade unions negotiate wage levels without any government interference.

Besides, the trend has already been going in the right direction for some time. "Germany exhibits robust wage growth," reads the Finance Ministry document. This has led to higher consumption of growth drivers, it continues, which also benefits the economies of partner countries. In addition, companies are investing more, which strengthens the supplier industry in the euro zone.

Moreover, the new grand coalition currently being negotiated by the CDU, its Bavarian sister party, the Christian Social Union (CSU), and the Social Democratic Party (SPD) has already agreed to increase both government investment and the minimum wage. Both stimulate domestic demand, which should put critics at least somewhat at ease.

Benefits More Widespread than Believed

Politicians in Berlin and scholars alike wonder whether criticism of the special German business model is justified. Should Germany have to be punished for having such a successful export economy?

"That would be absurd," says economist Holger Görg, a professor at the Kiel Institute for the World Economy (IFW), in northern Germany. After all, Görg argues, no one can be forbidden from buying German goods. Germany was still a problem child in the 1990s, he explains, but then it regained its strength. "Should that be held against the country today?" Görg asks incredulously. The real issue, he says, is why countries like Spain or Italy haven't managed to become more competitive.

The crisis-ridden countries can also thoroughly benefit when German exports are flourishing. Products from other countries, often from deficit countries, can be found in almost every car, machine and chemical product with the "Made in Germany" label.

According to a study by Munich-based Ifo economic think tank, the share of these inputs in German exports rose from 13.5 percent in 1995 to 20 percent in 2008. Compared with their foreign competitors, German companies even exported a disproportionately high share of these inputs, a new study by the IFW concludes. Relatively many components come from Central and Eastern Europe.

Their share of German industry is almost three times as high as in Spain, France or Italy. BMW, for example, sources almost half of the parts for cars built in Germany from abroad.

In addition, German companies create growth and jobs in other countries with their overseas plants. Volkswagen, with its manufacturing facility in Portugal, is the country's largest foreign investor. At the BMW plant in Spartanburg, South Carolina, about 7,000 employees produce almost 280,000 vehicles each year, two-thirds of which are sold abroad.

The German economy's export orientation has developed over the generations and wouldn't be as easy to alter as the critics would like. Highly specialized family-owned businesses have matured into global players that generate a large share of their sales and profits abroad. This explains why industry accounts for a relatively large 22 percent of the German economy.

Eurocrats in Brussels contradict the impression that Germany's surpluses are already a case for prejudgment. "We are only at the beginning of the process," says a Commission expert. He notes that surpluses are not generally a reason for concern, and that the Brussels agency is aware that Germany must remain the Continent's engine of growth. Although there has long been a push for more domestic demand, says the expert, there are certainly positive signs emerging in this regard.

This is just what Schäuble and his officials like to hear. "Fortunately," says a senior official, "there are people besides Marco Buti."

Translated from the German by Christopher Sultan

Markets Insight

November 4, 2013 7:04 am
Debt crisis has left Germany vulnerable
Weakness in the periphery will affect German economic prospects
During her successful re-election campaign, Chancellor Angela Merkel’s message was that Germans were living in a prosperous, recession-proof economy and the eurozone problems were contained. But Germany’s economic power and financial strength is overstated.
Germany remains dependent on its neighbours, with 69 per cent of total exports going to European countries, including 57 per cent to the member states of the European Union.

In 2012, Germany ran a trade deficit of €27bn with Russia, Libya and Norway, mainly for energy imports. Germany also had trade deficits with Japan (4.7bn) and China (11.7bn). In contrast, Germany had a trade surplus with the eurozone (France, Italy, Spain, Greece, Portugal, Cyprus and Ireland) of €54.6bn.
Continued weakness in these troubled countries will affect German economic prospects. High energy prices and increasing stresses in emerging markets will exacerbate its problems. Eurozone members remain committed to avoiding the unknown risks of a default and departure of countries from the euro.

Governments in the at-risk economies are unlikely to meet agreed budget deficit or debt level targets. Banks will face rising bad debt losses and require capital infusions. For both weaker sovereigns and banks, access to financial markets will remain restricted. Cost of commercial funding will remain above affordable levels, meaning that assistance will be needed.

Greater reliance on ESM

Peripheral countries will be forced to rely on the European Stability Mechanism and European Central Bank to provide financing directly or indirectly via cheap funds to banks to purchase government bonds which will be used as collateral for the central bank loans.
National central banks will also use the “Target 2 payment system to settle cross-border funds flows between eurozone countries financing peripheral countries without access to money markets to fund trade deficits and capital flight.

Over time, financing will become concentrated in official agencies, the ECB and national governments or central banks. Risk will shift from the peripheral countries to the core of the eurozone, especially Germany and France.

For example, the ESM relies primarily on the support of four countries: Germany (27.1 per cent), France (20.4 per cent), Italy (17.9 per cent) and Spain (11.9 per cent). If Spain or Italy needs assistance, then the contingent commitment of the remaining countries, especially France and Germany, would increase.

This reflects the reality that the stronger countries stand behind each of the support mechanisms.
German guarantees supporting the existing bailout fund are €211bn. The ESM will require a capital contribution from Germany. If the ESM lends its full commitment of €500bn and the recipients default, Germany’s liability could be as high as €280bn. There is also indirect exposure via the ECB and the Target 2 claims.

The size of these exposures is large, in relation to Germany’s GDP of around €2.5tn and German household assets estimated at €4.7tn.

Germany also has substantial levels of its own debt (over 80 per cent of GDP). German demographics, with an ageing population and deteriorating dependency ratios, compound its problems.

If unfunded social security liabilities are taken into account, then the level of German debt increases to over 190 per cent of GDP.

Transfer of risk

At best, increased commitments to support its European partners will absorb German savings, crippling the economy. At worst, default of one of the weaker countries or a restructuring of the euro will result in large losses to Germany; the best estimates are in the range of €750bn to €1,500bn.

Voters seem unaware that each step in the crisis has resulted in a transfer of risk, liability and losses to Germany. Given strong opposition to debt pooling and institutionalised structural wealth transfers, their reaction to eventual revelation of this increasing commitment and their status as the “permanent creditor” within Europe is unknown.

Germany’s history is one of monumental reverses and extremes. Miscalculations and errors in the handling of the eurozone debt crisis have left it vulnerable to another one of these events.

Anxious to maintain their relative prosperity and central place in Europe, Germans have sought to avoid the reality of their predicament. But as C.S. Lewis advised: “If you look for truth, you may find comfort in the end; if you look for comfort you will not get either comfort or truth, only soft soap and wishful thinking to begin, and in the end, despair.”

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money


Copyright The Financial Times Limited 2013.