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China Economic Quarterly

December 2016 Vol. 20 No. 4

Xi Jinping’s China Leninism for the 21st century

Stormy Weather Xi and Trump get ready to tango Technology Why China will win from the rise of robots Books Conundrums of the 19th Party Congress

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China Economic Quarterly Vol. 20 No. 4

December 2016

The Party Line

Can Stability Maintenance Survive Trump?

By Arthur Kroeber

Xi Jinping’s China

Putting The Lenin Back In Leninism Xi’s governance strategy is a decisive, strong-man response to eroding Communist Party legitimacy.

Leninism Upgraded: Xi Jinping’s Authoritarian Innovations Xi has improved the technology of authoritarianism and turned his back on Deng Xiaoping’s explorative model of governance.

By Sebastian Heilmann

Grand Bargain Or Grand Conflict With The US? The confrontation between a newly assertive China and a belligerent President Trump is bound to produce some sparks.

By John Pomfret

The Economy

Steady As She Goes (Despite Trump) China is still on track to produce 6% GDP growth in the run-up to the 2017 party congress.

By Chen Long

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By Joseph Fewsmith 15

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Technology

Only One Winner In The Global Robot War The US and Europe hope cheap robots will enable them to re-shore manufacturing. China has other ideas.

By Clay Chandler

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Sectors

Boom And Bust In The Electric Vehicle Market Beijing has poured massive subsidies build a self-sustaining electric-vehicle market. It’s not working.

By Matthew Forney

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Sectors

Nearing The End Of The Last Housing Boom?

The irresistible force of the 2016 property rally hits the immovable object of peak housing demand.

By Rosealea Yao

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Books

The Enigma Of Chinese Power 53 Four books explain why the Communist Party has been so successful, what could bring it down, and Xi Jinping’s strategy for keeping it alive.

By Arthur Kroeber

China Economic Quarterly (CEQ) is published by Gavekal Dragonomics, a unit of Gavekal Research Ltd. Subscriptions are available only as part of the Gavekal Dragonomics research service. Contact sales@ gavekal.com for details.

The trademarks “China Economic Quarterly,” “CEQ” and “Dragonomics” are the property of Gavekal Research Ltd.

Editor Arthur Kroeber Editor-at-large Tom Miller Assistant editor Agatha Kratz Design & production Big Brains

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The Party Line

Can Stability Maintenance Survive Trump?

By Arthur Kroeber To meet the needs of their own political cycle, Chinese leaders will aim to ensure steady economic growth for the next year. Unfortunately, it seems that the political need of US president-elect Donald Trump is to cause as much disruption for China as possible.

The course of China’s economy over the next year or two will be heavily determined by politics, both in China and in the United States. Most shorter- and longer-term economic issues have been subordinated to the need to deliver stable, 6%+ growth ahead of the all-important 19th Communist Party Congress in the autumn of 2017. The question is whether policymakers will be able to maintain that steady course in the face of threats of a trade war and other disruptions by the incoming Trump administration in the US. China’s political priorities are now clear-cut. After four years of bruising political warfare, during which he dismantled rival political networks through an anti-corruption campaign, Xi Jinping was designated the “core” of the leadership at a plenary meeting of the party’s Central Committee in October. This designation had eluded Xi’s predecessor Hu Jintao.

Moreover, the two prior leaders (Jiang Zemin and Deng Xiaoping) were named the “core” of their respective “generations” of leaders; Xi’s “core” status carries no such qualifier. A possible implication is that Xi’s leadership could continue, in one form or another, past 2023 when his second and last term as president will end.

This move sets up a sprint toward next year’s party congress, where Xi is likely to have two main goals. The first will be get as many of his loyArthur Kroeber is editor of the China Economic Quarterly.

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alists as possible into the next Central Committee and the next Politburo standing committee—the apex leadership body. A subsidiary aim might be to reduce the membership of the standing committee from seven to five, making it easier for him to control.

The second likely aim will be to avoid designating a clear successor, thereby solidifying the expectation that Xi will remain paramount leader even after the customary two five-year terms. Just how he will do this is uncertain, since in addition to term limits on the presidential office, the party has an established retirement age which would require Xi to leave his other main post, party general secretary, at the 20th Party Congress in 2022. One possibility is that the retirement age norm could be subverted by arranging for Xi’s friend and close ally, anti-corruption czar Wang Qishan, to stay on after 2017, even though under current rules he would have to retire next year. Waiving the age limit in this case could pave the way for waiving it for Xi five years later.

Power—to what end?

It will thus be possible to gauge the extent of Xi’s power by seeing how many of these likely aims he is able to achieve. Assuming he gets at least some of what he wants and thereby establishes himself as a reasonably powerful leader, the question then becomes what he does with all that power. Much of the ambitious reform agenda that he outlined in November 2013 has since stalled. If Xi is really serious about dealing with China’s economiic problems, the urgent tasks would have to be:

• Streamlining the role of state-owned enterprises (SOEs) so that they

can contribute to national development, rather than dragging the economy down into a quagmire of debt and inefficiency.

• Enabling enough productivity growth so that the economy can keep growing at a reasonably fast pace (say 5% or more) without relying on escalating leverage.

• Reining in the explosive growth of the financial system and forestalling its steady slide toward some kind of debt crisis.

All this would be a tall order under the best of circumstances. But it is possible that the circumstances over the next year or more will be far from the best. President-elect Trump made China-bashing a central element of his campaign, and it seems that he owes his victory in part to the votes of disgruntled workers in industrial regions that have suffered especially large job losses thanks to competition from China.

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The Party Line

Trump has threatened several actions against China, including an across-the-board 45% tariff on Chinese imports (which is unlikely to be implemented because the biggest victims would include Apple and other US consumer electronics firms whose products are assembled in China) and labeling China a curTrump appears to have no rency manipulator (which is more intention of scaling back the US’s likely because it is essentially a sympresence in Asia bolic move carrying few immediate consequences). Recently he has also talked about imposing a special tariff on imports from American firms that move production from the US to other countries. This and other protectionist measures, however, will almost certainly be opposed by the Republican majority in Congress.

Shaking things up My initial reaction was that while Trump’s volatile and somewhat bellicose personality could cause China some short-term economic headaches, his withdrawal of the US from the Trans-Pacific Partnership (TPP) would be to China’s strategic benefit.

It now appears, however, that Trump has no intention of scaling back the US presence in Asia; if anything, he seems to want to make it more bumptious. His decision to take a congratulatory telephone call from Taiwan president Tsai Ing-wen, breaking a four-decade tradition of non-contact between US and Taiwan leaders, was clearly calculated to shake up the East Asian security status quo and put Beijing on notice that the US remains committed to defending the effective sovereignty of the island that China considers its territory.

Just where this will all lead once Trump assumes office is far from clear, but China could decide to accelerate militarization of the South China Sea, or to abandon any pretense of cooperating with the US to rein in the dangerous nuclear weapons program of North Korea. For decades, geopolitical risk in East Asia has been minimal, and the region has prospered economically as a result. The possibility that it will become the arena of a new cold war between the world’s two largest economies and trading nations is a dismal one and will almost certainly be negative for trade and investment flows.

Despite its heavy reliance on foreign trade and investment, China is well placed to ride out such a confrontation, thanks to a high domestic savings rate that enables it to support debt-financed domestic investment China Economic Quarterly, December 2016

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Arthur Kroeber

and consumption for some years to come, and to well-funded policy banks that permit it to buy support from its immediate neighbors through subsidized investment deals. In the last two months both Philippines president Rodrigo Duterte and Malaysian prime minister Najib Razak made pilgrimages to Beijing to pledge fealty, and went home with investment packages worth US$25bn and US$34bn respectively.

It is also possible, of course, that once in office Trump will tone down his rhetoric and switch to deal-making mode. But this is looking less and less likely. Despite Xi Jinping’s hope of having a smooth year of economic growth as he prepares for the political transitions of next autumn, he may have to deal with an unwelcome rise in international economic volatility and political uncertainty driven by his unpredictable counterpart in Washington.

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Putting The Lenin Back In Leninism

By Joseph Fewsmith When Xi Jinping took power four years ago, the Communist Party was plagued by opposition and factionalism, a loss of control over provincial governments, and an erosion of legitimacy. To solve these problems Xi has centralized power in a single leader—himself. Such a retrograde approach bodes ill for China’s long-run economic and political future.

To understand the Xi Jinping era and where China might be going, one has to look at the situation that he and the Chinese Communist Party (CCP) faced in 2012. Three major problems plagued the party at that time: “extra-organizational political activity” (the collusion of party officials outside approved party channels); an increasingly dysfunctional party that was losing its ability to control provincial power networks; and an erosion of legitimacy. In addition, two issues greatly affected Xi’s ascension to leadership: the nature of leadership in general and his own biography. [Xi has responded by working hard to concentrate as much power as possible in his own hands. This is a logical response to the party’s Leninist nature, but raises questions about the country’s economic and political future.]

The story of Bo Xilai—the ambitious, populist party secretary of Chongqing who was purged in 2012—filled the newspapers with sometimes lurid stories of corruption, intrigue, and murder, but its importance really lies in the threat Bo posed to party organization. At the 17th Party Congress in Joseph Fewsmith is Professor of Political Science and International Relations at Boston University’s Pardee School of Global Studies. He is the author of The Logic and Limits of Political Reform in China and China Since Tiananmen: The Politics of Transition.

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2007, the party had made a collective and authoritative decision to pass over Bo Xilai in favor of Xi Jinping. No doubt there were many reasons for this, but Bo’s raw ambition certainly rubbed many people the wrong way. When fellow Politburo member Zeng Qinghong reportedly said of Xi Jinping that he was “somebody everybody could accept,” he was perhaps alluding to the strong opposition that Bo Xilai aroused in some quarters.

Bo Xilai’s challenge to party unity Bo was sent off to Chongqing, perhaps to get him out of the capital. But, as everyone knows, he did not go quietly. Instead he “put up a rival show,” drawing attention to himself as a populist leader who went after organized crime, trumpeted socialist values through the singing of “red songs,” built housing for the poor, and cultivated “New Left” intellectuals who proposed ideas well outside the mainstream of the party’s established policies of reform and opening. All that was challenging enough to the central authorities, but Bo evidently went well beyond individual acts to make common cause with others in the political hierarchy—most notably the powerful head of the Political and Legal Commission, Zhou Yongkang, but also apparently Ling Jihua, the head of the party’s General Office; Xu Caihou, the vice chairman of the Central Military Commission; and Su Rong, vice chair of the Chinese People’s Political Consultative Conference (CPPCC). We do not know the details, but in an extraordinary statement published in January 2016, Xi said: In recent years, we have investigated high-level cadres’ serious violation of discipline and law, especially the case(s) of Zhou Yongkang, Bo Xilai, Xu Caihou, Ling Jihua and Su Rong. Their violation of the party’s political discipline and political rules was very serious; it had to be viewed seriously. These people, the greater their power and the more important their position, the more they ignored the party’s political discipline and political rules, even to the extent of being completely unscrupulous and reckless! Some had inflated political ambitions, and violated the party’s organization to engage in political conspiracies, to immorally violate and split the party!

It is worth emphasizing that we do not know the details, but in the last sentence Xi appears to be accusing Bo Xilai of plotting some sort of extra-organizational activity to challenge the decisions already made by the party about succession—a charge repeated in Xi’s “Explanation” of the party’s norms on inner-party behavior passed at the recent Sixth Plenum.

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Although what Bo did and did not do remains obscure, it appears that he was far more guilty of “splitting the party” than was Zhao Ziyang in 1989. Zhao, the party’s general secretary during the Tiananmen Square demonstrations, made a speech calling the students “patriotic” and supporters of reform—evidently straining against an earlier People’s Daily editorial approved by For the son of a revolutionary to Deng Xiaoping which accused the ignore basic party discipline and students of being a “small group” engage in political conspiracy seeking the overthrow of socialism in China. Zhao was pushing as far as suggests an important deterioration of party consciousness party discipline would allow to urge a different policy; Bo simply ignored party discipline. For the son of a revolutionary who had spent his whole life in the party to ignore the basic discipline of the party, and apparently to engage in political conspiracy, speaks to an important deterioration of party consciousness.

Curbing unruly Shanxi The Ling Jihua case reveals a different but structurally more important problem in the party. Again, there is much we do not know, but it became apparent on September 1, 2012—when Ling was suddenly shifted from the extremely important position of head of the party’s General Office to the much less important post as head of the United Front Work Department, that a political earthquake was underway (and that his patron Hu Jintao would not fare well at the 18th Party Congress later that autumn).

Subsequently almost the entire leadership of Shanxi province—Ling’s home province—was changed, with eight members of the provincial standing committee being placed under investigation for corruption. By the time the upheaval in Shanxi was over, more than 15,000 cadres had been removed from office.

The problem in Shanxi was that personal and locality based factions had formed in ways that were not only corrupt but made it impossible for outside forces (such as officials appointed from Beijing!) to have much of an effect on provincial policy or politics. As one media commentary at the time pointed out, retired officials retained a great deal of influence. When outsiders were appointed to high office in the province, as they have been in recent years, they do not know their way around local networks and have to rely on the advice of retirees. Provincial politics became impenetrable.

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Although Shanxi became the poster boy for local networks and corruption, and the reach of those networks extending all the way up to the corridors of the Zhongnanhai leadership compound in Beijing, it is hard to believe that Shanxi is the only province that suffers from this sort of ingrown factionalism. This suggests a party that is becoming increasingly dysfunctional. Orders from Beijing could simply be ignored by local party officials if they disagreed.

The problems with Bo Xilai and others who opposed Xi, and the problems of corruption and factionalism revealed in the Ling Jihua case suggest a party that has lost the discipline and sense of mission that once characterized it. And that late-Leninist malaise was reflected in Xi’s concern with the party’s loss of legitimacy. The fate of the Communist Party of the Soviet Union was evidently much on his mind. During a trip to Guangdong shortly after taking office he asked in an inner-party meeting: “Why did the Soviet Communist Party collapse? An important reason is that their ideals and convictions wavered.”

Xi’s message was later underlined in an authoritative commentary in the People’s Daily: “Today, the Soviet Union, with a history of 74 years, has been gone for 22 years. For more than two decades, China has never stopped reflecting on how the Communist Party and nation were lost by the Soviet Communists.” And Li Zhanshu, the head of the General Office and close ally of Xi’s, wrote that “reform” in the former Soviet Union had led to “burying the socialist enterprise.” “The lesson is extremely deep,” he concluded.

Becoming the ‘number one hand’ In addition to these three challenges of opposition, party sclerosis, and weakening legitimacy, there was the issue of succession. Although Chinese commentators sometimes like to contrast the centralized, monotonic organization of China with the divided government of democracies, believing that the former is more efficient, the Chinese system also incorporates checks and balances, perhaps in reaction to their absence in the Mao era. One institutional check is that a new general secretary does not get to pick the other members of the Politburo or its Standing Committee.

These members are chosen either because they have not completed their two terms (and are not forced by age to retire) or because party leaders are trying to balance different interests within the party.

The other way in which a new general secretary is balanced is by allowing the former general secretary in particular, and retired elders in general, to play a role in policy making and particularly in personnel selection. This 10

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role is not very well understood and seems to vary over time, but it has clearly existed from the time that Deng Xiaoping gave up his last official office (head of the Central Military Commission) in November 1989.

Deng’s successor Jiang Zemin was relatively fortunate. Deng faded mentally by 1994, dying in 1997, while other elders, including senior economic specialist Chen Yun, As the son of a revolutionary leader, passed away before Deng. The natuXi seems to have a deep sense of ral life cycle facilitated Jiang consol‘ownership’ over the party idating power. Hu Jintao was not so lucky. Jiang Zemin continued to live throughout Hu’s two terms and clearly intervened in personnel issues at the 17th and 18th Party Congresses in 2007 and 2012.

Chinese use the term “number one hand” (yibashou) to express the ability of a leader to “slap the table” and make the final decision on important issues. Hu Jintao never gained that ability. Obviously Xi wanted that ability. He was not willing to wait for time to elevate him naturally to that position, perhaps because of the urgent problems he and the CCP faced, and perhaps because of who he was. He finally gained that ability on October 26 of this year, when the Sixth Plenary Session of the Eighteenth Central Committee officially named him “core” of the party. This decision made clear that Jiang Zemin was now officially retired and that Hu Jintao had never been the “core.”

What will Xi do with his power?

One never wants to reduce political analysis to political biography; political systems are always complex. But neither can one ignore political biography, and in Xi’s case, family history was important, as it clearly also was for Bo Xilai. As the son of a revolutionary leader (a “princeling”), Xi seems to have a deep sense of “ownership” over the party. Perhaps this is a manifestation of the Cultural Revolution “bloodline theory,” that if the father is a hero then the son must be a stout fellow as well, or perhaps just a sense of inheriting a revolutionary tradition. But it seems to have influenced both his desire to consolidate power quickly and his policy preferences.

Certainly Xi’s emphases on party tradition, discipline, and “ideals and convictions” seem to reflect his personal biography and contrast with Hu Jintao’s quasi-Confucian emphasis on building a “harmonious society.”

Xi’s adoption of the “two thirty-year” framework—which tries to reconcile, somewhat awkwardly, Mao’s three decades in power with the subsequent three decades of Dengist reform and opening—seems to reflect China Economic Quarterly, December 2016

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a concern with revolutionary history as well as a turn away from more liberal solutions to China’s problems.

If these challenges to party organization and legitimacy and issues with succession and Xi’s personality help us understand the political dynamics of the past four years, what do they say about the future? Xi’s drive to centralize power seems to have generated a degree of opposition, particularly in early 2016, but with his recent elevation to “core” status, the odds seem to favor him consolidating power at the 19th Party Congress in the fall of 2017. This is not unexpected; after all, the CCP has a long history of centralized power. In this sense, it is the periods during which Jiang Zemin and Hu Jintao were general secretary and some degree of “collective leadership” developed that now appear anomalous. And one can argue, given the way the party is organized, that the party functions best when power at the center is not contested (as long as the person possessing it does not go off the rails as Mao did). But then the question is: what will Xi do with the power he has amassed?

The issue that garners particular attention is whether or not a successor to Xi will be promoted at the 19th Party Congress, but the real question is: will a successor—whether or not one is anointed at next year’s Party Congress—be allowed to take power in due course? Assuming that Xi is able to consolidate his position as yibashou, it will be very difficult for a successor to truly take over unless Xi passes from the scene (as Deng did) or becomes vulnerable (as those close to Jiang Zemin and Hu Jintao did).

It seems highly likely that Xi will continue to exercise ultimate power, whether directly or indirectly, for many years to come.

The outlook gets gloomier If this proves to be the case, it raises at least three questions. First, what is the relationship between the party and the government? Of course, the party has always controlled the government: the premier of the State Council has always been the second or third ranked member of the Politburo Standing Committee, never the first. But a certain division of labor has developed and the premier has generally held considerable influence in economic policy. Under Xi, though, the creation of such party organs as the Central Leading Small Group for the Comprehensive Deepening of Reform has eroded the power of the State Council, making it uncertain whether decisions made by the State Council will be supported and implemented by the party.

Second, how can a highly centralized political system with narrower bounds set on public discussion be reconciled with an increasingly diverse 12

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society that is nestled in a complex global system? When China joined the WTO in 2001, one of the catch phrases among Chinese policy makers was “joining tracks with international norms.” Since then, we have had a number of discussions that distance China from this stance. The term “China Model” seems to have entered Xi looks likely to continue to China around 2003, but it was only exercise ultimate power, whether with the global financial crisis in directly or indirectly, for many years 2008 that the term took off. In 2009 to come Pan Wei, an influential scholar of international relations at Peking University, edited a long book on the China Model to which he contributed a lengthy essay that both scathingly critiqued liberal commentators and ardently defended cultural continuity.

Other scholars have put the idea of “universal values” under increasing criticism. After the November 2014 APEC meeting in Beijing, the People’s Daily published a commentary about China starting to rewrite the rules of international trade. No doubt China’s views will increasingly be taken into account as international trade and investment rules are written. But it is no longer clear that China will continue to play by the rules as the outside world understands them. Instead it may try to develop its own norms for international relations.

Meanwhile, Chinese society is clearly diversifying. Social media are filled with conflicting views. At least for now, the state’s response has been to try to put a stopper in the bottle. In 2013, Xi’s first full year in office, the party issued its now-infamous Document No. 9 outlining seven topics that were not to be discussed in academia and the media, including “universal values,” “civil society,” and “constitutional government.” But these are precisely the topics that Chinese society must confront over the coming years. Putting a stopper in the bottle is not an adequate answer. Perhaps Xi can find some way to deal with these issues quietly while staunching pubic discussion, but if he does not, then China will likely face a wrenching set of problems when he is no longer yibashou.

Finally, to the extent that Xi can revitalize the CCP—by putting the Lenin back in this Leninist party—the more difficult it will be to move away from hard authoritarianism in the future. This is an outcome Xi and other leaders presumably desire, but studies show a positive correlation between the development of more “Weberian”-style bureaucracies and long-term economic growth. Weberian bureaucracies are rule-based and compatible with rule of law; Leninist bureaucracies concentrate power in China Economic Quarterly, December 2016

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individuals and are hostile to rule of law, and this makes it hard for them to run more sophisticated, diverse economies. More worrying is their tendency to decay over time, something Xi Jinping apparently also worries about. But campaigns against corruption and constitutional government are unlikely to remove the incentives for corruption and institutional decay. So the long-term prognosis for China, both politically and economically, remains troubling.

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Leninism Upgraded: Xi Jinping’s Authoritarian Innovations

By Sebastian Heilmann In order to cement Communist Party control and discipline, Xi Jinping has dismantled China’s successful model of ‘explorative governance’ and latitude for local initiative.

China’s long-term success depends on whether he is willing to relax the reins after the 2017 Party Congress.

When Xi Jinping took power in 2012, he found the Chinese Communist Party (CCP) in a state of erosion. The CCP had lost its organizational hold and internal discipline. Formal command structures had been undermined by informal modes of exchange, resulting in endemic corruption.

Political institutions were incapable of addressing the rapid developments in China’s economy and society, disruptive technological changes, and a shifting global environment. On the whole, in the eyes of Xi Jinping, the CCP had become unfit to rule China. To overcome this predicament, political power would have to regain priority over market logic, with the party firmly back in charge and a strong leader at the helm.

Building from this realization, Xi has spared no effort to reorganize and strengthen the party’s governance over the past four years, and has established a centralized leadership system that revolves around himself as the ultimate decision-maker. This however created a top-heavy decision process and a degree of inertia in policy implementation that may put the country’s political and economic future at risk. Various scenarios are plausible for China’s development in the coming decades, none of which include a transition to a competitive democracy.

Sebastian Heilmann is the founding president of the Mercator Institute for China Studies (MERICS) in Berlin and professor of the political economy of China at the University of Trier, Germany.

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Xi’s approach to governance, strongly influenced by Marxist dialectics, has mainly aimed to reconnect the party to its historic roots, while propelling it into the future.

Xi has reinforced Leninist-style hierarchies and party discipline, and started a relentless rectification campaign. He also set out to centralize political decision-making and reassert party control over the economy, society, media and the security apparatus. Bureaucracies in charge of discipline and surveillance, which had previously kept a lower profile, were mobilized and expanded to curtail organizational, political and ethical deviations within the party and state apparatus. A vehement anti-corruption campaign was launched that brought fear and feigned compliance back to the center of inner party life. Finally, the state security apparatus, which had been busy pursuing its own business operations (from arms exports to the operation of casinos in Macao), was reorganized to watch more effectively over Chinese and foreign organizations inside and outside China.

Tightening and modernizing party governance Amidst all this repression, Xi also promoted a more creative type of Leninist restoration. In particular, to fulfill his vision of “top-level design,” he altered the mechanisms of the core executive organs of the party and government. The installation of a number of new Leading Small Groups is a primary example. These groups had traditionally been tasked with defining broad strategies (such as long-term development goals) or coordinating policy on narrowly defined issues (such as poverty alleviation).

Xi has reasserted Leninist-style party The newly established or reorganized leading groups, many headed control over the economy, society,

by Xi himself, were turned into cenmedia and the security apparatus ters of policy decision-making. The Leading Small Groups have become parallel, leader-driven units whose meetings regularly precede and predetermine the formal decisions of the Politburo or its Standing Committee.

They also serve to entrench virtually all key decision-making in the party center, at the expense of the government.

Perhaps Xi’s most important innovations are the new ways in which the leadership interacts with and controls the public. The communicative element of power in today’s digital society presents a major challenge to the Chinese party-state. Xi is determined to turn this challenge into strength. China’s authorities have moved beyond censorship of undesir16

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able content, employing sophisticated instruments to shape the online narrative. Refined algorithms have been set up to steer users towards officially approved websites and away from potentially subversive content.

In addition, the propaganda apparatus has created new online formats to make the party line appealing to a broader audience. Finally, China’s government is making advances in providing e-government services to its citizens, suggesting a degree of transparency or accessibility that stands in sharp contrast to the prevailing opacity of political and administrative procedures.

The leadership has also incorporated big data into its national security strategy. In a context where anything that might endanger the CCP’s hold on power is considered a threat to national security, China is establishing a “Social Credit System” to monitor and rate all of its citizens’ economic, communicative, and social activities. This is arguably the most ambitious Orwellian scheme in human history, seeking to establish an all-seeing state. And this comprehensive approach to security spreads wider: no business operating in China today can escape the dragnet that is built into current cybersecurity regulations. China’s cyberspace is purposefully designed to be an essential component of the overall political control structure.

This big data-enabled, IT-backed authoritarianism has the potential to put China on a path towards an entirely new, potentially totalitarian future; while also providing precedents and tools to other authoritarian regimes. This is not just warmed-over traditional authoritarianism; it is a new digital Leninism.

Design flaws in ‘top-level design’ In a system where the main objective is to secure the one-party state’s survival, the re-tooling of institutions and governance procedures so far has been quite successful. Discipline, defined as strict adherence to the party center’s orders, has basically been restored, and some of the most egregious trespassers among high-ranking cadres have been prosecuted.

Most importantly, by centralizing decision-making at the top, the leadership has reasserted its capacity for unified action and long-term policy agendas—two crucial advantages in the intensifying competition with Western democracies.

However, the practical disadvantages of this rigid party-centered system are also becoming increasingly apparent. The renaissance of “hard authoritarianism” has thrown out of balance the relation between the party and other actors in government, the economy and society—with China Economic Quarterly, December 2016

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consequences that may hurt China’s future development.

For one, the system of top-down policy-making has created an avalanche of overambitious or unrealistic projects. These range from swiftly turning China’s mediocre national soccer team into a world champion, to establishing costly infrastructure corridors along the continental and maritime “Belt-and-Road,” regardless of financial returns. Most problematically, sweeping policies—such as those outlined in the 2013 Third Plenum reform agenda—are essentially un-implementable due to conflicting goals or the stiff resistance of vested interests. The blame for implementation failure is routinely put on Premier Li Keqiang and the government bureaucracies. The true causes of failure, though, are ill-conceived and overly abstract policy formulation, and a lack of understanding for administrative realities on the ground.

So far, Xi has demonstrated that he is brilliant at making the party hierarchy work for his purposes. But he might underestimate the powerful influence of informal rules, incentives and interests on China’s vast government bureaucracies tasked with putting the party center’s policies into practice. So far at least, the decentralized, explorative approach pursued under Deng Xiaoping and Jiang Zemin appears to have resulted in more effective policy formulation and implementation than Xi Jinping’s “top-level design.”

Economic policy confusion A particularly vexing problem is that the clarity of economic policy-making has deteriorated under the current system, which prioritizes political goals over economic ones.

The confusing interventions into the stock market following the June 2015 crash are a case in point. The market rout did little harm to China’s real economy, but it damaged the credibility of Chinese policy-makers abroad. As a result, the international narrative about China has turned from one of steady success to one of impending crisis. Over the past year, policy-makers and regulators have demonstrated time and again that they lack the direction, consensus and instruments to effectively deal with the growing risks in China’s financial and fiscal systems. The clumsiness of financial regulators and their apparent inability to control China’s surging levels of debt has increased the actual and perceived risk of a systemic financial crisis in the near future.

Another striking example of policy drift is the lagging pace of stateowned enterprise (SOE) reform. Rather than requiring its SOEs to become more competitive, the Xi administration has continued to protect state 18

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behemoths from domestic and foreign competition. It even promoted the merger of public giants into even larger monopolistic organizations—a stark reversal of the state sector reorganization undertaken by former Premier Zhu Rongji after 1998, which stressed competition. Today’s SOEs once again appear to function as the business arms of the party, free from profit orientation, market competition and corporate governance.

Finally, top-level design has also stifled decentralized initiative at lower levels of government. The end of the previous approach of flexible, explorative governance has resulted in outright paralysis in local administrative action and policy implementation. Chinese data show a sharp decline of pilot projects at the subnational level after 2012, indicating that there is no appetite for local experimentation in the absence of official approval from Beijing. Most strikingly, a plethora of new experimental Free Trade Zones have turned out to be non-functional. They lack the capacity for policy innovation that was characteristic of the vibrant experimental zones during the Deng and Jiang eras.

What the future holds Taking into account these new features of China’s political and economic system under Xi Jinping, three main scenarios emerge for China’s future: a return to explorative governance, institutional ossification under an

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ever more repressive security state, or a loss of central control. The one outcome we can confidently rule out is an evolution towards more democratic governance.

Scenario 1: Back to explorative governance It is reasonable to expect that the current system—a centralized party and security state that thrives on tight control of key economic actors, aggressive industrial policies, anti-Western ideology and aspirations to regional hegemony—will prevail beyond the 2017 Party Congress. Yet in the medium term (between 2020 and 2025) China’s worsening economic outlook—including rapidly increasing risks in the real estate and financial markets, and mounting debt levels despite slowing growth—will force the leadership to make adjustments to the current, rigid approach to governance.

In its modified form, the “Xi system” may retain its centralized character with respect to domestic political and societal control as well as foreign and security policy. In terms of economic policy and regulation however, Deng’s proven exploratory methods may well re-emerge to allow for more flexible reactions to novel domestic and international challenges.

In this scenario, a strengthened private sector could push for overdue reforms of state-controlled oligopolies and a reorganization of SOEs. A loosening of the state’s grip on the economy would result in progressive decentralization, opening up spaces for self-organization and a more pluralistic society. China’s approach to international cooperation may fluctuate, but the leadership’s willingness to cooperate with the US in the Asia-Pacific could prevail, capping China’s military ambitions.

This eventual softening may already be built into the current model.

In line with Communist Party tradition, Xi’s leadership is likely to pursue the current hard course as part of an extended (but finite) period of rectification and reorganization. As soon as it deems the “clean-up” to be completed, and feels safe enough at the levers of power, the party center may relax some of the rigid controls currently in place.

Scenario 2: Security state and institutional ossification China’s development could also take a less pragmatic direction. Should Xi try to seek a third term as CCP General Secretary beyond 2022, a strongman system will be in place.

In this scenario, an ossification of the current system would result in deepening political paralysis and a loss of economic dynamism. The climate for domestic and international investment would deteriorate sharply 20

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as a consequence of political hardening. Uncertainty and tension within the central leadership would cement the concentration of power in a single leadership figure. Decision-making would rely more on the whims of a strong man than on unified action by a collective party leadership. Such a strong leader, however, would need to secure the continuing support of oligarchies within the party center, security organs, military headquarters and state enterprises.

Selective domestic repression as well as nationalism and populism would play an even bigger role in this scenario than in today’s “Xi system”.

The leadership could seek to distract attention from domestic troubles by stirring up regional conflicts or by The one option off the table: China’s engaging in military adventurism. evolution towards a Western style All-out strategic rivalry with the democratic constitutional state United States would not only fuel a costly arms race, it would also create a de facto state of war in cyberspace. With China pursuing narrowly self-interested and disruptive foreign policies, decision-making in key multilateral institutions would be blocked, preventing progress on issues such as trade policy and financial governance.

Scenario 3: Loss of central control A third and final scenario could see Xi Jinping’s leadership suffering a backlash due to domestic economic difficulties, intra-elite strife and/ or foreign policy disasters such as serial defaults of large-scale overseas projects, or skirmishes in the South China Sea demonstrating US military superiority. These setbacks would lead to an erosion of the CCP’s authority and to a power vacuum similar to that in post-Communist Russia during the 1990s.

The CCP leadership would disintegrate into feuding groups while many ordinary members would abandon the party. The emergence of oligarchic and mafia-like structures would cause a fragmentation of political power on the regional level, the emergence of a chaotic pluralism, and political strife that could well turn violent. The economic slump would provoke capital flight and a withdrawal of foreign investors. Finally, a loss of central civilian control over the military would create risks of maverick military action and nuclear proliferation.

This very disruptive scenario appears unlikely today, but should not be ruled out. The risk of systemic collapse is higher in China’s rigid party-state than in weak-looking yet structurally more elastic systems with China Economic Quarterly, December 2016

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regular democratic turnover. China’s system of government is particularly vulnerable to abrupt economic shocks (such as a real estate bust or a steep decline in the exchange rate) or a visible foreign policy failure (such as unsuccessful foreign projects or a striking demonstration of weak military capability). A system that derives its legitimacy from economic performance and nationalist pride cannot afford to disappoint popular expectations in these areas.

Scenario impossible: competitive democracy Whichever scenario plays out, one option seems fully off the table: China’s gradual evolution towards a Western style democratic constitutional state.

The political leadership under Xi Jinping and large parts of Chinese society currently display zero appetite for transforming the party-state into a liberal competitive democracy. We should therefore prepare ourselves for a less welcome, and potentially nasty, evolution of the Chinese political system.

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Grand Bargain Or Grand Conflict With The US?

By John Pomfret For more than two centuries, China-US relations have swung back and forth between high expectations and dashed hopes. Today the stakes are higher than ever, as Beijing seeks to carve out a sphere of influence and Washington struggles to craft a response. And where the relationship is headed under a volatile President Trump is anyone’s guess.

Americans and Chinese have been dealing with each other for more than two hundred years. Yet the United States has never quite figured out how to cope with China. American diplomats, businessmen, and missionaries for religion and the American Way have been torn between accepting China as it is and trying to change it. The result has been a tangled web of ties characterized by rapturous enchantment followed by crushing disappointment with each turn of history’s wheel.

The election of Donald Trump looks to continue this cycle of contradictions. On the campaign trail, Trump blasted China for “raping” the United States on trade and promised to slap punitive tariffs on Chinese goods and declare China a currency manipulator. At the same time, he intimated that as president he planned to cede the Western Pacific to Beijing. He expressed a desire to walk away from America’s commitments to its Asian allies, South Korea and Japan, if they did not begin to pay “their fair share” of the costs of defending them and he announced that dealing John Pomfret is the former Beijing bureau chief for The Washington Post and the author of a new history of US-China relations, The Beautiful Country and the Middle Kingdom (Henry Holt, 2016).

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with North Korea’s nuclear program was China’s responsibility, thereby giving Beijing enormous leeway with its sole ally.

As president-elect, Trump has signaled that he’s open to challenging the very architecture of the relationship when he broke with decades of precedent by speaking on the phone with Tsai Ing-wen, the president of Taiwan. Trump’s phone call prompted criticism from Beijing, which insists the island belongs to China, as well as concern from veteran China-watchers that Beijing would take even more steps to isolate Taiwan.

Containment, or a grand bargain?

The president-elect has surrounded himself with advisors who have spouted a perplexing mixture of bellicosity and vague plans for a breakthrough between Washington and Beijing. A day before the election, two of Trump’s campaign advisors—an economics professor named Peter Navarro, known for his strong criticism of China, and Alexander Gray, an advisor to Republican congressman J. Randy Forbes—published an essay in Foreign Policy arguing that the Obama administration had not been tough enough on China. They predicted that a Trump presidency would pursue a more forceful response to China’s expansionist maneuvers in the East and South China Seas.

During the campaign, Trump promised to add more than 70 ships to the US naval fleet, turning it into a force of 350 surface ships and submarines. To ride herd over this massive build-up, Trump has reportedly tapped Forbes as the next Secretary of the Navy. Forbes has long supported a bigger navy and stronger pushback against China in the South China Sea. Yet on November 10, James Woolsey, a former CIA chief and another Trump advisor, ran an essay in the South China Morning Post in which he contended that the US would back off of its criticism of China for human rights violations and expressed hope for “a grand bargain” in which the US would accommodate China’s rise in exchange for China’s commitment not to challenge the status quo in Asia.

Obama’s friendly opening…

In their contradictions, Trump and his advisers are not alone. The Obama administration approached China with a similar, though less bombastic, mix of battling impulses. Barack Obama was the first president in decades to enter the White House without having criticized the China policy of its previous occupant. His first secretary of state, Hillary Clinton, made Asia the destination of her first trip. In her version of a “grand bargain,” 24

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she announced that henceforth the United States would not obsess over human rights and the protection of Taiwan and Tibetan culture. Instead it would work on more consequential issues with China such as climate change and the global economy.

China’s response to these overtures was to treat Obama in 2009 to the roughest handling that any American president visiting China had ever received. The Chinese censored Obama’s remarks to college students in Shanghai and his host, President America’s confusion over how to Hu Jintao, declined to hold a press approach China dates back at least conference with Obama. Their intertwo centuries action was so wooden it became the subject of a skit on “Saturday Night Live.” Then, starting in 2010, Chinese dredgers began transforming reefs and rocks in the disputed Spratly archipelago in the South China Sea into islands large enough to boast military installations and airplane runways.

The 2015 US Department of Defense’s annual report to Congress on China’s military noted that Chinese had fashioned at least 3,200 acres of new land in the Spratly Islands over the past couple of years. Over the same period, all the other claimants to the region reclaimed 50 acres combined.

Beijing’s reasons for building the islands mixed a nationalist notion that the 2-million-square mile South China Sea belongs to China, a desire to push the US Navy as far as possible from its shores, and a strategic goal of ensuring that its soon-to-be-deployed Jin-class nuclear-armed submarines would be able to enter the oceans without being tracked, and thereby preserve China’s ability to strike the United States with a nuclear warhead.

Beijing wagered that now was the time to stake its claims because America, caught in its contradictions about China, couldn’t decide whether to confront or accommodate it. …gave way to a half-hearted ‘pivot’ Indeed, the American response to China’s bumptiousness tracked neatly with two centuries of confusion over how to approach the Middle Kingdom. In October 2011, in a move that reversed her previous “grand bargain” approach, Secretary of State Clinton announced an American “pivot” to Asia. This involved deploying US Marines to Australia, bolstering America’s allies, strengthening ties with India and encouraging America’s former enemy, Vietnam, to stand up to Beijing. This was widely seen as an effort to counterbalance China’s growing influence. But Washington soon waffled. In 2012, after Chinese ships forced Philippine fisherChina Economic Quarterly, December 2016

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men from their historic fishing grounds around the Scarborough Reef, a group of rocks a mere 140 miles from Manila Bay, the US brokered a deal between China and the Philippines under which the Chinese would withdraw their Coast Guard vessels from the area. When the Chinese walked away from the arrangement, Washington did nothing.

As part of the pivot, Clinton and Obama also announced that the US would pursue a broad trade deal to unite friendly nations along the Pacific Rim in a massive market. In November 2015, the Obama administration announced the signing of the Trans-Pacific Partnership (TPP). But once the deal was signed, the administration waited for a year to bring it to Congress. And now, with Trump riding a populist revolt against free trade into the White House, the TPP is dead. The failure of this trade agreement constitutes a huge win for Chinese power. The pivot is left without an economic component, and China is poised to set the rules for trade and economic development in Asia for years to come.

Underperforming on trade and security, the Obama administration tried to overcompensate by unnecessarily challenging China’s perquisites elsewhere. In June 2014, when China announced the establishment of the Asian Infrastructure Investment Bank (AIIB), administration officials criticized it as a Chinese gambit to create an international institution beyond Washington’s sway. The White House leaned on its allies Britain and Australia to boycott the bank. Whitehall and Canberra ignored Washington’s entreaties and signed on as members to the AIIB anyway. In his South China Morning Post piece, Woolsey called Obama’s opposition to the bank “a strategic mistake” and expressed hope that Trump would give a warmer welcome to China’s plans for an infrastructure build-out in Central Asia. This exemplifies a desire among some Trump advisers to accommodate—and see American companies profit from—China’s rise.

Southeast Asian allies start jumping ship Obama’s contradictory response to Chinese expansionism allowed Beijing to accomplish another goal. In building its islands and in incurring the constant criticism of the US government with scant action to back it up, China showed the region and the world that the US was, in Mao Zedong’s old phrase, a “paper tiger” incapable of halting China’s rise. This was a priceless gift to the Communist Party and specifically to the political prospects of its current leader Xi Jinping. Thanks to his successful promotion of a more assertive foreign policy, Xi’s prestige is high as he prepares for the party’s 19th Congress in the fall of 2017, where he will most likely consolidate his grip on all elements of the Chinese state.

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Confronted with a Washington that did not know exactly what it wanted from China, Asian leaders worried about the sustainability of America’s commitment to the region. Asian analysts such as Thitinan Pongsudhirak, a Thai professor of international relations, took to calling Obama’s pivot an attempt to gain “superpower status on the cheap.”

First to publicly toy with the idea of jumping ship was the Philippines’ newly-elected president Rodrigo Duterte who traveled to Beijing in October 2016 landed pledges of US$24bn in Chinese trade and investment and announced it was “time to say goodbye” to Washington. While Duterte’s courting of Beijing was clearly a cynical attempt to start a bidding war between the US, Japan and China over the Philippines, his doubts about Washington’s commitment reflect fears felt throughout the region. Duterte was followed to Beijing by Malaysian prime minister Najib Razak who announced plans to buy four Chinese naval vessels and was rewarded with US$34bn in deals. The clear impression is that the balance of power in Asia is swinging in China’s favor.

The North Korean pressure-cooker The erosion of US influence in Southeast Asia is humiliating; the situation in nuclear-armed North Korea is downright dangerous. For eight years, Obama effectively outsourced his policy on the rogue state to Beijing. His stance was one of “strategic patience” which amounted to hoping that North Korea’s governChina is far less interested than the ment would collapse or that China US in the denuclearization of the would somehow convince it to end Korean peninsula its nuclear weapons program. Neither has occurred and, in fact, the pace of North Korean testing has accelerated. In his four years in power, North Korean dictator Kim Jong-un has conducted 35 missile tests and three nuclear tests—compared to just 18 missile tests and two nuclear tests during his father’s 17-year reign.

What’s more, despite years of US pleas, China is clearly far less interested than the US in the denuclearization of the Korean peninsula. Indeed, the maintenance of the North Korean regime as a buffer state between China and the pro-American South is considered an issue of existential importance to the Chinese. It’s no exaggeration to say that North Korea is viewed in China as its East Germany and that Beijing worries that a collapse there could lead to the fall of the Chinese Communist Party itself. China has agreed to United Nations sanctions on North Korea, but China Economic Quarterly, December 2016

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ensured the sanctions were drafted so that China is not obliged to report its oil exports to the North and that under the sanctions’ “livelihood” loophole Chinese companies can sell North Korea almost anything.

During the campaign, Trump seesawed between competing instincts to hand the problem to China and to solve it on his own by scheduling a personal meeting with Kim. But again, following the election, Trump’s position seems to be evolving, perhaps under the influence of adviser John Bolton, a former US ambassador to the United Nations who has long advocated a hard line on North Korea. At a conference in Seoul following the election, Christopher Hill, who negotiated with North Korea during the George W. Bush administration, warned that Trump would have little compunction about approving a preemptive military strike against North Korea if it was shown that Pyongyang possessed an inter-continental ballistic missile armed with a nuclear warhead. “North Korea needs to understand that there will be a new sheriff in town in Washington,” Hill said.

But as North Korea’s nuclear program advances, it could also play into China’s continuing goal of sowing doubt about America’s commitment to the Asia’s security. While it doesn’t appear that Kim Jong-un is suicidal, it’s a safe bet that his regime is preparing to force a crisis on the peninsula at a time and a place of its choosing. And North Korea’s nuclear program at that point, an American president could play into China’s goal of will be faced with a fateful choice. sowing doubt about American With a pre-emptive strike, would commitment to Asian security Trump be ready to risk losing Seoul to the North Korean artillery guns just over the border? Or would he hesitate because, understandably, the prospect of the deaths of hundreds of thousands of South Korean civilians was too heavy a price to pay? If the second scenario comes to pass, the United States will once again be exposed as a “paper tiger,” and Beijing, not necessarily Pyongyang, will be the beneficiary.

The North Korea issue was high on Trump’s agenda when he met with President Obama following his election. China-watchers have expressed concern that Trump’s call to Taiwan’s president might be part of a plan to signal Beijing that if it does not do more to deal with North Korea, then the US will stop respecting China’s claims to Taiwan. The island of 23 million with a real democracy will then be relegated, as it has been before, to the status of bargaining chip between Washington and Beijing.

In the 1860s, America’s first minister to the Qing dynasty court in Beijing Anson Burlingame had a clear answer as to whether America should 28

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try to mold China in its own image or let it be. Accept China as it is and China will respond with friendship, Burlingame proclaimed. The very next US minister, John Ross Browne pronounced Burlingame’s views a “hallucination,” and advocated taking China “by the throat” to force it to modernize and follow the rules of international discourse. US policy makers have bounced between forbearance and impatience ever since.

Best frenemies forever China, too, has its own oscillations in how it has approached the United States. It has tried to rope America into alliances against its enemies, from Great Britain, to Russia, to Japan. It has embraced US technology and free-market reforms to grow strong. But its rulers—from Qing dynasty mandarins to the apparatchiks of the Chinese Communist Party—have also tried their best to shield Chinese people from the influence of American ideas, religion and values.

In the past, China’s responses to the United States were constrained by its position of relative weakness. Now, however, its rising economic, financial and geopolitical power gives China more leeway to aggressively pursue what it believes to be its interests. Still Beijing’s position remains delicate because China has been an enormous—perhaps the main— beneficiary of the US-led international system, and the costs of disrupting or replacing that order are dauntingly high.

Against this perilous backdrop of an Asia facing a nuclear-armed dictator in North Korea and a China eager to capitalize on American missteps, Donald J. Trump will enter office. How he juggles America’s (and his own) mix of enchantment, disappointment and realism about China will help determine the future of the relationship and of the globe.

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Economy

Steady As She Goes (Despite Trump)

By Chen Long China is still on track to maintain GDP growth of 6% or more in the run-up to the 19th Party Congress in late 2017.

Despite threats of a trade war with the US, Trump’s election probably hands China some long-run strategic benefits The year 2016 saw striking political events in the West as both the Brexit vote and the US presidential election ended with unexpected outcomes which triggered high degrees of policy uncertainty. China by contrast has been a sea of tranquility since the shocks in the foreign exchange and equity markets in the first few weeks of January. In fact, its economy surprised on the upside as a strong property market surge boosted commodity prices and pulled the country out of four years of producer-price deflation.

For 2017, the outlook is generally similar. Politics will remain a key theme in the developed world, as several major European countries face important elections, and President Donald Trump will try to impose a controversial agenda in the US. China faces its own political cycle, with a reshuffle of top Communist Party leaders to occur at the 19th Party Congress in October or November 2017. One of our key calls has been that macro-economic policy is now subservient to political necessity, and the need for a calm environment heading into the Party Congress means the economy is likely to remain stable through next year. This remains the base case, but it is worth considering what might upset this scenario.

Property and credit growth are still the keys Loose credit, a property boom and rising commodity prices were the major forces enabling the economy to grow at a 6.7% in the first three Chen Long is the China economist at Gavekal Dragonomics.

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quarters, slightly above the government’s 6.5% target. Not all of these trends can continue through 2017. Growth in debt was much faster in 2016 than in 2015, thanks to an epic boom in mortgage lending and local government bond issuance. Total credit (including government bonds) was still growing by 15.5% year-on-year in October, about double the rate of nominal GDP. The leadership certainly has no appetite for serious tightening, so the rise in leverage will persist. But credit growth has ticked down from its peak rate of over 16% earlier in the year, as the government policy focus shifted from supporting growth to containing risk. One possible downside for 2017 is a deceleration in local government bond issuance and household mortgage credit.

The real estate market responded very well to this year’s monetary easing. Mortgage lending increased by more than 30% year-on-year, and total property sales rose by 20%—enabling a sharp reduction in housing inventories, at least in Tier 1 cities. New real estate investment and construction activity also saw modest gains. The strength of the property sector helped keep GDP growth above target, but housing markets are now distinctly frothy. Property prices in Beijing and Shanghai are up 25% year-on-year and an average two-bedroom apartment in those cities now costs US$1mn.

The government is now trying to moderate the property bubble, without popping it. The People’s Bank of China (PBOC) has asked banks to China Economic Quarterly, December 2016

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keep an eye on their mortgage lending, and in its latest quarterly monetary policy report the central bank said it would shift to a balanced approach of both supporting growth and managing the risk of bubbles. The PBOC made a slight adjustment in short-term interbank rates in mid-October: it reduced its injections of short-term liquidity and increased medium-term liquidity, pushing up short-term interbank repo rates by 20-30 bps.

Over the next several months the most likely scenario is a gradual deceleration in credit growth. This likely means that property sales will soften quite significantly in 2017 from a very high base, unless another round of monetary easing takes place. The good news is that construction activity will hold up better than property sales, as developers build new housing in response to lower inventories in some cities.

The end of deflation One positive factor that can probably persist is the reflation of industrial prices. Four-and-a-half years of decline in China’s producer price index (PPI) ended this year thanks to the strong rally in commodity prices.

When prices stopped falling, the troubled heavy industry sector saw a welcome rebound in profits. Given low base effects, the PPI can stay in positive territory at least until the second half of 2017, supporting decent growth in industrial revenues and profits. This in turn will continue to underpin wage growth and consumption. As a result, maintaining a 6.5% 32

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year-on-year growth rate at least through the first half of 2017 should be achievable.

The external environment poses some real risks, mainly emanating from the US. The immediate worry is that Trump makes good on his threat of a trade war with China on taking office on January 20, by imposing an across-the-board tariff of up to 45% on Chinese imports. Any such action would certainly be met by strong retaliation from Beijing, both through both higher tariffs on American products and more stringent regulation of US businesses operating in China.

The probability of this outcome is low. Trump’s more outlandish anti-China rhetoric was most likely an electoral tactic. Actually implementing it would be self-defeating, as it would effectively impose a massive tax on the working-class consum- A stronger US dollar could lead to a ers Trump claims he wants to help, rise in capital outflows from China and would hurt many US companies.

A more plausible scenario is that Trump pursues a handful of high-profile but largely symbolic anti-dumping actions against specific Chinese industries, much as President Obama did in his first term in office. This would placate Trump’s protectionist supporters without materially affecting trade volumes.

The more important question is how a Trump presidency would affect the trajectory of the US dollar. The trade-weighted dollar has been stuck in a fairly narrow trading range for most of the past two years, and this has permitted the PBOC to execute its strategy of quietly depreciating the trade-weighted renminbi without having to devalue sharply against the dollar—which could be a trigger for unwanted capital outflows.

Since Trump’s victory, however, the dollar has appreciated sharply against every major currency: markets seem to believe that under Trump the US will see larger fiscal deficits, higher inflation, and higher interest rates. This makes life harder for the PBOC, because it means that simply maintaining a constant trade-weighted value for the RMB requires sizable depreciation against the dollar.

Managing the currency down So far the PBOC has handled the dollar’s rise smoothly. It has allowed the RMB to fall against the greenback, to a rate of around 6.9. But on a trade-weighted basis the RMB has held an almost constant value since July.

Moreover, it is noteworthy that the decline of the RMB against the dollar has produced no spillover effects on other asset prices—in stark China Economic Quarterly, December 2016

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contrast to late 2015 and early 2016, when a RMB decline was seen as a trigger for panic on both domestic and international stock markets. As the RMB moved from 6.56 to 6.91 against the dollar over the past six months, the Shanghai Composite Index rose by 16%. The base case therefore is that further RMB declines against the dollar are unlikely to be disruptive to asset markets.

The larger worry is that a weaker RMB could lead to a rise in capital outflows. So far this seems not to be the case: underlying capital outflows have been small in recent months, and an apparent spike in outflows in October mainly reflected valuation changes in the PBOC’s non-dollar reserve holdings, rather than real flows of money abroad. The government is also taking further steps to tighten capital controls, most recently by imposing rules on outbound direct investment that permit the State Administration of Foreign Exchange to block property investments by state enterprises or non-strategic investment by private firms that exceed US$1bn; or any deal by any firm that exceeds US$10bn.

On a longer time horizon, Trump’s presidency probably delivers China some strategic benefit in its quest to build a regional sphere of influence.

With the caveat that it is still quite uncertain what policies Trump will actually pursue once in office, his promise of a more isolationist stance— and his apparently transactional attitude toward long-standing US relationships in the region—could diminish US influence in Asia. At the very 34

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least it is clear that the Trans-Pacific Partnership—the economic centerpiece of President Barack Obama’s “pivot to Asia”—is now dead. At the margin, this probably enhances China’s ability to forge economic relations with other Asian countries via infrastructure investments.

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Technology

Only One Winner In The Global Robot War

By Clay Chandler The US and Europe hope that the rise of robotics will bring manufacturing back to advanced economies. But China is well equipped to make the most of the robot revolution, leaving little space for other players.

In May, Adidas unveiled a 4,600 sq m shoe factory it billed as a prototype for manufacturing in the digital age. The plant, which the German sportswear and equipment maker dubbed “Speed Factory,” was almost entirely automated. Yet even more remarkable than the facility’s state-of-the-art industrial robots was its location: not China or Vietnam, but Ansbach, a small town in southern Bavaria.

Journalists who toured the plant hailed the facility as a harbinger of a new era in which factories that had been “offshored” to China and other developing economies would be “reshored” to developed economies in North America and Europe. In the US and Europe, which have been roiled by the backlash against globalism and free trade, the idea that advances in robotics and artificial intelligence will usher in a resurgence of Western manufacturing has obvious appeal. So, too, does its implied corollary: that a technology-led industrial renaissance in the West will come at the expense of China, as robots replace tens of millions of factory workers.

Much of this optimism is misplaced. There is little evidence of widespread reshoring to the West, and China enters the robot age with formidable strengths: modern infrastructure, advanced logistics knowhow, a highly-evolved ecosystem of suppliers, a disciplined and reasonably Clay Chandler is principal of the Barrenrock Group, an independent research firm in Hong Kong. He is a former McKinsey & Co. consultant, and reported from China and Japan for the Wall Street Journal, Washington Post and Fortune.

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well-educated labor force, and a large and growing domestic market. It stands uniquely poised to exploit these new technologies, and is far more likely to benefit from them than to suffer.

The robot revolution China came late to the robot revolution. In 2015, it had only 49 robots per 10,000 manufacturing workers, according to the International Federation of Robotics (IFR). This compared with 531 in South Korea, 305 in Japan, 301 in Germany and 176 in the US. Chinese auto factories were less than a third as automated as plants in the US and Japan.

But China is rapidly gaining ground. Between 2010 and 2015 its purchases of industrial robots grew at an annual average rate of 36%, enabling it to overtake the US as the world’s largest market for industrial robots. In 2015, Chinese factories bought 68,600 of the 248,000 robots sold globally—more than all robots sold to European factories. Beijing has set a goal of raising the ratio of industrial robots to 100 per 10,000 manufacturing workers by 2020. IFR estimates that, by 2019, China will account for four out of every 10 industrial robots in the world.

The government has aggressively promoted automation of China’s manufacturing sector, with President Xi Jinping himself calling for a “robot revolution.” In March 2015, Beijing rolled out “Made in China 2025,” an industrial roadmap that elevates factory automation to a nationChina Economic Quarterly, December 2016

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al economic priority. The plan includes initiatives that will unlock billions of dollars for Chinese manufacturers to upgrade their technology, including advanced machinery and robots. Provincial governments, too, are bankrolling the effort. Guangdong and Zhejiang have allocated US$150bn and US$120bn respectively over the next five years to equip factories with industrial robots.

Not all this money will be well spent, of course. China’s state-owned enterprises, which by some estimates account for about a quarter of China’s industrial output, have a poor record when it comes to allocating capital.

China’s media is filled with reports of factories gussying up labor-intensive assembly lines with low-end robots to qualify for subsidies. Fortunately, China’s machine drive isn’t purely government led: private manufacturers, too, are moving boldly to automate operations. At Foxconn, the leading supplier of Apple’s iPhone, founder Terry Gou has vowed that, by 2030, robots will assume more than 30% of tasks now handled by humans. In Kunshan, an industrial hub near Shanghai, more than 600 firms plan to use robots to slash headcount, according to a recent government survey.

Machine learning For now, more than 70% of robots sold in China are foreign made. But already homegrown robot makers such as GSK CNC and Shenyang’s Siasun Robot & Automation have developed a host of robots for factory use. Shen38

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zhen’s SZ DJI Technology Co. is the world’s biggest consumer drone maker.

Forecast International, a private market researcher, recently predicted that state-owned defense firm Aviation Industry Corporation of China will produce nearly US$6bn worth of unmanned aerial vehicles by 2023. Meanwhile, China’s largest manufacturers have demonstrated their willingness to pay top dollar for foreign companies with robotic capabilities they cannot find at home. In July, Midea Group, a leading appliance maker, overcame local political opposition to close a US$5bn takeover of Frankfurt-listed Kuka AG, one of Germany’s most advanced robot manufacturers.

Will Chinese robot makers ever compete with the likes of Japan’s Fanuc Corp. or Swedish-Swiss conglomerate ABB Group? Skeptics dismiss the notion as preposterous. Many cite China’s inability, despite prodigious government support, to develop world-class manufacturers in fields such as commercial aircraft, memory By 2015, China was the world’s chips and pharmaceuticals. Yet manlargest market for industrial robots ufacturing and industrial automation play to China’s strengths. A recent McKinsey study distinguished between four categories of innovation: customer-focused, efficiency-driven, engineering-based and science-based.

While China is still struggling in the latter two categories, the report found it was already a world-leader in the first two. “In manufacturing,” it noted, “China’s extensive ecosystem has provided an unmatched environment for efficiency-driven innovation.”

Factories, come home The notion that industrial robots and artificial intelligence will revive manufacturing in North America and Europe is the most recent iteration of a broader Western debate about re-shoring. The idea took shape at the end of the last decade as executives at a handful of prominent Western multinationals gauged that, for at least some products, rising wages and energy costs in China combined with the challenges of meeting faster product cycles had altered the calculus of manufacturing there.

Reshoring attained mainstream credibility in 2009 when General Electric announced it would spend US$800mn to shift production of its energy-saving GeoSpring water heaters, previously made under contract in China, to the company’s fabled Appliance Park complex in Louisville, Kentucky. At its peak in 1973, Appliance Park employed more than 23,000 people; by the end of the global financial crisis, the sprawling compound was a ghost town, with fewer than 2,000 workers. But oil prices had tripled China Economic Quarterly, December 2016

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since 2000 and Chinese wages had jumped fivefold in little more than a decade. Meanwhile, US labor unions had become more flexible, and labor productivity was rising. It seemed to make economic sense to move manufacturing back home.

GE rapidly ran into difficulties at Appliance Park, as its engineers had lost the knowledge of how to assemble the heaters. This forced them, at considerable time and cost, to rethink how to build them. By focusing on efficiency, however, GE’s US plant eventually beat the “China price” for the heater by 20%. Delivery time from factory to warehouse dropped from five weeks to 30 minutes. GE began to bring back manufacture of components for the heater, and later shifted assembly of one of its top-ofthe-line refrigerators to from Mexico. By 2012, Appliance Park had 3,600 hourly employees and GE’s appliance business boasted sales of US$5bn a year, 55% from products made in the US. In the years that followed, there were other success stories. Caterpillar opened a new plant in Texas to produce excavators that it had previously made in China. Whirlpool Corp returned to Ohio for production of its KitchenAid hand-mixers. And K’Nex Brands LP, a family-owned toymaker based in Pennsylvania, brought back production of its popular Lincoln Logs. In 2012, the Boston Consulting Group published a survey of manufacturers with sales of more than US$1bn showing that 37% “plan or are actively considering bringing production back from China to the US.” 40

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And yet, for all the hoopla, America’s industrial renaissance never materialized. In 2014, A.T. Kearney found that there were no more than about 300 cases of reshoring to the US. A comprehensive survey of 85 top global manufacturing companies conducted in 2015 by supply chain experts from seven leading business schools detected a slight positive shift in manufacturing volume to the US, but found the gain was “not driven by American corporations bringing back manufacturing.” Rather, US gains reflected the actions of “European and Asian firms looking to move their production to the United States as they see the country as a very appealing market destination and source of knowledge.” Notably, the survey found that China remained the most popular destination for new manufacturing investment.

Why did the reshoring prophecies not come to pass? One explanation is oil prices, which fell by more than half starting in 2014, lowering shipping costs for Chinese exporters. Even so, Chinese wages continued to climb, and potential savings from lower transport costs were offset by the appreciation of the renminbi against the dollar until mid-2014.

The loss of “industrial commons” Harvard Business School professor Wally Shih, who conducted extensive research into reshoring efforts at Appliance Park and other ventures, believes something more fundamental is going on. In his view, the US economy’s underlying problem is the loss of what he calls “industrial commons.” In outsourcing to China, GE’s appliance unit abandoned basic knowledge about how products were made. But that failing goes far beyond the decisions of a single firm: the entire ecosystem needed to support domestic manufacturing—product design, supplier base, and the pool of skilled labor—has been “hollowed out,” not just at GE but throughout the US economy.

At GE, Shih found that worker turnover was crippling. For its initial job posting in 2012, Alliance Park started with 10,000 applicants. Of the 6,142 who passed the initial screening, 730 were hired but 228 demoted in the first year. It was almost impossible to find American workers who could operate a model printed circuit board line. Even if the data on comparative labor and energy costs suggested companies could save money by moving back to the US, reshoring made no sense if companies couldn’t find reliable suppliers or workers with the right skills. GE eventually found an economic way of producing GeoSpring heaters at home, but the reshoring process was fiendishly hard to manage.

The erosion of America’s “industrial commons,” coupled with the sophistication and durability of its equivalent in China, is reason enough China Economic Quarterly, December 2016

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to believe the advent of robots is more likely to bolster China’s prowess as a manufacturer than to undermine it. But that is not all: China’s manufacturing sector will be strengthened by its own vast consumer market. Its economy may be slowing, but China remains home to the world’s fastest growing middle class. In 2015 it had 82mn “affluent” households, with an annual income of at least US$21,000. Gavekal Dragonomics forecasts that number will rise to 137mn by 2020, and to 182mn by 2025. By that point nearly 40% of all Chinese households will fall in the affluent category.

Still China, China, China…

That does not mean that reshoring is dead. One of the themes of Donald Trump’s presidential campaign was that China “stole” American manufacturing jobs, and that they should be brought back. Slapping punitive tariffs on China-made goods would certainly hurt exporters there, Chinese and American alike. In such circumstances, it may indeed make sense to manufacture at home. But this does not mean the US, or any other advanced economy, is set to win the robot war. Today, Appliance Park is going strong, employing 6,000 workers at an average of US$15 an hour. But it no longer belongs to GE. In June, GE announced it was selling Appliance Park and its entire US appliances business for US$5.6bn. The buyer? China’s leading appliance maker, Haier.

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Boom And Bust In The Electric Vehicle Market

By Matthew Forney China has poured immense resources into creating a market for electric vehicles. But it is struggling to create a selfsustaining industry. As with the failed industrial policy for conventional autos in the 1990s, too much intervention might be the problem.

“People buy this car for one reason,” says the BYD dealer in Shanghai.

We are sitting in a new Qin, a sedan that can run either off a BYD-made battery or a traditional gasoline-powered engine. Named for China’s first emperor, the Qin was the best-selling electric car in China in 2015. It is comfy, stylish and contains all the mod-cons—but people buy the car neither for its smart looks nor for its battery-powered motor. “They buy it for the license plate,” the dealer says.

What he means is that in congested Shanghai, the government raises money and prevents total gridlock by limiting new cars and charging hefty fees. New-car owners in the city must pay the equivalent of at least US$12,000 for a license plate. They must also join a closed auction and spend up to two years bidding to receive plates for cars they already own.

But there is a way to beat the system: buy electric. In Shanghai, electric cars entitle owners to immediate, free license plates.

And that’s the problem with China’s electric-vehicle industry: the market is driven by government policy and subsidies. As policies change, both at the central and local level, the market whiplashes between boom and bust. Remove subsidies altogether, and sales of the electric vehicles would dwindle toward zero. The daunting news for the industry is that subsidies Matthew Forney is president of Gavekal Fathom China, a boutique research firm specializing in analysis of Chinese companies.

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National-level subsidies for battery-powered cars will decrease Subsidy to car buyers per vehicle type, RMB

Pure electric 100-150km (distance per 150-250km 250km+ charge) Plug-in hybrids

2016 2017 2018 2019 2020 25, 000 20,000 20,000 15,000 15,000 45,000 36,000 36,000 27,000 27,000 55,000 44,000 44,000 33,000 27,000 30,000 24,000 24,000 18,000 18,000 Source: Gavekal Fathom China research

are certain to decline, although there is still enough gas in the government support tank to lift sales for a few more years.

In 2015, China surpassed the US to become the world’s biggest market for electric vehicles. Domestic automakers sold 331,000 units, nearly five times as many as in 2014, according to the China Association of Automobile Manufacturers. Beijing supports the development of clean vehicles to combat smog, reduce greenhouse emissions and curtail rising oil imports.

To reach its ambitious sales targets of 3mn units a year by 2025, Beijing is offering subsidies that can total 60% of an electric vehicle’s sticker price.

Clean vehicles are much more expensive than normal ones, and very few Chinese consumers would pay such a premium without the government’s helping hand.

Rule driven How China’s electric-car market develops will be determined largely by shifting government regulations. More than 200 startups are vying with the big two incumbent players, BYD and Shanghai Automotive Industrial Corp. (SAIC). The Ministry of Industry and Information Technology is reportedly preparing stricter technology standards, aiming to chop the number of players down to just 10. Those that survive the cull will benefit from a raft of subsidies designed to nurture a competitive domestic industry and create a vibrant consumer market in electric vehicles.

Policymakers want China to lead the world in specific battery technologies. The most common type of electric car internationally is the hybrid, which has a gasoline-powered engine that charges the battery. Such cars do not require roadside charging stations. But China offers no subsidies for hybrid cars, which are mainly produced by foreign competitors such as Toyota. The only battery-powered cars eligible for subsidies in China are pure electrics—charged only from an external power source—and “plug-in hybrids,” which have a gasoline engine and a battery that is recharged externally. Regulators are promoting a type of powerful battery 44

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that will allow more cars to run on electricity without the backup of a gasoline engine.

Most established car companies in China—especially the foreign firms that dominate the industry—are reluctant makers of electric vehicles. Foreign car companies in China typically offer a few standard hybrids simply to comply with government regulations, rather than out of a long-term strategy to win market share. But sales of electric and plug-in hybrid electric cars produced by a handful of domestic players have accelerated since late 2012, when the central government introduced targeted consumer subsidies. Margins on electric vehicles are much higher than on gasoline-powered cars, thanks to government efforts to reimburse consumers for their high costs.

But subsidies from both the central government and localities often change on the fly, leaving both car makers and buyers guessing what will happen next. For example, the central government decided in 2014 that its plan to cut subsidies for battery-powered cars would imperil its goal of putting 5mn battery-powered cars on the road by 2020. So in early 2014 it changed its schedule and did not reduce subsidy levels as much as planned. Will subsidies continue to decrease? Will new ones be implemented? It is hard to say.

Local subsidies are even more uncertain, and are almost always designed to favor a local champion. The city of Beijing, for example, is China Economic Quarterly, December 2016

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home to Beijing Automotive Industry Corp (BAIC), which makes pure electric cars but not plug-in hybrids. So it should come as no surprise that Beijing city offers high subsidies for pure electrics but no subsidies at all for plug-ins. By contrast, Shanghai provides generous subsidies for plug-in hybrids, largely because the Shanghai government owns SAIC, which makes that type of vehicle. Localities tailor their subsidies to fit only locally made cars, or direct city governments to augment their fleets with locally made electric cars.

All eyes on Shanghai Regulatory uncertainty has serious repercussions for BYD, a private company based in Shenzhen that is China’s top seller of electric vehicles. Its prowess in battery-powered cars was the stated reason that a subsidiary of Warren Buffet’s Berkshire Hathaway invested US$230mn in the firm in late 2008. Until 2013, BYD’s sales of battery-powered cars were essentially nil, but its long spadework started to bear fruit in 2014, when sales of electric vehicles rocketed. They now contribute about a quarter of BYD’s revenue, of which about two thirds comes from electric cars and the rest from electric buses.

BYD has bet its future on plug-in hybrids. Its business depends heavily on the Shanghai market, where it has piggybacked on policies designed to favor the local player, SAIC. Shanghai’s generous subsidies to car buyers in 2015 made that city the market for roughly half of the Qin’s total Electric cars now contribute about a sales of 30,000 units. Shanghai is also believed to account for the spurt in quarter of BYD’s revenue sales of BYD’s three plug-in hybrid SUVs—the dynastically- named Tang, Yuan and Song. BYD’s success so far has hinged on the good graces of the Shanghai government, which is keen to encourage clean vehicles, even if it entails greater competition for the local champion.

Unfortunately for BYD, Qin owners have not kept their side of the green bargain. Those with no access to power outlets simply ignore the battery and rely solely on its internal combustion engine—which, thanks to the 160 kg battery, is significantly less fuel efficient than traditional sedans. Far from reducing pollution, Shanghai’s policies have enabled BYD owners to jump the license queue and save on fees, all while pumping more fumes into the smoggy air than regular cars. In response, officials have slashed subsidies for purchases of electric vehicles and now require new plug-in hybrid car owners to prove they have access to local 46

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charging stations before becoming eligible for subsidies or license plates.

Meanwhile, thanks to changes in the subsidy’s fine print, SAIC’s electric vehicles continue to enjoy high subsidies.

Government intervention may backfire Shanghai’s experience is not unusual. The Wild West nature of Chinese markets means that every new subsidy plan seems to result in scams in which consumers or even entire city governments collect money for vehicles that are misused or do not exist at all. A rare State Council investigation following a series of such scams in 2016 resulted in fines and tougher rules for companies claiming subsidies. The central government has also published a subsidy schedule calling for gradual declines in rebates to buyers. The idea is that as car makers reach higher production figures and enjoy greater economies of scale, they will lower the cost of their cars and reduce the need for buyer subsidies.

If the past provides any guidance, policymakers’ attempts to micromanage the market will backfire. China’s entire auto industry is, after all, Exhibit A of the limits of central government planning. Since the mid-1990s, China has tried to copy the US auto sector by fostering a Big Three-style triumvirate of SAIC, Dongfeng Motor and First Auto Works.

It forced foreign automakers like Volkswagen and Toyota to pair with these state-owned companies in joint ventures that were expected to China Economic Quarterly, December 2016

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transfer technology and know-how to the Chinese side, which would one day boot out the foreigners.

But that did not happen: instead, the state-owned firms grew fat on joint-venture dividends and never developed market-beating cars themselves. Without exception, China’s most profitable auto companies are still the joint ventures, which still rely heavily on foreign inputs of technology and expertise. At the same time, private upstarts like BYD, Geely Automobile Holdings and Great Wall Motor enjoyed success at the low end of the market despite the central government’s explicit hostility. (All, however, enjoyed support from city or provincial governments.) Unlike their state-run competitors, which lived off their foreign partners, these stealthy private companies expertly carved out profitable market niches: BYD and Geely made the cheapest sedans; Great Wall specialized in inexpensive SUVs. A market built on sand Just as the central government was unable to impose its will on the traditional car market, so it is unlikely to control the market for electric cars.

Instead, the future will probably bring more market booms with new subsidies, then busts as subsidies are suddenly curtailed. Meanwhile, local protectionism will hinder the emergence of national champions.

To be sure, the government remains committed to new-energy vehicles. It will probably hit its goal of 5mn electric vehicles on the roads by 2020—even if it has to count every golf cart in the nation to reach its tally.

Government departments will add electric cars to their fleets; charging stations, now rare, will slowly become available in urban apartment buildings and offices. Even the worst-case scenario still has BYD and its competitors muddling through. But the market the government has conjured into existence is at best an unstable one, only as solid as the state subsidies underpinning it.

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Nearing The End Of The Last Housing Boom?

By Rosealea Yao In 2016, China had its strongest housing market upturn since the global financial crisis. Driven by policy and debt, this surge is unlikely to continue through next year.

Fundamental demand has peaked and the government wants to keep prices in check.

It almost felt like the good old days for China’s property market: surging sales, heady price rises, accelerating construction volumes. Housing boomed in 2016, fueled by a powerful cocktail of easy credit and lax regulation. But the party is already over, as the sharp light of the new year will reveal.

Both sales and prices will fall in 2017, as credit growth stabilizes, banks extend fewer mortgages, and city purchase restrictions dampen local sentiment. Construction starts will rise, but only modestly, as developers look to satisfy strong demand in a handful of prosperous cities with low inventories. In the majority of cities, inventories are still too high to justify a big construction boom. The year ahead will be tougher for miners, metals producers and hard-commodity traders. There is little appetite for serious monetary tightening ahead of the 19th Party Congress in the fall of 2017, and a strong incentive for the government to support the property market in order to maintain stabled GDP growth. So next year’s slowdown should be modest. But fundamental demand for housing has peaked, and the long-term outlook for construction remains negative.

When in doubt, lend After a decent rebound in 2015, property sales went on a tear in 2016, rising 27% in Q1-3. Full-year sales will top out at about 1.55bn sq m, well Rosealea Yao is the China investment analyst at Gavekal Dragonomics.

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above the previous peak of 1.3bn sq m in 2013. The surge was underpinned by supportive policies from local governments and an unprecedented boom in mortgage lending, which prodded households to purchase earlier than they had planned. This whittled away at the vast pile of unsold housing, but also created a worrying credit-price spiral in the most attractive urban markets.

The boom was almost entirely policy driven, as officials acted on the demand for “de-stocking” as part of the government’s “supply-side” structural reform program, announced in late 2015. Policymakers encouraged banks to ramp up mortgage lending, exploiting Chinese households’ relatively low debt levels. Banks offered discounted rates, pushing the effective mortgage rate down to 4.55% by June, 15 basis points below the level after the last interest-rate cut in October 2015. On top of that, local governments bolstered housing sales through various subsidies and tax cuts. As a result, outstanding mortgage loans are on track to grow 30% in 2016 to Rmb18 trn, representing about 42% of the estimated full-year sales value.

The implicit loan-to-value ratio exceeds even that of the 2009 credit surge after the global financial crisis.

These “de-stocking” policies proved quite effective: we estimate that nationwide housing inventories fell to 21 months of sales in September, down from 31 months in early 2015. But the reduction in inventories was very unevenly spread across the country, with the biggest declines in the 50

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big Tier 1 and 2 cities. Across southern and eastern China, inventories have fallen to barely more than a year of sales, on average. In much of northern China, where the stock of unsold housing is highest, the declines were much more modest—down to 35 months of sales from their peak of 41.

In more prosperous regions, where inventory levels have now almost normalized, surging prices have fed renewed fears of a speculative bubble—especially in Tier 1 and 2 cities, where the credit boom was concentrated. In the four Tier 1 cities—Beijing, Shanghai, Shenzhen, Guangzhou—prices surged by more than 30%, while 14 Tier 2 cities recorded gains in excess of 20%. But with high inventories still plaguing much of the country, the gains remain highly concentrated. Among the 70 cities tracked by the NBS, the median price rise was in the low single digits.

Overall, housing affordability is improving, given that most cities recorded only modest price growth. But the sharp price appreciation in Tier 1 & 2 cities prompted a response from policymakers, who have generally tried to prevent prices from rising too much faster than income. A statement from the Politburo’s July meeting on the need to “contain asset bubbles” was widely interpreted as a signal of concern about housing prices. By October, 22 cities had tightened local purchase restrictions, signaling a clear change in policy. As total credit growth moderates, both prices and sales will continue to decelerate. We expect sales to decline by about 10% in 2017.

More volatility, same fundamentals This year’s boom disguised the long-term secular downtrend in housing sales. The market is becoming more volatile as the government alternates between supporting economic growth with easy credit and moving to stop prices from surging out of control. These short-term dynamics have made the housing market more speculative and policy-driven. But its fundamentals are quite clear: housing demand has peaked, which means that construction volumes will decline over the coming decade.

This reflects the law of diminishing returns: future increases in income will lead to smaller incremental gains in demand for housing. The previous decade’s surge was driven by rapid growth in per-capita living space, as rising incomes led people to demand larger homes. Our estimates show that per-capita living space rose from about 25 sq m in 2008 to 32 sq m in 2015. This jump in living space will not be sustained now that modern housing is available to most of the urban population, especially as per-capita living space in lower-tier cities now matches rich-city levels.

For construction volumes to keep rising over the long term, China’s future China Economic Quarterly, December 2016

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per-capita living space would have to exceed 40 sq m—above the levels in wealthy European countries such as the UK or France. It is not feasible for China’s densely populated cities to offer such large, US-style housing.

That is not good news for developers and the heavy industrial complex that feeds off the housing market. This year’s sales boom produced a temporary recovery in construction activity, as falling inventories encouraged developers to start building again. Construction starts grew by high single digits after falling 14% in 2015, and crude steel use turned positive for the first time in two years. But the impact of the demand rebound on construction and property investment was quite modest, and the level of starts was actually well below its peak in 2011. On the whole, the surge in sales did more to clear out some existing excess construction than to stimulate a new construction boom.

The upshot is that we expect growth in starts to fall below 5% in 2017.

Starts will not fall into negative territory, as they will be buoyed by the government’s reluctance to tighten policy too much. Growth in starts will depend on continued demand for new construction in provinces with low levels of unsold stock. Over the longer term, we project construction volumes to hover around their peak level until around 2020, and then fall 15-20% from current levels by 2025. It is a cautious outlook, but one that seems to be widely shared by developers.

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The Enigma Of Chinese Power

By Arthur Kroeber The Dictator’s Dilemma: The Chinese Communist Party’s Strategy For Survival

by Bruce Dickson (Oxford, 2016) China’s Crony Capitalism: The Dynamics of Regime Decay

by Minxin Pei (Harvard, 2016) CEO, China: The Rise Of Xi Jinping

by Kerry Brown (I.B. Tauris, 2016) Chinese Politics In The Xi Jinping Era: Reassessing Collective Leadership

by Cheng Li (Brookings, 2016) The year 2017 will be pivotal for Chinese politics. At the 19th Congress of the ruling Chinese Communist Party (CCP) in October or November, about two-thirds of the senior leadership will turn over, including as many as five of the seven members of the Politburo standing committee, the apex of the country’s power structure. Beneath all this churn lurk two crucial questions. First, how much power and authority can Xi Jinping establish over China’s intricate party-state, given that he may have a rare chance to stack the leadership deck with his followers? And second, where is the party’s rule headed and how sustainable is it?

Students of Chinese politics are divided on both of these questions.

Many believe Xi has succeeded in amassing an unusually large amount of Arthur Kroeber is editor of the China Economic Quarterly.

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authority, has neutralized competing power networks (including that of his one-time sponsor Jiang Zemin) and stands a good chance extending his rule past 2022, when current term limits would require him to leave office. But almost as many analysts believe that Xi remains constrained by the system of “collective leadership” established by Deng Xiaoping in the 1980s, and will be forced to hand over power to a successor on schedule.

The second question is tougher, and the answers to it are to some degree contingent on whether Xi succeeds in establishing strongman rule or is forced to conform to party norms on retirement. Much analysis clusters around varieties of the “resilient authoritarian” view: the CCP has so far adapted well to the demands of an ever more complex society, faces no serious opposition, and is likely to maintain its rule for some time.

Just how long “some time” might be—ten years? 20 years? 50 years or more?—depends on how well the party continues to adapt its institutions and practices to the dynamic society it oversees.

The history of successful adaptation provides good reason to believe it could continue, but no guarantee. The precedents for sustained one-party rule are discouraging: the Communist Party of the Soviet Union (CPSU) lasted for 74 years before collapsing; Mexico’s Institutional Revolutionary Party held power for 71 years before losing an election. The CCP has just completed 67 years in power. By the standards of modern one-party states this looks long in the tooth; but in relation to imperial dynasties (which seems to me as relevant a point of comparison as distant regimes in Russia and Mexico), it is just the end of adolescence. The last two dynasties to govern China, the Ming and Qing, lasted 276 and 268 years respectively.

Does wealth = democracy?

A more compelling reason for doubting the CCP’s longevity is the observation that as countries modernize and get richer, their political systems open up. Of the 56 countries whose per-capita GDP exceeds the global average, all but four are at least nominally democratic, in the sense that they hold regular contested elections for the top leader. The exceptions are all oil-based oligarchies, a qualification which also applies to the most obvious fake democracy in the industrialized world (Russia) but just as obviously does not apply to China.

Authoritarianism’s lack of success in wealthier economies leads some to reject the resiliency hypothesis and claim that the party is already in or will soon enter a state of terminal decay. The basic argument is that to avoid the middle-income trap and maintain high-speed, productivity-based economic growth, more robust, more independent and less cor54

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rupt institutions are required (e.g. reliable markets and judicial systems).

Such institutions are incompatible with a continued political monopoly by an unaccountable Communist Party.

Fortunately for those who want to make sense of the upcoming political transition year, and the longer-run trajectory of Xi Jinping and the party’s rule, a crop of recent books by Chinese politics specialists offers a wealth of helpful data and analysis. Definitive answers to the key questions remain elusive, but at least we have a better basis for informed judgment than poorly sourced rumors of the twists and turns of personality politics within the leadership compound of Zhongnanhai.

More legitimate than you think The question upon which all other questions ultimately rest is: just how much legitimacy has the party gained for itself among the Chinese people?

If the legitimacy foundation is weak, the decay hypothesis looks credible and Xi Jinping’s bid for strongman rule could be a desperate throw of the dice by a regime that is running out of options other than repression for sustaining its rule. If legitimacy is strong then the resiliency hypothesis gains support, and Xi’s power play can be understood in part as a move in a long-running struggle within the party about which style of governance is more effective: centralized Leninist command-and-control, or the flexible “explorative” collective leadership model pioneered by Deng.

Bruce Dickson’s The Dictator’s Dilemma makes a well-founded case that the party’s legitimacy is stronger, and based on more varied sources, than is commonly believed. His principal tool is a pair of extensive surveys of urban Chinese conducted by his research partners at Peking University in 2010 and 2014. Dickson, who teaches political science at George Washington University, used sophisticated surveys in three previous books to document the relationships of private businesses to the Chinese state, arriving at the general conclusion that the party has been pretty successful at co-opting the support of the private sector and neutralizing it as a source of potential political opposition.

An oft-told story is that the party’s grip on power depends on economic growth and repression. As economic growth slows, the party has no choice but to double down on repression. Dickson persuasively dismantles this story. In his surveys, regime support shows no correlation with GDP growth but a strong tie to personal income growth. In other words, urban Chinese judge the effectiveness of government based on their personal “pocketbook” issues, rather than on an abstract judgment on how the whole economy is doing. Hence the ongoing effort to rebalance the China Economic Quarterly, December 2016

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economy towards a consumption-based growth model—which requires strong household income growth—can be understood in part as a rational legitimacy strategy by the party.

Dickson also identifies four other types of legitimacy that the party actively cultivates: political reforms to increase responsiveness at the local level (notably through tolerance of an explosion of social-service NGOs, even as it cracks down on NGOs engaging in policy or rights advocacy); more effective provision of public goods such as healthcare and education; an emphasis on nationalist and traditional Confucian values; and co-optation of key elites such as urban professionals and private entrepreneurs.

Dickson does not deny the importance of repression, but argues that it is a high-cost tactic whose significance is exaggerated relative to these other legitimacy tactics. His surveys find that about three-quarters of urban Chinese express support for the party’s rule, a finding comparable to levels of support (or acquiescence) seen in surveys conducted by Tianjian Shi of Duke University in the 1990s and by Martin K. Whyte of Harvard in the 2000s, as well as in the annual attitude surveys done by the Pew Research Center.

It is sometimes claimed that we cannot trust opinion surveys in China because respondents may feel under social or political pressure to say only nice things about the government. This is unconvincing. For one thing, survey findings are consistent over time, despite the use of different methodologies and survey groups. For another, respondents in Chinese tend to blame problems on these surveys are happy to express high levels of discontent on specific specific local officials, while giving the central government high marks issues such as pollution, food safety, income inequality and corruption.

But there is little systematic evidence that discontent on these specifics translates—yet—into a corrosive lack of confidence in the regime. Dickson, like many other surveyors before him, finds that Chinese tend to blame problems on specific local officials, while giving the central government high marks.

Dickson neatly sums up the party’s vision of political reform as “consultation without accountability.” The state offers more channels for individuals to express their views, and increasingly makes a great show of soliciting citizen viewpoints on new policies. But there is no mechanism for ensuring that these views actually shape policy, and for holding officials to account if they do not. This is deeply unsatisfactory to liberals inside and outside China; but evidently it is adequate for most Chinese, 56

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at least so far. Overall, Dickson’s findings are in line with the resiliency hypothesis: the party continues to successfully adapt its governance to the shifting demands of a richer and more diverse society, and its legitimacy has roughly kept pace with the nation’s modernization rather than being eroded by it.

The varieties of corrupt experience A cogent contrary view comes from Minxin Pei, a political scientist at Claremont McKenna College in California, who argues in China’s Crony Capitalism that the pervasive corruption throughout all levels of government is indicative of “late-stage regime decay” in a Leninist state incapable of reforming itself.

Using a database of 260 corruption cases prosecuted by the government and reported in the Chinese press, Pei documents the dizzying array of ways in which government and party officials collude with private businesspeople and gangsters to plunder state assets, skim off vast sums from land sales and infrastructure projects, and auction government posts to bidders who are then compelled to engage in corrupt activity to recoup their investments. It is a meticulous and graphic typology of graft.

Even more usefully, Pei provides a simple but compelling analytical framework for understanding why Chinese corruption takes the forms that it does and is so persistent and pervasive. China’s graft springs from two sources: vaguely defined property rights, and highly decentralized administration. Uncertain property rights, especially over land, resource extraction rights and other state-owned assets, mean that businesspeople have to enter into informal or corrupt arrangements with officials to make use of these assets. The basic problem is that the party has never really accepted the idea of privatization, with the result that any time the “userights” to an asset are sold, various state actors may retain some sort of residual claim on the asset. As a result, entrepreneurs have to buy off anyone in any government agency who could block their project; conversely, officials have great scope to enrich themselves by taking equity stakes (either directly or via family members) in projects that require some sort of approval or asset sale.

Decentralization means that local officials have almost complete control over disposal of state assets and over personnel appointments.

This enables the creation of corrupt networks, beholden to a local boss or yibashou (“number one hand”), that the central government has no easy way of policing. On average, corrupt networks operate for 8-10 years before being exposed.

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Pei’s picture is convincing, yet he makes a questionable logical leap when he asserts that the prevalence of corruption is proof of “late-stage regime decay.” For one thing, China’s success at building a technologically competitive economy with rapid and broad-based income gains stands in sharp contrast to the failures of classic crony-capitalist states like the Philippines, Indonesia and many Latin American countries. On most measures of public goods proviDickson’s surveys suggest that sion, China scores about the same as corruption has so far done little to countries at similar income levels— erode regime legitimacy not lower, as Pei’s thesis would predict. And Dickson’s surveys suggest that corruption has so far done little to erode regime legitimacy: over 70% of people who agreed with the statement “almost all central government officials are corrupt” still expressed broad support for the Party’s rule.

Finally, the information in Pei’s book is derived entirely from state corruption investigations and related coverage in the Chinese press. It is hard to imagine such a well-documented book being written, say, about 1990s Indonesia, which really was a crony capitalist system in late-stage regime decay. The vigor of prosecutions since Xi Jinping took office in late 2012 belies the notion of a sclerotic state incapable of facing the rot at its core. So we should be skeptical of the idea that pervasive corruption poses an immediate threat to the CCP’s survival. But Pei is surely right to observe that so long as the basic conditions remain in place—vague property rights with a large residual state claim, and decentralized power networks with few mechanisms for accountability—large-scale corruption will remain a chronic disease of the Chinese state.

Is the doctor in?

This brings us to the question of whether Xi Jinping has the right recipe for treating, if not curing, this and other diseases of the Chinese state, and the political power to impose his treatments on an unwilling patient.

Details of Xi’s vision, patronage networks and leadership techniques are laid out in two other books: CEO, China, by Kerry Brown, a former British diplomat who now teaches at King’s College London, and Chinese Politics in the Xi Jinping Era by Cheng Li, who runs the China program at the Brookings Institution (with which I am also affiliated as a research fellow).

Of the two, Brown’s is the easier read for the lay person: it is a quick but informed sketch, written briskly, that hones in on a handful of key points.

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compiled database of Chinese officialdom to trace those who influenced Xi and those through whom he might exert power.

The two authors converge on an important conclusion: Xi is strong and skillful, but also constrained by the system in which he operates. He is not, and has little hope of becoming, as untrammeled a tyrant as Mao Zedong, nor even as arbitrary an autocrat as Vladimir Putin. Brown stresses the contingent nature of Xi’s power: unlike Mao, “Xi has no existence separate from the Party, and no autonomy from it….His skill is in being an instinctively good reader of the Party’s interests….Xi is only powerful through [the Party], operating within the limits it sets.”

Li, more concretely, argues that Xi’s power is hemmed in first by well-established practices and norms, such as term limits and age limits for senior officials. These could perhaps be broken to extend Xi’s term in office or the political life of key allies such as Wang Qishan, his close friend and anti-corruption czar—but only at considerable cost, and only by offering concessions to other blocs within the senior leadership.

Xi da man Another important constraint, according to Li, is the balance of power between the two main coalitions he perceives within the Central Committee (the approximately 350 people constituting the broad senior leadership): the “princeling” group of hereditary CCP aristocrats, including Xi and Wang, and the “Communist Youth League” grouping of officials with a more populist bias, whose main representatives are former president Hu Jintao and current premier Li Keqiang.

Li finds that the princeling camp dominates the current Politburo Standing Committee, 6 to 1, but that the populist camp commands a majority in the Central Committee. At the 19th Party Congress, he suggests, Xi could gain a majority in the Central Committee, but might also be forced to accept a smaller majority in the Standing Committee, unless he takes the risky route of breaking some of the promotion norms.

Many scholars have faulted Li’s factional analysis as too facile. But whether or not one agrees with his depiction of the battle lines, the claim that powerful coalitions in the Party constrain the top leader is backed by a lot of evidence: for instance Xi’s apparent failure to implement much of the ambitious reform program he released with great fanfare in late 2013, and his inability to secure promotion for some key protégés, which Li documents.

What does this all add up to? I draw three conclusions. First, despite the many forecasts of its imminent doom, the CCP remains a durable China Economic Quarterly, December 2016

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institution well grounded in China’s sophisticated statecraft traditions, fully capable of managing the political challenges thrown up by the economic modernization program it directs, and with a substantial degree of consent from the Chinese populace. It is not going anywhere.

Second, Xi is on track to become the strongest Chinese leader since Deng Xiaoping. At the moment, his shortcomings in economic reform are overshadowed by his successes in two other realms: domestic politics and foreign policy. He has neutralized the political networks of his two predecessors, tightened party discipline, and brought a wayward army to heel (Cheng Li has an illuminating section on Xi’s swift, crucial, but under-appreciated revamping of military leadership in 2015). In foreign policy, he overturned a long-standing bias towards reticence and set China on course to carve out a big sphere of economic and political influence in Asia. It is likely that formally or informally, Xi will remain the nation’s paramount leader past 2022.

Finally, it is as yet impossible to judge whether extended centralized rule by Xi—which in any case will be significantly constrained by the influence of a broader party elite—will be a net benefit for Chinese society. The contradictions in his policy pronouncements (for instance, his alternating emphasis on market mechanisms and state control in the economy) make it hard to know whether he really has a coherent governing vision or simply a grab-bag of slogans designed to appease various constituencies. That Xi will amass more power is almost certain. As to what he will do with that power, we will just have to wait and see.

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