The Story So Far
In the decades following China’s 1978 decision to reform and open, its growth was driven by demographics and structural adjustment – letting market logic reshape the economic landscape. But in recent years, as the easier phase of development gave way to middle-income challenges, Beijing has attempted to reassert control over investment and markets. This was not the first choice. President Xi Jinping’s inaugural 2013 Third Plenum economic plan – while still couched in Communist Party nomenclature – was distinctly geared toward a decisive role for markets. Implementation of those goals, rather than aspiration, has been most lacking. By tracking China’s own 2013 objectives across 10 economic domains, The China Dashboard seeks to inform public debate with objective data on just how close to or far from those aspirations China is trending.
Gauging China’s policy progress objectively is essential for understanding what sort of economy – and polity – China will have domestically in the future, and just as critically what role China will play in the international community. The current tensions between China and the United States represent the sort of situation we previously anticipated at the conception of the Dashboard project and seek to temper through the dissemination of respected data indicators and interpretation. For this reason, we eschew normative advice or prognostication about the future of the Chinese economy, though we do point out clear conundrums in the outlook.
The once-unimaginable scenario of China decoupling from major parts of the world economy is starting to appear realistic. It is useful to recall how this started. For China, engagement with the capitalist world was initially about earning a capital surplus to permit investment at home and acquire technology from abroad. Beijing became almost too good at this game, amassing foreign currency (and thus foreign government bonds). In recent years, Beijing was forced to relax its hoarding fixation. Not only was there no marginal benefit, but China’s twin surpluses were becoming a liability, breeding overdependence on foreign bond markets and resentment from the United States and other countries for its never-ending trade deficits. Beijing loosened capital account controls in 2014 and, lately, its firm hand on the value of the currency, which also stabilized the balance of payments.
The era of certainty about net capital inflows into China is over. The trade surplus has thinned as a share of gross domestic product (GDP), even in absolute value terms. After capital controls were loosened in 2014, $1 trillion in foreign exchange (net) left the country in about a year and a half, with the next trillion in line behind it, leading to controls being reinstated. The door is being opened wider to global portfolio capital, but it is not clear that capital wants to come in. Multinational corporate direct investors, long a mainstay of China’s domestic investment scene, are publicly diversifying into Vietnam, India, and other economies.
Beijing now has to contemplate a world in which trade is not in surplus and capital flow pressures are skewed toward the outbound side. The readiness of middle-class Chinese citizens to switch out of property-heavy domestic assets to a more diversified global portfolio exceeds the appetite of global savers to bring their wealth into the politically fraught world of Beijing’s socialist market system.
This picture—hardwired logic behind outflows but foreign investor hesitation on the inbound side—reawakens China’s anxiety about capital shortfalls sleeping just beneath the complacent surface.
Beijing’s ultimate challenge is ensuring that the trillions of dollars in domestic savings that it is eager to diversify abroad are balanced by a similar magnitude of foreign capital willing to invest in China over the long term.
That is the background against which we discuss investment opening announcements in the first half of 2019 in this edition of the China Dashboard. In our Cross-Border Investment assessment, we detail a new Foreign Investment Law approved in March and a new “negative list” approved in June to open more space for foreign investment. In May, the banking regulator announced removal of equity caps and asset requirements on foreign investment in banks and branch networks. For the securities industry, regulators approved majority ownership in joint ventures, with Premier Li Keqiang promising to remove all equity restrictions by 2020. Foreign ownership caps for insurance companies will also be lifted by 2020, according to a July 20 announcement. All this represents a concerted effort to attract foreign capital.
But partial financial account opening will not overcome investor hesitation. Portfolio inflows so far have had a short-term, cyclical flavor, and outflow pressures remain high and are rising. So far, index inclusion schemes like MSCI have brought active capital investments sensitive to short-term macro fluctuations, and not the long-term buy-and-hold, passive funds that nations crave. In the on-again, off-again U.S.-China trade talks, Beijing was strikingly eager to see Washington accept its offer of accelerated financial sector opening. This left some skeptics wondering: what if Beijing opened the door and no one, or not many, walked through?
Beijing’s ultimate challenge is ensuring that the trillions of dollars in domestic savings that it is eager to diversify abroad are balanced by a similar magnitude of foreign capital willing to invest in China over the long term. Past GDP growth was an irresistible lure to foreign investors, but that growth depended on Beijing’s constant intervention, data smoothing, and macro-engineering, along with a foreign tolerance for an uneven commercial playing field which has now become exhausted.
The risks of poor investment returns are now made more complicated by the advent of a less managed, more market-determined renminbi exchange rate, if the People’s Bank is to be taken at face value: on August 5, 2019, the authorities stopped intervening to keep the currency above a symbolic level of 7 to the dollar. The era of an assured, stable currency is ending, both because of the financial realities that China has built up at home over a decade, as well as because of the policy tensions with Washington. Going forward, foreign investors need to consider exchange rate risks much more carefully.
The most revealing aspect of Beijing’s exchange rate move was not the extent of weakening (a mild 1%–2%, compared with 10%–15% swings from June to August 2018) or that it broke through the 7-to-the-dollar barrier, but rather that the central bank explained it in terms of China’s attractiveness to global investors: "China is the only country among major economies that has kept monetary policy in a normal state while developed economies including the U.S. and Europe are currently all shifting to an easing bias. The valuation of Yuan-denominated assets is still relatively low, and therefore more stable—this should attract global funds because of these low valuations."
The People’s Bank of China spokesperson was not only trumpeting the currency weakening as an opportunity to buy Chinese assets at a discount, but also, by implication, suggesting that Beijing would set monetary policy to protect international investor wealth. Whether it does so will be easily tested and observed by this Dashboard and other indicators, so this is a bold claim revealing a strong concern with attracting foreign capital.
For all China’s newfound potency in the international arena, its balance-of-payments resilience has not been tested in slow growth circumstances. Those conditions are approaching, and economic leadership is clearly thinking a lot about them, as reflected in the currency policy statement.
China’s economic growth continues to fall, following a declining pattern since 2010. The most recent second-quarter growth of 6.2% was the slowest since 1992, when official quarterly records were first published. This, combined with heightened international scrutiny on China’s economic practices, sees their political economy at a crossroads between President Xi Jinping’s political predilection for a state-centric economic growth model and the economic reality of private sector-led growth. This contradiction raises uncertainty around Beijing’s policy support for the private sector, contributing to low private sector business sentiment through official and unofficial measures among firms who have grown distrustful of Beijing.
The Dashboard Gauges: Primary Indicators
The 360-degree perspective on China’s economy offered by the Dashboard indicators makes clear why the abundance of piecemeal financial opening described earlier will not necessarily ensure a balance in capital flows. Beijing is pulled between keeping interest rates high enough to attract investors and keeping them low enough to avoid nationwide bankruptcies. The recent failure of several banks (Baoshang and Jinzhou) shows how potentially close to the edge of a banking crisis China is. Myriad institutional reform impediments are evident. Equitable regulation of foreign and non-state firms alongside state enterprises is far off (as seen in our competition policy indicators); data blind spots are persistent (trade policy, legal decision reporting); financial globalization is shrinking instead of expanding (cross-border investment); and deference to markets in financial intermediation is falling by the wayside, with policy pressure to lend for stock trading and pressure not to lend for mortgages.
Our indicators point to reform slack in these critical areas. In our Competition assessment, we see that foreign-involved mergers are three times more likely to be reviewed by regulators than domestic-only mergers, and enforcement responsibilities are being shifted more to local governments—more often the source, not the remedy, for anticompetitive practices in China. Authorities sought to promote competition policy and intellectual property protection with special courts and transparent legal outcomes. But China is publishing less than 5% of the competition and intellectual property disputes handled each year, and in 1Q2019, courts even removed 400–600 previously published cases per year from their websites. This does not inspire confidence in a fair competitive environment.
One of the most significant obstacles to balanced capital flows is corporate governance reform for shareholders of Chinese corporations, including state enterprises (which dominate equity market capitalization). In 1Q2019, we see an increase in the state-owned enterprise share of listed company revenues in “normal” industries, hinting at an expanding state even in areas where Beijing set out to withdraw influence at the 2013 Third Plenum that initiated the Xi-era economic reforms. Despite repeated pledges to reduce state intervention and empower boards of directors at state firms, authorities are ramping up inspections and reporting requirements, creating new obstacles to market-based decision-making.
China’s partial financial and investment opening in the first half of 2019 is positive, though overdue. It is also not sufficient. Pervasive policy challenges such as the ones mentioned above will continue to stymy the capital inflows that Beijing’s currency policy justification expected to attract with lower dollar-basis valuations thanks to a weaker currency. Credible liberalization across the full spectrum of policies is needed to move trillions of dollars into China over the long term.
Two policy areas—Labor and Innovation—did move in a positive direction in early 2019. Both urban and rural workers saw wage growth improving in 1Q2019 from the fourth quarter of 2018; however, most earners saw income grow at a slower pace than GDP, while structural impediments like hukou restrictions and government social spending continue to hinder labor mobility. Innovative industries are playing a greater role in China’s manufacturing sector. So far this year, Beijing has taken steps to marginally reduce market entry barriers, improve the intellectual property regime, and expand capital market access for domestic tech companies, which are positives for innovation but are undermined by lack of progress in the competitive environment.
The China conversation in capitals and business centers around the world in late 2019 is based less on China’s economic fundamentals and more on political anxieties, American political brinksmanship, and often a weak grasp of emerging economic facts.
The View from Abroad
These indicators of China’s economic dynamics should be the foundation of macroeconomic and geopolitical thinking for China’s national and commercial counterparts around the world. If Beijing is concerned about balance-of-payments shortfalls, as we conjecture, leaders will resist overdue policy adjustments that would nudge them toward current account deficits. China’s technocratic economic officials are pushing policy reforms as much as they can—for instance, interest rate reforms and investment opening—but at this stage, piecemeal measures no longer have as much credibility as they once did. Bolder and more decisive demonstrations of marketization are necessary. Examples might include comprehensive elimination of foreign equity caps for direct investors to remove this channel of forced technology transfer, a significant sell down of state shareholding in the economy, and the definitive restoration of the previously relatively open public debate about Chinese economic conditions and policy options.
In reality, the China conversation in capitals and business centers around the world in late 2019 is based less on China’s economic fundamentals and more on political anxieties, American political brinksmanship, and often a weak grasp of emerging economic facts. The suggestion that Beijing’s withdrawal of policy to prop up the renminbi justifies the charge of currency manipulation is the most obvious case in point. The notion that Americans do not pay the price for U.S. tariffs, or that falling inward foreign direct investment makes America stronger, or that Federal Reserve officials are to blame for falling global investor confidence are just a few more.
While recognizing the reality of political and geopolitical risk for markets, the current conversation reinforces the need for as much objective economic analysis as possible on the real state of the Chinese economy, including all its strengths and weaknesses.