Quarterly Net Assessment

Bottom Line

The China Dashboard offers a regular assessment of China’s progress or regress on its own critical policy goals. The record more than five years after the Third Plenum plan was laid down remains in negative territory against the objectives set in 2013. For this Winter 2019 edition, we do not see market reform moving forward in 8 of the 10 areas we track. This is a continuation of what we observed in the previous Fall 2018 edition.

This edition goes to press less than one month from the March 1 deadline in U.S.-China economic negotiations. The complaints that impelled these talks focused on trade and intellectual property, but in actuality the agenda is much broader and deeper, cutting to the core of China’s economic model. Negotiations will include a focus on reducing the U.S. trade deficit with China through Chinese commitments to purchase U.S. goods and energy. This is the easy part. However, Washington also insists on fundamental structural economic reforms in China that would require no less than China’s reshaping its economic system.

It is unsurprising that China is resisting this demand. Chinese purchases of U.S. natural gas cargoes can be verified easily, ship by ship. But structural reform requires that China make the market decisive in its economy, not just promise a managed trade plan that would temporarily alter the U.S.-China bilateral balance at the expense of third nations. Without such commitments, any short-term outcome of the talks will not put U.S.-China economic relations on a sustainable path. And to assess how close or far we are from that path, we need a broad-spectrum, objective view of China’s policy priorities.

This is the moment our China Dashboard was made for – to gauge whether this transformation is happening. As of Winter 2019, we see modest forward movement in only two areas: Environment and Innovation. In other areas, we find that reforms are either stuck in neutral (Cross-Border Investment and Financial System) or worsening (SOEs, Trade, Competition, Fiscal Affairs, Land, and Labor). Each of these clusters is explored in depth in its respective section of the Dashboard.

China is not making headway toward its own reform objectives, which creates concerns about both the domestic consequences and external tensions.

We see multiple factors behind this lack of momentum. First, leaders lack conviction about the emphasis to be placed on reform, with official rhetoric emphasizing Party control rather than ongoing progress toward structural changes in the economy. This likely reflects a political aversion to the potentially destabilizing risks of rapid economic reform efforts, though as we argue throughout the Dashboard a failure to reform will prove just as risky, if not more so over time. Second, a serious growth slowdown is underway in China today, making reform more painful at this point in the cycle – though the lack of reform must be understood as a cause of that slowdown as well. Third, there may simply be a lack of experience and competence to implement the increasingly sophisticated reform measures that China, as a more advanced economy, now needs. Alternatively, officials may be “storing up” reform pledges for commitment in negotiations with the United States. This is a common phenomenon, where a negotiation causes reforms to be delayed rather than undertaken in a timely manner. Whatever the mix of reasons, the bottom line is the same: China is not making headway toward its own reform objectives, which creates concerns about both the domestic consequences and external tensions.

The Dashboard Gauges: Primary Indicators

Most of the policy areas we evaluate play a role in U.S.-China economic tensions, and China’s relations with other advanced economies as well. Of these, three are central to the current outlook.

First, SOE reform progress appears to be backsliding once again this quarter. Our indicators show SOEs advancing at the expense of private firms, with proposed solutions focused on increasing Party supervision instead of reform. We have watched over the past year as private sector firms were hurt disproportionately by government-led capacity cuts and controls on credit, while SOEs enjoyed better pricing power, maintained access to credit, and sometimes were able to acquire troubled private firms. This continued through the current review period, feeding an increasingly global uproar over the unlevel playing field between state-owned and private or foreign firms in China. Beijing acknowledged the pressures bearing on private firms (it had little choice, given the volume of public concern) but proposes to redouble state support rather than liberalize. Meanwhile, in many OECD capitals the concern about unfair competitive conditions has spread beyond nominally state-owned Chinese firms to include any firms lauded as national champions in China.

Our assessment of Competition policy reform remains negative, as this domain becomes a key focus of international pushback. Foreign firms are still targeted disproportionally in merger reviews in China despite bureaucratic reforms meant to level the playing field. All supplemental data point to continued weaknesses in China’s competitive environment: judicial transparency remains inadequate and foreign investment is slowing. If the state were withdrawing from the normal marketplace, then some residual but shrinking inequalities could be tolerated and mitigated; but with the current resurgence of state firms over private, the damage done by an unlevel playing field multiplies. Competition policy has not been a central part of the U.S. negotiating agenda with China; not everyone in Washington is comfortable opening that Pandora’s box, as it would provoke examination of competitive conditions in advanced economies as well. But China’s deal-by-deal promises to clear key transactions taken hostage – like Qualcomm-NXP – are bringing competition policy to the fore.

Financial System reform is arguably the most fundamental requirement for China to secure a more market-based economic future. That must mean both cleaning up risks and opening up to competition, both in terms of risk-based capital allocation between private firms and SOEs and in terms of foreign investment into domestic financial markets. A deleveraging campaign to de-risk China’s financial system continued into the review period, with such powerful effects (evidenced by slowing growth) that it may now be dialed down. The campaign reduced financial risks from banks’ funding channels, which were starting to resemble those in the United States before the global financial crisis, but consequently increased economic risks as less credit flowed to firms and households. This is a major driver of the current slowdown. Our primary indicator shows that financial reforms, such as they are, are not leading to better credit allocation yet, as far too much capital investment is still required to drive additional economic output.

We can report qualified progress in two areas this quarter. In our last edition, we downgraded our assessment of Environment policy reform from positive to neutral in light of deterioration in air and water quality, which we attributed to Beijing’s softening environmental controls to support growth. This quarter, China moves back into modest positive territory as both our air and water quality indices improved. But progress was not uniform: Beijing City’s large improvement in air quality was an outlier, and modest improvements in water quality likely resulted from declining industrial activity. This means conditions would likely deteriorate if the government uses stimulus to boost heavy industrial growth.

As in past editions of the Dashboard, we give Beijing credit on Innovation for increasing the share of higher-technology industries in the manufacturing sector. The data tell two interesting stories in this period. The first is that U.S. trade action against China has had minimal impact on its innovation goals so far, as China continues to provide considerable political support behind high-technology industries in line with its Made in China 2025 strategy. Second, the concentration of foreign firms in innovative sectors is helping high-tech sectors outperform a slowing Chinese economy.

We modestly upgrade our assessments in two important clusters; however, they remain in negative territory and subject to backsliding. We upgrade Trade reform because China’s external trade surplus declined during the review period: the $23.4 billion current account surplus in 3Q2018 was the lowest for a third quarter since 2004, driven by shifts in both goods and services trade. However, these data improvements result from the effects of high oil prices and significant spending on tourism services, rather than more sustainable trends.

A surge in local government special revenue bond issuance drove the largest quarterly improvement in our primary indicator of Fiscal Affairs reform in six years. However, while developing new financing channels for indebted local governments is important, Beijing also recently allowed local governments to extend and restructure their hidden debts from local state-owned enterprises rather than repay them. This is a step back for fiscal improvement, reinforcing dangerous expectations that high-yielding, high-risk local government financing vehicles are going to be guaranteed and bailed out by Beijing rather than allowed to fail.

The View from Abroad

Inside China, the discussion of structural economic reform turns on how to reconcile the need for market-supportive changes with the primacy of the Communist Party’s role in delivering growth. Abroad, attention is fixed on the Trump administration’s stark insistence that China must agree to a full panoply of structural reforms – as well as massive purchases of U.S. exports – by the end of a 90-day window (March 1) or face a further escalation of tariffs. Over the past year, the Trump team treated “marketization” as too abstract and intractable, resulting in the preference for short-term transactional deals focused on reducing the trade deficit with China. But as the March deadline for talks approaches, the importance of these policy matters has risen, with tremendous attention now being paid to the questions we consider in the Dashboard: Can China and the world agree on a common framework of indicators to manage their conversation about economic engagement?

As the profundity and difficulty of China’s structural reform agenda have become clearer to observers, some have grown pessimistic, either because they conclude that a deal will not be possible or because they assume the liberal economies will have to compromise.

But there is also a case for optimism. Over the past six years, Beijing has tried fairly hard to implement many of the first-order structural reforms that Washington and other capitals are now advocating. Sagging economic growth and the gloomy consequence of rebuffing the U.S. calls for change should strengthen the case for China’s economic reformers. Their influence will ride on their ability to rebrand the reforms sought by the United States in bilateral economic negotiations as positive adaptations for China’s domestic economic growth.

Whether as a justification for disengagement from the bilateral economic relationship or a basis to moderate its bellicosity, Washington will be looking at indicators of China’s economic policy arc in choosing its path forward in the bilateral relationship. Verification and enforcement are core components of the U.S. negotiating package, and structural changes will need structural evidence. The China Dashboard is a key tool for this assessment.