The US government and business leaders should pay close attention to subtle shifts in Chinese economic policy and foreign affairs.

China is undergoing the transition to what is often referred to as the fifth generation of political leaders. For the few true winners, the payoff is a de facto decade-long term on the Communist Party’s ruling Political Bureau.

A lot can happen in a decade. When the last transition started in late 2002, China had just joined the World Trade Organization (WTO) and had improved external political relations. A decade later, China is the model for state-led economic development and has antagonized its neighbors. Despite China’s mercantilist bent and assertiveness, the United States still regards the party as endorsing Deng Xiaoping’s pragmatism. His famous line about cats and mice was an exhortation to put aside ideology and choose the development model that works best for the country—market-driven reform. But Deng is long gone and his designated successors will be entirely out of power in 2013. What if pragmatism itself has started to fade?

Change could be for the better. Xi Jinping, who was recently appointed party general secretary and chairman of the Central Military Commission, and Liu Yunshan, a recently appointed member of the Politburo Standing Committee with experience in managing public perceptions thanks to his time at the Propaganda Department, could put off South China Sea disputes for future settlement. Likely Premier Li Keqiang and newly appointed Politburo Standing Committee Member Zhang Gaoli could authorize money to flow freely in and out of the country. Such changes would re-invoke Deng’s path of treading lightly overseas and instituting market reform at home. The United States should prepare to identify progress and respond quickly and positively.

There is danger, though, that pragmatism will be overcome by narrow party interests. An additional decade of a more advanced China behaving expansively will likely result in more extensive American alliances, basing arrangements, military exercises, and arms sales. An additional decade of an economically larger China that bullies partners and seeks advantage over the United States will spur calls for economic blocs that genuinely adhere to market-driven policies.

Chinese policy is unlikely to swing sharply in the spring of 2013, when the political transition is complete. But it could certainly shift over the course the next year or so. The United States was not prepared for what happened in 2002-03, when Hu Jintao’s regime did not sustain the market reform that occurred under previous President Jiang Zemin, and dangerous macroeconomic imbalances were introduced. Because China was less important a decade ago, the fallout from getting it wrong was limited. A failure now in American policy will have far worse consequences. The United States must prepare now for the new and possibly quite different Chinese government.

THE SITUATION IN CHINA

Long-standing conventional wisdom views the party as pragmatic, and assumes that the incoming leadership will not directly confront the United States because of the attendant risks. This thinking also assumes that the party must ultimately return to market reform because that is what works.

What if this conventional wisdom is wrong? Current party cadres have made a great deal of money from state firms—it may not be clear to them that market reform works. Their legitimacy rests in no small part on rising nationalism—it may not be obvious that conciliation with neighbors and the United States is the reasonable strategy.

The first five years of Hu’s reign was marked by foreign policy continuity, along the lines of Deng’s admonition to maintain a low profile and bide one’s time. China generally acted as a good economic partner, while largely avoiding rancorous issues such as territorial disputes. In the second half of Hu’s tenure, China’s foreign policy has become steadily more assertive, whether towards Japan and the Senkaku Islands, South Korea and Socotra Rock, Southeast Asia and the South China Sea, or India and Arunachal Pradesh. Since these tensions predate both the current power transition and the economic downturn, it is unclear what might have precipitated this shift. But the consequence has been a growing regional concern about China’s foreign policy direction. This is exacerbated by China’s military modernization. The People’s Liberation Army’s (PLA) growing array of modern combat systems stands in stark contrast with planned reductions in the US defense budgets over the next decade. China’s ability to employ military force in territorial disputes, which could interfere with East Asia’s trade routes, is steadily growing.

Meanwhile, Chinese leaders show little compunction about employing economic tools to further political ends. In 2010, China decided to institute a rare earths embargo after a diplomatic dispute with Japan. In 2012, China’s central bank governor skipped a meeting of the International Monetary Fund in Tokyo, and there are ongoing boycotts and riots targeting Japanese factories.

Internally, at the 2007 Party Congress, China was supposedly still reforming, though evidence was weak. By 2010, there was an acknowledgement that economic reform had died and an insistence that a state-controlled approach had helped China avoid the worst effects of the global economic crisis. A 2012 World Bank report, issued in conjunction with the State Council’s Development Research Center, argued that a return to market reform is necessary, but there are reasons to doubt the reformers will triumph.

First, the new Politburo Standing Committee, China’s most powerful ruling body, suggests stolidity much more than change. Although reformers in the new leadership are almost impossible to identify—the last 10 years have seen little in the way of liberalization—none of the members is clearly linked with reform efforts.

In early 2003, the Hu regime moved decisively to expand investment and suppress consumption, which is characteristic of planned economies. Eventually, the preponderance of investment must reverse or the market experiment will end. This can only be seen as pragmatic if the end-point is a command system. High investment has been enabled by unsustainable subsidies for state-owned enterprises (SOEs). The subsidies shelter SOEs from competition. There is also a multi-industry effort to consolidate large SOEs. In 2006, the State Council asserted explicit control over energy and other sectors to go with implicit control of banking and other sectors. In 2012, the demand for state primacy was ostensibly recognized as an error and the private role is supposed to expand again. But no genuine liberalization has yet occurred. Investment has also been supported by state bank lending, which surged in 2002 and again in 2008. Increased leveraging now limits monetary and fiscal options. Land and power subsidies for SOEs inflate resource use.

Guaranteed SOE profits helped make some cadres stunningly wealthy. But the subsidies are paid for by depressing consumption—creating a huge gap between consumption and investment GDP shares. What’s now best for the party is not best for China.

With the new lineup, Deng’s pragmatism will become more remote in time and, perhaps, personnel. China’s first economic challenge will be capping liquidity. The massive monetary stimulus in 2009 has rendered further actions along these lines largely ineffective—the analogy is throwing buckets of water into a lake of existing money supply. China’s M2 to GDP ratio is three times higher than America’s. Deleveraging requires accepting that stimulus has limited impact and is thus politically unpleasant.

Rebalancing would require consumption to grow faster than investment for some time. Consumption cannot match the high pace of investment growth seen under Hu, so rebalancing means slowing investment significantly. The obstacle is the belief touted by government officials that China needs 8 percent GDP growth to keep unemployment levels low. This is false. Five-percent, labor-intensive growth would create more jobs than recent 10-percent capital-intensive growth. The 8 percent rule has justified investment that primarily benefits SOEs and the party, not the country as a whole.

More investment would push China toward command economy status. Consumption-led growth is better for the country, as recognized in state media as early as 2003.

Members of China’s new Politburo Standing Committee—Zhang Gaoli, Liu Yunshan, Zhang Dejiang, Xi Jinping, Li Keqiang, Yu Zhengsheng and Wang Qishan—greet the media at the Great Hall of the People on November 15, 2012 in Beijing. (Lintao Zhang/Getty Images)

IMPLICATIONS FOR THE UNITED STATES

The anticipated decade of the new government’s term is likely to see considerable change. For one thing, given rules for mandatory retirement, the age of the rest of the Standing Committee members means none of them will replace Xi or Li. Another succession battle is likely to be fought at the 2017 Party Congress. This will likely discourage any attempts at any kind of reform or policy innovation over the coming five years.

On policy, new Chinese governments have a clearer track record of economic shifts than security shifts, though Hu’s regime ultimately chose both. Economic changes also tend to become visible more quickly. Analysts face different challenges in monitoring the two realms, but it is vital to good American policy. More than that, the United States must anticipate what types of changes the PRC government may undertake. China’s current importance in the world is greater than in 2002, when the United States misread Hu and what his ascension signified.

The makeup of the Standing Committee suggests there is little reason to think the new leadership will support domestic political reform. The past two decades have seen virtually no movement towards democratization. The continued repression of dissidents and violent suppression of protests in Tibet in 2008 and Xinjiang in 2009 and 2011 underscore limited prospects for liberalization. Official Chinese figures report a higher rate of growth in internal security budgets (including the People’s Armed Police) than external security budgets (the PLA), suggesting that Beijing seems more concerned with internal than external threats and anticipates the need for a strong hand.

In foreign policy, the new leadership has a stark choice: They can either move back toward Deng’s pragmatism or maintain the more recent, assertive foreign policy stance and antagonize China’s neighbors and the United States. Maintaining the recent hard line on territorial issues will likely result in some neighboring countries taking countermeasures. If Beijing militarizes these disputes, it will drive most of its neighbors to seek help in balancing China, probably from the United States. Indeed, a China threatening the regional status quo provides impetus to US military repositioning.

On the other hand, a more subdued policy would challenge Beijing at home, requiring consensus from the new leadership. This is a relatively untried group of officials, including military leaders, and one likely to be tested fairly soon by issues concerning the next succession. In the absence of a revolutionary-era leader, a more subdued policy risks both vulnerability in the intra-party jockeying and a backlash from nationalist elements. Portraying their actions regarding the South China Sea and other disputes as defending sovereignty, the current leadership adopted a stance the incoming government would find hard to alter. Popular protests over the Senkakus reflect genuine emotion, as well as government manipulation.

For the United States, the situation is tricky since any policy change may be initially low-key, marked by studious silence rather than loudly declaimed initiatives. A reversion to Deng’s pragmatism might start with just restricting Chinese fishing in waters around the Senkaku or Spratly islands or altering news coverage.

On economic issues, the United States must prepare for China returning to the market reform path and continuing to move slowly back to a planned economy. The latter may seem implausible, but the investment-consumption imbalance created by the outgoing government constitutes exactly this result. And both the backgrounds of the men on the new Politburo Standing Committee and the incentives created over the past decade for lower-level cadres suggest a continuation of current policy rather than a new wave of market-oriented reform.

If there is no restructuring, investment-driven economies eventually stagnate. The liquidity that China has built up over the past four years brings that day closer. However, stagnation will not be immediate, and China will continue to grow. For the next decade, the United States may have to face a China that has global reach and impact, suppresses competition at home, and subsidizes its firms in international commerce. Such an outcome might call for narrowing the scope of participation in American-led economic initiatives—reshaping the global economy so that an increasingly difficult China is excluded from American partnerships.

Alternatively, Beijing could head in the opposite direction. Implementation of reform would still be cautious, but the U-turn by the incoming government could be dramatic, as in the past. Here, China would progressively become a better economic partner, in particular by putting its consumers first and allowing more foreign trade and investment access to the home market. This would not eliminate bilateral friction, but it would considerably ease heavy political pressure in the United States to sanction China.

Much slower public investment would be a definitive signal of liberalization. The share of private investment should rise and some sectors should lose their state monopoly status. Allowing more truly foreign capital—not money recirculated through Hong Kong—would help curb state monopoly power and contribute to effective liberalization of interest rates. In contrast, continued large-scale use of state banks as fiscal tools would indicate Beijing is unwilling to trade economic control and financial rewards for cadres in exchange for broader prosperity.

The first task for American policymakers is to discern which course China is following. The assignment of government positions at the 2013 National People’s Congress should be informative.

WHAT THE US GOVERNMENT SHOULD DO

The US government, both executive and legislative branches, must recognize the limits of its leverage. Chinese decisions will be determined by internal costs and benefits far more than American actions.

Major Chinese initiatives are unlikely the first year, as the new leaders acclimate to their roles and each other. There will not be a quick, sharp repudiation of the approach to growth, housing, infrastructure, or other prominent economic issues. There will not be a visible Chinese “pivot,” either to or away from the rest of East Asia. There are unlikely to be major changes in the trend for military or internal security spending or policy toward high-profile countries.

Nonetheless, important changes can occur in the first year. American policy makers must be attuned to subtler Chinese behavior.

  • President Barack Obama should challenge the incoming Chinese government to choose market reform and a more conciliatory foreign policy. America’s pace and scope of diplomatic engagement and support should be conditional on China’s behavior. If China does implement changes, they are as likely to involve cessation of certain behavior as a loud policy shift. It is as important to see what the Chinese stop doing as what they start.
  • The Department of Treasury and Office of the US Trade Representative should monitor Chinese economic policies in 2013-14 to ascertain the direction of the new government. Especially important is overcoming flaws in Chinese reporting of economic growth and the make-up of production.
  • If China continues to move away from open competition, the United States should be aggressive in creating or expanding institutions that exclude such economies. An example is the Trans-Pacific Partnership, trade agreement negotiations between the United States and several Asia-Pacific nations that exclude China. If China moves back toward the market, the administration and Congress should encourage the process as much as possible. Here, a bilateral investment treaty is a worthy goal to recognize reform progress and encourage more reform by addressing Chinese complaints about investment access to the United States.
  • If Beijing continues its aggressive foreign policy, the United States should counter. There must be sufficient American military capabilities in the Pacific to balance and deter. This means transferring forces in the short term and increasing defense spending in the long term. The United States should also deepen alliances. If China returns to Deng’s pragmatism, the United States should foster increasing military-to-military contact and offer greater interaction under the Maritime Military Consultative Agreement and the Defense Consultative Talks—perhaps in areas such as humanitarian assistance and disaster relief.

BUSINESS GUIDANCE

Much of the business community misunderstood the last political transition and paid the price, as the open China anticipated by some analysts post-WTO accession never materialized. The obvious lesson is not to make assumptions and then be caught off-guard.

Business must prepare for further, slow regression toward a command economy. This could feature worsening policy paralysis and perhaps be punctuated by nationalist outbursts that do not only target Japan. This last risk, especially, is worth evaluating now.

On the positive side, pragmatism may yet triumph, bringing external conciliation and genuine liberalization. In this case, the broad commercial environment will improve and specific, unanticipated opportunities may arise. Reform could start in financial services, to undercut shadow banking, or in energy, given the desire to match the progress on energy made by the United States. Which sectors might see the first move could be tipped by the government positions assigned to reformers on the Politburo (even though they are not on the Standing Committee).

The companies that will outperform are those with the best information and the most flexibility. The former means staying or becoming directly engaged in China, rather than learning of developments second-hand. The latter means being able to increase or decrease commitments when the new government’s intentions become clear.

[author] Derek Scissors ([email protected]) is a senior research fellow for economics and Dean Cheng is a research fellow on Chinese political and security affairs at the Heritage Foundation’s Asian Studies Center. [/author]

Posted by Christina Nelson