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Global Market Brief: Sorting Out China's Economic Conundrum - Stratfor Today » August 21, 2008 | 1509 GMT
The Chinese yuan lost 0.6 percent in the weeks following a July 25 special Politburo meeting on the economy. This marks, at least temporarily, a reversal of the gradual strengthening of the yuan against the dollar that began in July 2005 and saw the currency appreciate some 20 percent. The change in part reflects the recent strengthening of the dollar against other major currencies. But more than that, China’s yuan policy, as a part of its overall economic policies, has been part of the debate raging among the country’s top leadership — one that may have come to a head in July.
The reversal of the yuan, coming after the critical July economic meeting, could mark a shift in the balance of power among the Chinese leadership, with those arguing for maintenance of the high-growth, export-based policies of the past winning out over those calling for slower growth and a shift to building the self-sustaining foundations of a domestic consumption-driven economy.
In some ways, China’s currency policy has acted as a barometer of the economic challenges facing the leadership, and how they have dealt with them. From April 1980, at the dawn of China’s reform and opening, until Jan. 1, 1994, China had a dual-currency system — one set at an official rate for domestic use (that foreigners were not allowed to possess) and another, the Foreign Exchange Certificate (FEC), at a slightly more flexible rate for foreigners. This dual-currency policy gave preferential treatment to foreigners — part of the government’s desire to attract investment and technology — while keeping the domestic rate stable as a way to control inflation and ensure social stability.
But the system led to a thriving black-market exchange, and with the Chinese increasingly traveling abroad and investment flows recovering after the 1989 Tiananmen Square incident, the system was abolished. After a radical revaluation of the new single yuan, the currency gradually strengthened over the succeeding year and a half, as the remaining FECs were withdrawn from circulation, eventually settling at a little over 8.25 to the dollar — a place where it remained pegged until the latest revaluation in July 2005. The pegged currency made China predictable, and meant that when the Asian economic crisis struck South Korea and the rising Southeast Asian tigers, China became the go-to place for cheap exports.
The boom in the Chinese economy, facilitated in part by the decline of its neighbors, saw China take an increasingly important role in the global economy. It also meant that the yuan became significantly undervalued. And as China’s political and military strength grew with its economy, international pressure on Beijing to change the yuan grew apace. But it was not only foreign complaints that led to the changing yuan policy. There were domestic concerns as well. After gaining from the misfortune of their neighbors, the Chinese began to realize that the export-based Asian growth model of the economy was one fraught with risks, and in China it had nearly run its course.
In the mid 1990s, Chinese leaders began to seriously examine the Chinese economy as it became clear that the widening gap between the rich and poor and between the coastal urban areas and the rural inland areas was stirring social unrest. Under then-President Jiang Zemin and Premier Zhu Rongji, China began revising its method of collecting statistics, and the more accurate numbers painted a stark picture of economic and social reality far different from the sugar-coated official reports feeding up the chain from the local levels. China’s age-old problem — balancing the distribution of wealth — was once again at the forefront, as it became apparent that economic growth had primarily benefited the coastal third of the population, leaving the remaining two-thirds behind.
This in turn meant that China’s rural interior population was growing restless. With the massive displacement of migrant labor, the chances for upheaval were very real in the minds of China’s leaders. When Jiang launched his Go West program, seeking to move economic growth into the interior, it was to address this economic imbalance and pre-empt its social consequences. The power of local officials, given relatively free rein in economic affairs under the economic opening and reform, meant that the Go West program met with little success; any serious effort to tackle the economic imbalance faced stiff resistance from the wealthy coastal urban leaders (who were being told, in effect, to transfer their wealth to the interior). While Jiang’s links to the so-called Shanghai Clique meant that he wielded influence among these powerful economic forces, he was also dependent upon them for his continued political strength.
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China’s Economic Imbalance
The compromise was to continue to encourage strong exports (which meant jobs for the migrant workers, continued flow of capital into China and reduced stress with the coastal provinces) while encouraging a shift of the coastal regions into higher-end manufacturing, and hoping the low-end manufacturing moved inland. This was seen not as a replacement for a shift in economic patterns, but a stop-gap measure to allow a more gradual transition from the export-based economy to one based on strong internal consumption. The concern was that too swift an attempt to change the economy could lead to an economic, social and ultimately political crisis. The debate among China’s leaders was no longer whether there needed to be change, but instead over how fast and in what way to implement that change.
When President Hu Jintao came to power, he began to target corruption as a way to rein in local officials and reclaim economic policy-making for the central government. The resistance of local governments — the effective decentralization of power — was seen as the biggest challenge to economic reform and thus to social stability. After testing out the central government’s strength against the old rust bucket of China’s northeast, Hu set his sights on the main political challenger to central authority: Shanghai. This was an attack not only against the municipal Shanghai government, but against the entire network of political connections the city leadership represented, including Jiang. At its core, this was a struggle for political power, played out on the battlefield of economic policy.
Hu’s team started promoting a more radical approach to economic management — the recentralization of key economic sectors, starting with heavy industry; trying to tackle the energy industry; and reducing incentives and support for low-end manufacturing (such as textiles). Included in this was the expansion of the All-China Federation of Trade Unions, meant to put into place control mechanisms for the central government to deal with labor (and management) as the consolidation of industry and centralized control set in.
Both policy ideas — continued growth fueling the transfer of money, technology and employment to the interior, and a radical and rapid shift in the economic organization — have their attendant social risks. The former risks social unrest getting out of control before the transfer of the economy is complete; the latter creates social unrest, but follows the theory that it is better to shape the location and timing of that unrest than have it thrust upon the leadership by fait accompli. Both see social instability as a reality, both want to preserve the rule of the Communist Party of China (CPC), but the timing of action is different.
Struggles over economic policy in China have often led to massive political and social upheaval. The Great Leap Forward and the Cultural Revolution were both manifestations of leadership struggles over China’s economic path. The 1960s and 1970s in many ways reflected a battle between Mao Zedong’s calls for relative economic isolation (with its focus on evenly distributed wealth as a way to control social stability) and Deng Xiaoping’s push for integration into global markets, gaining technology and currency rapidly. Both sought growth and prosperity for China, but their policies were incompatible. The economic realities of China meant that the Deng faction would win out, but the politics made this a long and brutal struggle, as entrenched interests do not give up their power easily.
The two broad policy factions among the Chinese elite in today’s struggle are loosely represented by Jiang (who still retains influence in the Politburo), who argues for the continuation of unrestrained growth and the Deng policies, and Hu, who argues for a recentralization of economic control and reduced focus and exposure to international influences on the Chinese economy, and in some ways reflects the Mao line. The debates have spilled into China’s media and pronouncements from various government officials and researchers, with dire warnings of economic slowdown, calls for support of the flagging textile industry (the centerpiece of low-end, high-employment export manufacturing) and discussions of China’s past, when high gross domestic product and a large military did not translate into true national power.
While such debates ramble on in China often for years if not longer, the commodity crisis earlier this year, coupled with a downturn in the global economy, seems to have brought the debate to a head. Manufacturing is slowing, tight monetary policies are failing to curb inflation, and a slowdown in the global economy and an increase in commodity prices, coupled with a rising yuan and domestic factors, has begun to eat away at China’s export-based growth economy. Key Chinese export hubs, like Guangzhou and Shanghai, have already reported slowing growth, and Chinese textile manufacturers in particular have been hard hit and are calling for changes in economic policies — particularly the value of the yuan and export tariffs.
Foreign and domestic economic analysts have increasingly fretted about the dangers of an undefined pool of speculative capital — so-called hot money — that has flowed into China in recent months, found its way into real estate and construction sectors, and may be fleeing the country after the Olympics. Chinese analysts have more publicly warned that there will be no anticipated economic boom after the Olympics conclude, and in fact there may be a short- to mid-term dip as much of the rise in investment leading up to the Olympics flowed into infrastructure development projects in preparation for the events. At the same time, Chinese leaders have been downplaying the economic and political significance of the Olympics in state media, preparing the country for a much different economic outcome than initially touted.
The Olympics have played into the debate due to their timing at the peak of the commodity crisis. The officials who pretty much backed the continuation of the export-based growth policy, and the gradual economic changes, are also the ones in power when China applied for and received the Olympics. A “failure” of the Olympics exposes the fallacy of their economic and social program by showing the weakness of the Chinese state despite two decades of economic growth. In July, there was a notable shift in rhetoric from the CPC leadership as it tried to downplay economic and political expectations from the Olympics — an apparent sign that the pro-export, pro-Olympic faction was feeling pressure.
As social unrest simmered — stoked by rising inflation and natural disasters — and spilled over into an increasing number of locations, these factors culminated and prompted the Politburo, the CPC’s top leadership body and the government’s guiding force, to call a special session to discuss the economy. Before the July 25 meeting, the top leadership were sent on inspection tours of the economic areas of the country for a first-hand assessment and consultations with local officials and researchers.
What came out of the meeting was apparently a reversal of several years of efforts to slow inflation through interest rate hikes, consolidate industries and in essence begin to recentralize the government. The Politburo said the key focus was no longer avoiding inflation and avoiding economic overheating; rather, the new focus was on promoting more stable and relatively fast economic growth and controlling inflation — the “one maintain one control” policy. On Aug. 1, in a meeting with foreign media, Hu said that after the Olympics, China would pursue strong economic growth — apparently reversing his own policies. The decline in the yuan, an obvious boon to cheap Chinese exporters, also appears to reflect this reversal.
The battle lines have been forming for years, and some in the CPC might be reconsidering their decision in July after the recent dip in commodity prices.
There is no doubt both factions see a need to set economic policy more firmly in one direction, as opposed to the current hybrid system. And the two policies are not compatible. That also means that those whose power and influence are based on relationships involved in one system or the other have plenty to lose if their policy preference fails.
A critical question now is whether the crisis of economic policy — and thus political policy and political survival — came to a head at the Politburo meeting in July. If it did, then there is no turning back from political confrontation inside the top echelons of the Party — and that also means purges and the collapse of power networks. If there were things said in July that cannot be unsaid, the lines are drawn and the crisis will come quickly, perhaps within months if not weeks. If the emergency Politburo meeting did not resolutely draw the lines, then there is still more muddled time.
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