The politics of China's economic adjustment

After 30 years of growth, China is facing a difficult adjustment to a new economic model. History suggests further political turmoil will ensue as the process gets underway.

The past two years have seen a surprising amount of turmoil at the highest levels of the Chinese political establishment. We have seen political alliances re-shuffled, powerful business and political leaders arrested, factional disputes magnified, and an explosion of rumours of more to come. After twenty years of what seemed, on the surface at least, remarkable cohesion within China’s political elite, events of the past two years have come as a great surprise to many.

And yet the historical precedents suggest that none of this should have surprised us. After nearly thirty years of spectacular economic growth and impressive social and political advances, China has probably exhausted the growth model that had once served it so well. It now suffers from many of the internal imbalances that were the near-automatic and easily predictable consequences of the policies associated with the growth model it had pursued, and policymakers in Beijing are very aware of the urgent need to adopt a new set of policies that will allow China both to rebalance the economy so as to protect itself from the consequences of soaring debt and to lay the foundations for another thirty years of solid economic growth and social and political advancement.

In the early 1980s when China’s reforms began, the country was seriously underinvested and urgently needed to improve its infrastructure, its manufacturing capacity, and housing and education. As the country’s farsighted leaders engaged in a massive program of investment, there were many opportunities for the state and for the political and economic elite to benefit directly from transforming the country’s capital stock from one of the weakest in the world to one of the best. Among the consequences was that while the lives of ordinary Chinese improved at a pace perhaps unmatched in human history, the share of China’s GDP retained by the state sector and the political elite actually increased for thirty years as they benefited disproportionately from Chinese growth. China produced more billionaires more quickly than anyone in history.

But every country that has experienced a growth miracle has also developed imbalances that had to be reversed, and the adjustment process is simply the process by which these imbalances are reversed. China is no exception. In order to rebalance the Chinese economy we must move from a period during which the elite received a disproportionate share of growing Chinese wealth to one in which ordinary households and small businesses receive a disproportionate share. After thirty years during which Chinese households retained an ever smaller share of the rapidly growing Chinese economy, doing nonetheless very well in the process, we must shift to a period during which ordinary Chinese households receive an ever rising share of a more slowly growing Chinese economy, in fact this is almost the very definition of rebalancing in the Chinese context.

China’s economic adjustment necessarily involves, in other words, a sharp reduction in the rate at which the state and the political elite have been able to grow their assets during the past thirty years, and perhaps even an overall decline. It also requires significant changes in the ways in which the financial system funds economic activity, an increase in the role of small businesses and the service industry, a very different legal framework, and a number of institutional changes that represent a sharp break from the recent past.

Aligning incentives

None of these changes will be easy, and these changes will be all the harder to make by the fact that there must also be, as a necessary part of what it means for China to rebalance, a sharp reduction in the amount of assets and resources to be distributed among the various state and elite players. China’s old economic model, which rewarded both the country and the elite very handsomely, must now be transformed into a model that will reward the country, but at least partially at the expense of the elite. This was the challenge faced by every country as it adjusted from it’s period of rapid, investment-led growth, and it has always been a politically challenging process, whether that process involved the bitter political upheavals and the redistribution of wealth from the rich to the poor forced onto the United Sates by President Roosevelt’s reforms in the 1930s, or the Brazilian rejection of it’s military rulers in the 1980s as they painfully but surely built a robust democracy.

The historical precedents are fairly clear. Every country that has emerged from many years of “miraculous” investment-led growth has either embarked willingly, or been forced by debt, into an adjustment process that turned out to be economically far more painful than anyone had expected. In every case among the greatest challenges has been a very fractious and difficult political environment. China is now beginning it’s own adjustment process and we should be prepared for both tougher economic conditions and a more difficult political environment.

History has a lot to teach us about this process, and it has a lot to teach us about which countries were able to manage the difficult adjustment in ways that created a basis for long-term success and which countries were not able to do so. China’s leaders have already demonstrated sufficient foresight and ability to have managed the growth period successfully, and we have every reason to hope that they will manage the adjustment process equally well. But there should be little doubt that thirty years of astonishing growth was the relatively easier part, and that President Xi Jinping and Premier Li Keqiang face a greater challenge than that faced by their predecessors. And there should also be little doubt that the recent political turmoil in China is not an accident. History makes it very clear that the next ten years will be a political challenge for China even more than it will be an economic one.

And how will things evolve politically in China? Of course it is a little foolhardy to make predictions, but work that I have already cited many times before by Daron Acemoglu and James Robinson suggest that most cases of successful adjustment have occurred either in countries with highly competitive political structures (democracies, for example) or in countries with highly centralized decision-making (China under Deng Xiaoping, perhaps). Authoritarian countries in which political decision-making is widely dispersed, like China today, have historically found it difficult to make a successful transition.

So which way should China move? There is a widespread belief that only political reforms that impose rule of law and democratize the political decision-making process will allow China to reform successfully. For example a recent editorial in the Financial Times argues:

Much of this is difficult, for one important reason. It requires the Communist party to loosen its grip. Yet it has little choice. Unless meaningful reform can be implemented, the chances of China’s economy running out of steam are high. 

This may be true, but it also may be true that a successful adjustment in China actually requires that China move temporarily ‘backwards’ towards greater centralization of power and a tighter grip on decision-making by President Xi and his allies. After all it took Deng Xiaoping to unleash the radical reforms of the 1980s, and it is an open question as to whether he would have been able to do so had political power in China been as dispersed in the 1980s as it is today. In that sense what seems like an attempt by President Xi to consolidate power more tightly within a small group is perhaps not a step ‘backwards’ in political liberalization but more of a temporary retreat in order to ensure a successful adjustment, which itself might be a precondition to further political liberalization some time in the future.

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets, where a longer version of this article first appeared.

InvestSMART FORUM: Come and meet the team

We're loading up the van and going on tour from April to June, with events on the NSW central & north coast, the QLD mid-north coast and in Perth, Adelaide, Melbourne, Sydney and Canberra. Come and meet the team and take home simple strategies that you can use to build an investment portfolio to weather any storm. Book your spot here.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Related Articles