China’s communists depend upon capitalism

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Now that the transition is over, the real change begins. Following America’s election two weeks ago, the focus has quickly switched to Barack Obama’s ability to wrangle a taxation and expenditure agreement with Congress to avert a US ‘fiscal cliff’. In China, now that incoming president Xi Jinping has been formally appointed, attention turns to whether he and the other six members of the new Politburo Standing Committee have what it takes to press through long-awaited political and economic reforms.

Though the ‘election’ of Xi and his premier, Li Keqiang, by China’s 18th National Congress has been widely anticipated since he became vice president to Hu Jintao in 2007, many commentators greeted the ascension of the other members to China’s top decision-making body with disappointment.

Notwithstanding promises of reform by many in the Communist Party hierarchy – including outgoing premier Wen Jiabao who has prominently, on several occasions pronounced China’s economy as “unstable, unbalanced, uncoordinated, and unsustainable,” the ‘four uns’ – a particularly conservative line-up appeared on the dais last week. No less than five of the appointed members are seen as acolytes of Hu’s predecessor, Jiang Zemin, who at 86 is still believed to exercise great power behind the walls of the Zhongnanhai, the central Beijing complex that serves as the Party’s headquarters. And while Li is attributed to be a protégé of Hu, and Xi, a son of a Mao-era revolutionary, is widely believed to be his own man, the feeling that this was a leadership of vested interests was palpable.

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Despite delivering an annual average growth rate of 10.7%, which has continued to lift hundreds of millions of people from poverty – one of the greatest economic feats of history – the other legacy of Hu’s ten years at the helm has been the entrenchment of vested interests, ranging from the military to state-owned enterprises (SOEs), and the deepening of a severe inequality between China’s urban rich and its rural poor.

The social implications of China’s inequality are obvious. Sun Liping, a professor from the elite Tsinghua University, who is said to have been Xi’s PhD supervisor (such details are expunged from the official biographies of China’s leadership) estimates that mass public demonstrations rose from 40,000 in 2002 to 180,000 in 2010. Most of these incidents are over land seizures, abuse of the hukou registration system – where internal migration is kept in legal check – labour rights, environmental degradation and high property prices.

The economic implications of China’s vested interests are less evident, but no less insidious. The common Chinese phrase “the state advances while the private sector retreats” encapsulates the past decade, an era that, with China’s entry to the WTO, was hoped to be far more deregulated and decentralised.

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The corruption, inefficiencies and political inertia created by such imbalances have reached a point where they could now destroy China’s brittle political and economic equipoise. A potential crisis in SOE and local government non-performing loans, accrued during the infrastructure and fixed-asset investment binge of the past ten years (household consumption, by contrast, fell as a percentage of GDP from 45% to 35% between 2001 and 2011), could be the tipping-point, but so could unrest in China’s provinces, any number of looming environmental catastrophes or an internal Party schism. And whether demonstrated by the extreme stage management of China’s leadership transition, the government’s instinct to cover up last year’s Wenzhou high-speed rail disaster, or the purge this year of charismatic provincial leader Bo Xilai, once a contender for the Politburo, it seems that the Party is well aware of these threats.

Still, in times of great stress, strong reforms are better than waiting for an accident to happen. Prominent China-watcher David Shambaugh, from George Washington University, has been quoted widely in the press for his sceptical view on reform: “We’re not going to see any political reform because too many people in the system see it as a slippery slope to extinction. They see it entirely through the prism of the Soviet Union, the Arab Spring and the Colour Revolutions in Central Asia, so they’re not going to go there.”

Yet at the same time it is exactly the prism of the Soviet Union, the Arab Spring and the Colour Revolutions that demands reform, which if initiated by the Party can at least be controlled by the Party. In the past twelve months, after all, two of the greatest ongoing political shifts haven’t been in the US or in China, but in Egypt and Myanmar, to which yesterday Barack Obama made an historic visit.

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One transition was noteworthy because it was forced upon an unwilling regime, leading to a tumultuous uprising from which we are still facing uncertainty as the leadership of the Muslim Brotherhood grapples with the belligerence of its Gazan offshoot Hamas. The other transition though was noteworthy for entirely the opposite reason in that it was instigated by the regime. And although Myanmar continues to face great challenges – not least of which is a rising ethnic conflict in Rakhine State – its political, social and economic outlook is infinitely brighter today than it was before November last year when Aung San Suu Kyi’s political party was allowed to re-register.

While Chinese reform will happen in China’s own way at China’s own time we therefore believe that change could come sooner rather than later. Assuming that such change will involve less reliance on fixed-asset investment to generate growth and a greater focus on social welfare, market liberalisation and domestic consumption then this will have major ramifications for Australia as well.

The effects of China’s slowdown since the growth rate peaked at over 13% in 2007 to 7.4% in the third quarter of this year have already been profound on commodity prices and government revenues, but they compare little to what a wholesale reorienting of China’s economy would produce. With reform thus looking likely despite the relatively conservative appearance of China’s new Politburo, Australia’s economy better do some reforming of its own. The only problem, however, is unlike China, we have politicians to deal with.

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Michael Feller is an investment strategist at Macro Investor. This is an article published in the Fairfax press.