Every day, new rules and moves are bringing Xi Jinping one step closer to regaining complete control of China's economy and society. One aspect of Xi’s psychology, like Mao’s, is how he can turn on a dime, how little past commitments to partners are worth and how much he remains shaped by his initial years of struggle, something he seldom forgets to bring up. Still, we had all become complacent: we knew he wasn’t a fan of the large-scale market economy, but he seemed perfectly at ease with hybrid conglomerates and national champions that have consistently delivered China’s fast growth. We understood his anti-corruption campaigns as first and foremost a political tool against real or potential opponents. We also saw his initial proclamations of economic reform as largely stillborn. We saw China’s increasing global economic leverage as key to Xi’s ambition for his mandate. As regards domestic economic policies, they still followed the stop-and-go budget and credit cycle of previous reform decades. Where Xi differed was in the strength of his red and nationalistic political rhetoric, in the additional boost given to high tech developments also started by his predecessors, and by a "take no prisoner" attitude to any potential challenger, at home or abroad.
It turns out we were wrong. Xi Jinping is now changing the face of China’s political economy. And it is not in the direction of market reform that China’s international partners awaited for years before giving up hope. In doing this, he is ready to incur risks beyond anything his predecessors had been willing to accept since Mao’s death. After describing the purely political face of this revolution, the economic aspect needs to be equally scrutinized.
First, the rationale for the policy changes - both explicit and implicit. The changes may have been preceded by some declarations of intent in previous years, but these were never carried through.
Xi Jinping is now changing the face of China’s political economy.
The sinking of China’s real estate companies is so much the result of convergent moves that it appears deliberate, even if the reasons for it lie as much in macrofinancial trends as in the housing bubble by itself. China’s real estate sector makes up a quarter of its GDP.
It is the middle to high income Chinese citizen's piggy bank and it is trusted far more than banks or the stock market themselves. Together with the physical infrastructure sector, it is also the number one factor in China’s continuous rise in CO2 and other emissions, a rise that is not fully mitigated by any improvement in the energy efficiency per unit of GDP. Incidentally, it is also the chief factor in the current price inflation for raw materials and construction goods all over the world. There are occasional doubts as to whether China really has a housing glut. In fact, the price trends in first-tier cities would seem to disprove this. But let’s get real: in 2013, the average Parisian had 31 square meters living quarters at his disposal, the average French living in a flat had 32.5 square meters. Shanghai, where in 1976 residents had only 4 square meters each, now has 37.5 to 40 square meters per resident, and Jiangsu province has 49 square meters. Chinese data for 68 cities in 2018 has a 24-70 square meter range. Only 21 cities have less living space per resident than Paris. When Xi Jinping came out in 2017 with his declaration that "houses are for living, not for speculation", he was poking at a financial reality, not a housing issue. And even if China’s real estate companies are not state-owned enterprises (SOEs), they have such close relations to local and national officials that they are believed to be backed by an implicit state guarantee.
This leads us to a second level of analysis. Ever since the Covid pandemic started, and despite China’s fairly successful exit for almost one year and a half, China’s budget and credit policies have been tightening. There are of course eye-catching exceptions to this, including select high tech sectors such as semiconductors and IT in general, and for a time in the spring of 2020, large scale SOEs, to protect fixed employment. But in other areas the trend is stunning. For example, China’s central and local budgets are currently decreasing on a comparative basis to 2019. Not only did the approved budget in March 2021 project a modest 4.5% increase of expenditures over 2020, but actual disbursements in the January-July 2021 period have fallen far behind. Central expenditures fell by 12.5% compared to 2019, and local expenditures by 1%. Worse, the deepest cuts in spending are for China’s officially stated priorities: environment, agriculture and forestry, education.
Our hypothesis is that an overriding priority of budget tightening has inadvertently led to cuts in the weakest and least money-connected sectors. How much these choices are approved by Xi Jinping is debatable, as this puts him in direct contradiction with the environmental and welfare targets that he has claimed. But it does coincide with a broader objective of stopping China’s domestic debt spiral and a tight monetary policy designed to limit international financial risk.
Ever since the Covid pandemic started and despite China’s fairly successful exit [...] China’s budget and credit policies have been tightening.
Not only are large GDP growth targets being abandoned, but against the wishes of theoretically liberal (but in reality Keynesian) Chinese economists, the Ministry of Finance and central bank motto is much more conservative. In its own words, it is to "keep the growth of money supply and social financing in line with nominal economic growth, while keeping the macro leverage ratio basically stable". This preference for a cross-cyclical policy over a counter-cyclical stimulus is more Hayek than Keynes, more Bundesbank than Fed. The only concessions, in July 2021, have been a small cut in the reserve requirement ratio for banks and small injections of liquidity in repo operations.
Meanwhile, the bulk of control and curtailing of new credit has fallen on the real estate sector. This was done directly but also through the curtailing of so-called local government financing vehicles - or "shadow debt" - most of which relate to the financing of land sales and construction that will ultimately bring key fiscal resources to these local governments. The ambition to regain control of local and real estate debt is not new. The pandemic in early 2020 blew a hole in this strategy. But in 2021, debt deleveraging has gathered pace. During the spring session of the National People’s Congress, the Ministry of Finance termed this a matter of "national security". The reduction affected both the central and local governments, as well as consumer debt. In the first half of the year, local governments sold only 42% of their total annual bond quota.
Meanwhile, the bulk of control and curtailing of new credit has fallen on the real estate sector.
Many other measures have been adopted or are said to be under consideration. Billionaires and large digital companies are "spontaneously" making large donations for the shared goals of "common prosperity". There is debate on a pension reform, where the rich would rely on specific contributions and also on the income tax system.
It is progressive in theory, but a 2018 reform creating many deductions and raising its threshold brought the percentage of the urban population concerned down from 44 to 15%. Sectoral measures have already been introduced, such as a 5% cap on rent increases (the first ever rent control in post-1978 China), and a compulsory rotation of teachers in large cities to avoid real estate speculation around the best schools.
In the last case, we also see the new social policies that are responsible for the sudden banning of private tutoring, leading to the wipeout of a 120 billion USD sector. The capping of video gaming at 3 hours per week appears difficult to enforce, as is the admonition to video game companies that they should not seek profit as their main objective. Rumor has it that the cosmetic surgery branch - a 50 billion USD industry - is the next target. A mobile phone app of 200 million users, initially designed to combat phone and internet financial fraud, is now used by authorities to query individuals who have accessed international financial news services. Then there is of course the ban on trips abroad, justified by the zero-Covid policy. The move against real estate and speculation now extends to new rules for urban renewal that clearly challenge the existing ethos of China’s real estate business. How economics, society and politics are inextricably linked here can be deduced from the following imperative: "We shall put an end to the bad practice where grand, strange, and Western-style buildings are sought for". Ironically, it does feel like the rest of the new regulation could have been written by a Western green or social-minded administrator.
Do these ambitions go any further? The rhetorics around "common prosperity" would suggest so. Strikingly, many professionals and media economists are falling over themselves to suggest ways to fight inequality. From pension reform to "tertiary redistribution" (philanthropy) to current income tax inequity, they are taking cues from Western socially minded thinkers (essentially American, and also with mentions of Thomas Piketty) to put flesh on Xi Jinping’s words. But what has previously happened with the entire platform economy, and is still reverberating with new announcements, suggests caution: control over data by the government is clearly the most consistent priority, beyond anti-monopoly action and the protection of private data from commercial endeavors. In all the policies listed above, we suggest that the limitation of financial risks and therefore the control on new debt and speculative bubbles are the primary intent, with social redistribution thrown in as a secondary goal and a useful political prop.
The snowballing economic effect that is starting this September will leave a deep imprint on China’s urban society and the so-called middle classes, as well as on international investors. The second part of this analysis looks at the risks taken and the international implications of these changes.