The First Year of the Xi-Li Reforms

From ‘shadow banking’ to lavish public spending, the message of President Xi Jinping and Premier Li Keqiang has been clear: the days of excessive spending and damaging liquidity are over.

The message was brought home in June 2013, when China’s inter-bank rates soared, but the People’s Bank of China (PBOC) did not intervene. In the past, the authorities had usually resorted to new injections of liquidity. Now it was declined. A déjà vu ensued in December 2013.

Initially, observers called the outcome a “cash crunch,” which fails to capture what really happened. PBOC and China’s new leadership were not behind the curve. Rather, the new administration prefers to act – not to react – to anticipated corrections.

That’s not an ideal result because it means higher borrowing costs. However, it is certainly preferable to the alternative – unsustainable liquidity creation and the rising probability of a debt default.

Forget stimulus, leverage and deferred reforms

By the Third Plenum in fall 2013, the Xi-Li reform initiatives focused on tripartite reforms, which sought to foster the role of efficient markets, competitive companies and a smaller but more effective public sector.

The core reform sectors included finance, taxation, state assets, social welfare, land, foreign investment, innovation and good governance. Further, the reform blueprints sought to relax control over market access, establish a basic social security package and allow sales of collectively-owned rural land. The old household registration system (hukou), which continues to discourage migration, would be phased out gradually in the course of massive urbanization.

Along with economic and financial reforms, Premier Li played a vital role in the launch of Shanghai’s free-trade zone (FTZ), which unleashed a slate of new FTZ initiatives in other Chinese megacities and provinces. These initiatives are moving in parallel with increasing financial deregulation and the internationalization of the renminbi.

In order to reduce bureaucracy and implement reforms, Li pushed the central government to delegate administrative approval powers to lower levels of governments, by drastically reducing approval in the administrative approval system.

However, the reforms promise no free lunches. When Li wrote his price-winning dissertation in 1994, he argued that structural change fuels productivity growth. Until the new leadership took over, China coped with economic challenges by acceleration and leveraging, which degrade the quality of growth. That is no longer an option.

Decoupling property markets and local debt

It is not by chance that Xi Jinping has now more power than any Chinese leader since Deng Xiaoping. Xi is a consensus leader, but consolidation of power is vital for strong leadership to enforce the relevant reforms.

One of the most important policy achievements of the new leadership has gone by almost unnoticed. After the global recession in fall 2008, the mainland avoided the worst thanks to a $590 billion stimulus package. But the latter also unleashed huge liquidity, which led to speculation, particularly in the property markets.

It has burdened certain provinces with excessive local debt. Meanwhile, the mainland’s total credit has increased from 75 percent to 200 percent as a proportion of the GDP.

If Xi and Li would deleverage too fast the volatile property markets and unsustainable local debt, they would risk a severe European style recession. If they would leave the outcome to the markets, the property markets would overheat and the local debt would eventually cause debt defaults in the provinces – something that U.S. experienced in 2008/9.

Even worse, the coupling of speculative property markets and soaring local debt could drive China to a lost decade, which has led some observers to predict China’s “hard landing” since 2009.

In a delicate balancing act, the new leadership has sought to prevent the concurrent deleveraging of property markets and local governments. As the two have been decoupled, “hard landing” forecasts have given way to predictions of “soft landing” or “long landing” in the medium-term.


Tough medicine

In the coming months, Xi and Li must cope with the U.S. Fed’s tapering, which began with reductions in bond purchases in December 2013 and will eventually mean higher interest rates in the West. In the past 3-4 months, it has meant “hot money” outflows, deflation and depreciation effects in weaker emerging economies.

It is in this volatile international environment that Xi and Li will try to curb fiscal deficit and stabilize the real estate market, even while financing urbanization and the impending hukou reform.

The risks and the rewards are particularly prominent in the financial and banking sector, in which the new leadership hopes to foster stability in the banking system and regulation of financial intermediation, along with interest rate liberalization and capital account opening.

If the policies of Xi and Li prove successful, China continues to have potential for 6-7 percent growth in the coming years.

In the Xi-Li era, adversities can no longer be faced with new stimulus packages, excessive leverage and deferred reforms, but with no stimulus, deleveraging and structural reforms – though with fiscal support.

It is tough medicine, but vital to deter the kind of liquidity traps that have led to a record-slow recovery in the U.S, one lost decade in Europe and two lost decades in Japan.

Dr. Dan Steinbock is the research director of international business at the India, China and America Institute (USA) and a visiting fellow at the Shanghai Institutes for International Studies (China). For more, see

The original version of this commentary was published as “A year of rewarding reforms,” by China Daily, Feb 25, 2014.