Silent Revolution in China
A silent revolution occurred in China in March, following the Chinese Communist Party’s (CCP) 19th Congress in December.

The National People’s Congress (NPC), China’s national legislative body, made significant changes to its top leadership and in the structures of the government and the CCP.

So what are the elements of this silent revolution?

First and foremost, the NPC – in accordance with CCP proposals – changed China’s constitution to eliminate the two-term limit for the president and vice president. This, along with enshrining President Xi’s “Thought on Socialism with Chinese Characteristics for a New Era” into the constitution,1 elevates Xi to the level of Chairman Mao. As a result, it is almost a foregone conclusion that his term will extend beyond 2020, making his consolidation of power absolute and the direction of policies more uniform.

The second is an overhaul of government and party structures that includes setting up a new National Supervisory Commission. This will further commingle party structures with those of the government. It also ensures that the CCP will supervise all government officials at every echelon of administrative hierarchy, including at the central, provincial, municipal, and even county levels. Hence the government and the party are becoming almost one.

Third, the restructuring of the government aims to rationalise and reduce administrative overlaps by consolidating functions that have been scattered through various ministries and agencies with different power and responsibility structures. This will likely improve implementation efficiency, but it is also in line with centralising power at the top.

Financial Regulatory Changes Finally in Place

For the markets, a significant part of this overhaul was the long-awaited changes in the financial regulatory system. China has long had a fragmented regulatory system based on the type of financial institution, rather than the type of assets or markets where they meet. The new system consolidates these fragmented agencies to a certain extent.

At the apex of this new structure is the State Council of Financial Development and Stability, led by Liu He, a long-time economic advisor to President Xi. Liu, who was seen as the person behind China’s supply-side reforms since 2016, was elevated to Vice-Premier in March. The People’s Bank of China (PBOC), which is second in the pecking order, was also given more control over the financial system through powers to write rules for macroprudential policies.

At the same time, China’s two regulators covering the banking and insurance sectors have been merged into the China Bank and Insurance Regulatory Commission (CBIRC), while leaving the China Securities Regulatory Commission as a stand-alone regulator of the capital markets. The new leaders of both of these institutions are known to be reformers who would work well with CCP leadership. The head of the consolidated banking and insurance regulatory agency will also be the party secretary to PBOC, elevating his position further and ensuring that the CCP’s overall financial policy is uniformly executed both through monetary and regulatory policies.

Looking above the trees, the party-government behemoth is now ready to mold China into President Xi’s vision of a modern country by 2035 and make it great again. This will take shape in structural policies to reduce poverty, improve the environment, and upgrade China’s manufacturing technology, while projecting soft and not-so-soft power internationally through the One Belt, One Road initiative2 and a more internationalist approach to trade.

Policy Priorities

In the wake of all these changes, China’s stated immediate priority is to manage financial risks that could jeopardise the larger plans should those risks unravel. That means continued regulatory tightening to reduce financial leverage in the system, primarily by reducing regulatory arbitrage, implicit guarantees, and off-balance sheet leverage. The deleveraging drive will increasingly move from the financial sector to state-owned enterprises (SOEs) and the real economy, and be supported by supply cuts and tighter implementation of environmental regulations.

In our view, fiscal policy will also be tightened, despite tax cuts to support investment and household consumption. The government reduced its fiscal deficit target to 2.6% of GDP from 3% for 2018. But the real fiscal policy in China is not as much on the budget as it is off budget. And the real adjustment will come from reducing off-budget spending and forcing more fiscal transparency in the process, which we consider a positive. Most of this will be felt by local governments and the public/private investment projects they were involved with, either via direct financing or through implicit guarantees.

At the same time, the merger of local branches of local and central government tax bureaus is another silent move to reign in local government excesses. We expect that this will result in more revenues going to the center, creating very firm incentives for local governments to move their financing onto a more sustainable base, rather than land sales and nontransparent off-balance sheet financing arrangements. We hope this sets the stage for the introduction of property taxes in 2019, which would help stabilise the wobbly housing market going forward.

Positive Developments for the Global Economy

We consider these developments, which reduce systemic risks in China and the associated risks of a hard landing, as positives for the global economy. We also believe that the regulatory policy complex is capable of channeling credit to the real economy in line with broader goals.  This expected tightening is a welcome reprieve from a further build-up of debt, without choking off the more productive parts of the economy, especially the “new economy,” which relies much less on credit than the SOEs in heavy manufacturing.

Furthermore, we expect the PBOC to continue following the U.S. Federal Reserve with minuscule rate hikes of 5-10 basis points (bps), as it did the last three times it tightened. In our view, this is an insurance policy rather than a hiking cycle, as we think PBOC would prefer to stay flexible in 2018 and focus more on liquidity policies rather than substantial rate hikes to manage funding costs.

With all these moving parts, we expect China’s GDP growth to come off its 2017 highs of 6.9% to a more sustainable 6.5% in 2018, while inflation will remain around 2.5%. In our view, the impact of this moderation in Chinese growth should be offset to a large extent by the strong pace of global growth, including by other emerging markets.

Broader efforts to support consumption will also find their reflection in trade and other liberalisation policies. Following the first round of rapid fire U.S. tariffs on Chinese steel and aluminum, and Section 301 tariffs3 on a broader set of goods, we expect China will try to reconcile its own interest in opening up its markets to more competition, and U.S. interests to reduce bilateral trade deficits without setting off a real trade war. China’s measured response to steel and aluminum tariffs are a reflection of this measured approach.

Nonetheless, with the U.S. identifying China as a strategic competitor, clearly the gloves are off now and unpleasant surprises are not out of the question, especially if China feels its future aspirations of improving its manufacturing technology are being choked off.

Welcome to China’s New Era!

  1. ^Also known simply as “Xi Jinping Thought,” the 14-point policy declaration is now China’s official political doctrine.
  2. ^First proposed by President Xi Jinping in 2013, the One Belt, One Road initiative (also known as the Belt and Road initiative) is a plan to connect Asia, Europe, the Middle East, and Africa with a network of roads, ports, airports, railways, and other infrastructure to facilitate trade and economic development.
  3. ^Section 301 of the U.S. Trade Act of 1974 enables the executive branch to take actions, including the imposition of tariffs, to respond to what it determines to be unfair trade practices by another country.