A Story of Two Chinas: Xi’s Vision and China’s Economic Reality

Eric Liu

November, 2017

Xi Jinping once resided on the hillside of a remote village in the Shaanxi province. Today, "the most powerful man in the world", as proclaimed by the Economist, sits as the President of the Peope's Republic of China

As a young boy, Xi's life was uprooted by the Cultural Revolution. From a pampered life as son of a vice premier, Xi was sent from Beijing to the small village of Liangjiahe as part of the Cultural Revolution’s initiative to re-educate the urban youth. For the following seven years, young Xi would work as an agricultural worker and call a small dug-in cave on the hillside home.

The villagers of Liangjiahe remember a frail young Xi entering the village and leaving it a hardened man. In essence, Mr. Xi story is one of adaptively amidst adversity –similarly to the issue China faces today. 

China convenes in its congress once every 5-years to determine the future of the country’s direction and to elect its leaders.

This October marked China’s 19th congress and the end of President Xi's first term.  In the earlier years of his term, Xi consolidated his power within the party by clamping down on corruption and as well as removing dissenting party members.  In China’s recent history, no leader has held as much political clout or has been as ambitious as Xi. 

Xi's current vision of China is one of a mounting role on the world stage, especially by evolving as a driving engine of global trade. His rhetoric during the 19th congress and his policies encouraging the ‘One Belt One Road Initiative’ confirm his belief that China is ready to become the world’s leading economic power. Though President Xi's congressional speech was sanguine, it runs contrary to China’s current economic reality.

In the wake of the 2008 global financial crisis, the Chinese government had to reassess its foreign and domestic economic policies. China found itself in a precarious situation. As an export driven economy, the country relies significantly on demand from regions such as the US and EU to sustain its growth. However, the crisis forced the US and EU to reduce its imports thus leaving Chinese companies with excess supply across multiple sectors.  In response, the government enacted a stimulus package aimed at maintaining its economic growth. This resulted in economic growth buoyed by credit. 

Consequently, this led to myopic credit allocation in China’s State-Owned-Enterprise (SOEs). Mostly, this involved Chinese businesses using debt to invest in less than profitable business opportunities. Overall, SOEs are 13 times larger than private Chinese businesses and account for a third of business assets in the country.  This is due in large part to the relationship between SOE and government that allowed SOEs to grow more quickly from easier access to capital and beneficial regulations. Eventually, they became the dominant player within industries due to their sheer size. 

Unfortunately, SOEs in sectors such as steel, coal, and real-estate became debt-ridden and unprofitable from the stimulus package. One theory as to why SOEs indebted themselves is because of the intricacies in the SOE and government relationship. Instead of board members electing a company’s management team, China’s SOE executives are elected by government officials. This could have led to a conflict of interest in that senior management prioritizes regional employment or infrastructure growth to maintain good government relations. 

In any case, these SOEs resulted in poor investments, resulting in vast debt and company interest payments consumed business profits.

As many of these SOEs companies represented key employment for regional communities and a linchpin of party power, the Chinese government was unwilling to see them fail. This forced the government to set policies that supported these dying companies at the expense of other parts of the economy. 

Thus far, Xi has tried multiple strategies to revitalize the SOEs. The current strategy involves “mega-merging” unprofitable companies with profitable ones. In short, this helps alleviate pressures of unprofitable SOEs in servicing their debt despite weighing down larger more lucrative firms.

Nevertheless, the Xi administration’s “mega-mergers” strategy only addresses the symptoms of why these SOEs are failing and not the root cause.

In theory, “mega-mergers” can help reduce overcapacity, gain greater economies of scale, and create larger SOEs that better compete with global multi-national companies. However, the issue of running profitable businesses and managing credit risks is a systematic hazard among all Chinese SOEs.

In 2016, the return on business investments from a Chinese SOE was a third of a comparable Chinese private company. Undoubtedly, China’s SOEs will continue to perform poorly without a comprehensive strategy that addresses their relationship to the government as the sole executive incentive.

Xi's vision for China’s economy is one of optimism, absent of the country’s present economic frangibility as these structural challenges persist. His next term will indeed be formative years for the Chinese economy and it can be expected that he will expand our understanding of state-owned-enterprises and socialist market economies. However, being a state controlled economy in a free market globalized world, Xi will have to make concessions between what socialist values China chooses to maintain and what regulations are ceded to free-markets to ensure Chinese state businesses are internationally competitive.

At a time when innovation is disrupting existing economies, Xi must ease this transition by creating financial regulations to support the aging business sector. Simultaneously, state regulations on businesses need to be reduced if China seeks to remain competitive in the contemporary global economy.

As with most visionaries, Xi's ability to execute his vision will determine his success. Ultimately, President Xi must address China’s structural problems before achieving his dream of seeing the Middle-Kingdom becoming the world’s economic superpower.