Xi Knows What It Takes To Sustain China's Rally

In the days that followed, Chinese stocks skyrocketed. By the end of the week and heading into Monday, though, some sobriety returned as traders started to wonder how many of the lessons from 2015 Xi's team had learned.

More troubling, is perhaps what they didn't. Namely, treating the symptoms of China's challenges with waves of liquidity is no substitute for supply-side reforms that fix the underlying ailments.

In China, circa 2024, the biggest ailment is a property crisis that Xi's reform team has yet to end. The fallout has nudged Asia's biggest economy toward deflation this year and, in the eyes of some economists, put it at risk of repeating Japan's mistakes since the 1990s.

The most obvious lesson is not to go much bigger on short-term stimulus than structural upgrades that repair balance sheets, increase competitiveness and reduce the risks of boom-bust cycles.

The 2015 episode saw something of a whole-of-government response to plunging shares. At the time, China Inc directed waves of state funds into markets, suspending trading in thousands of companies, scrapped all initial public offerings and enabled mainlanders to pledge homes as collateral on margin loans. It even rushed out buzzy marketing campaigns to encourage stock-buying as a form of
patriotism.

Though the response worked for a time, it was at odds with Xi's pledge two-plus-years earlier to let market forces play a“decisive” role in decisions about economic and financial policy.

Since then, this treating-symptoms-over-reforms pattern has played out too many times for comfort. All of which explains why investors worry that marshaling state-friendly funds to buy stocks and save the day might again backfire.

As a result, valid arguments can be made that gains in Chinese shares too often haven't been matched by moves to champion the private sector, increase transparency or strengthen corporate governance.

Only time will tell if Xi's most recent moves to support plunging stock prices might also slow the reform process. But this latest bull run for Chinese shares presents a test that Xi's Communist Party can't afford to fail.

Lu's case at Nomura is that nearly four years of turmoil in the property sector, made worse by Covid-19 lockdowns, has exacerbated troubles with rising local government debt. These pre-existing conditions collided with trade wars with the US and Europe and a Middle East in flames.

“While investors might still be OK to indulge in the boom for now, a more sober assessment is required,” Lu says.

What's needed, say economists like Michael Pettis, senior fellow at Carnegie China, is“rebalancing” efforts that mark a decisive“shift in the economic model” to“reverse decades of explicit and implicit transfers in which households have subsidized investment and production.” And as Pettis views it, Xi's latest fiscal effort“isn't really part of a real structural rebalancing.”

The problem, Pettis adds, is that if China doesn't upend its growth model,“imbalances will continue to build,” meaning the nation“risks facing the same problem in the future as it does now, only without a clean central-government balance sheet to help it manage potential disruptions.”

Breaking out of this cycle decisively is well within reach. Particularly in view of the party's most recent policy conclaves, including July's closely watched“Third Plenum.” There, Xi and Premier Li Qiang demonstrated anew that they fully grasp what must be done to move China upmarket, increase competitiveness and raise productivity.

Among the signals that were music to investors' ears were pledges to:“unswervingly encourage” the private sector; pivot to“high-quality development”; accelerate“Chinese-style modernization”; champion“innovative vitality”; and“actively expand domestic demand.”

Belinda Schäpe, China policy analyst at the Center for Research on Energy and Clean Air, says it's no small thing that the Plenum communique“for the first time mentions carbon reduction. This elevates China's commitment to reducing emissions and tackling climate change
to a new level.”

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Missing, though, has been urgent implementation since. That goes for recalibrating growth engines, reducing the dominance of inefficient state-owned enterprises still towering over the economy and financial imbalances from plunging real estate values to municipalities dealing with crushing debt loads.

To grease the skids for these and other disruptive reforms, says economist Brad
Setser, senior fellow at the Council on Foreign Relations, Beijing must overcome its aversion to fiscal pump-priming.

“The needed reforms to China's central government center around freeing itself from the set of largely self-imposed constraints,” Setser says.“Such constraints have limited its ability to use its considerable fiscal space to help China sort out its current predicament – a shrinking property sector and falling household confidence.”

Setser argues that“the central government has ample space both to assure that the property developers deliver on pre-sales – or provide a refund – and to expand the provision of social insurance while reducing regressive taxes. The central government equally has scope to adjust the revenue-sharing formulas to provide fiscal help to embattled provincial governments, even if that means a larger central government deficit.”

Conversely, Setser adds,“if China's central government has fiscal space – and it uses that space in ways that gives households the confidence to spend more – China might be able to recover from its property downturn on its own, without relying even more on exports .”

A major policy push also must involve moves to build bigger and more dynamic social safety nets to encourage households to spend less and save more.

Xi has made it clear time and time again that he understands how to fashion a more innovative, productive and market-friendly China. His team just needs to act - or pay the price for disappointing global investors yet again.

Follow William Pesek on X at @WilliamPesek

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