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China’s economy is bound up with Xi’s anti-corruption campaign

14th August 2014

Remember when discussions about China were dominated by whether you thought there was going to be a hard or soft landing? I’ll come back to that later, but you can’t pick up a paper or magazine nowadays, on-line or otherwise, without being drawn to President Xi Jinping’s anti-corruption campaign. For good reasons.

It’s a fairly brutal purge of political opponents. It’s also essential to clear the decks of vested interests who would block the ambitious reform agenda set out by Xi and the State Council at the Third Plenum late last year. It is probably having an impact on the economy now, but it will have a profound effect on economic prospects, one way or another, not to mention on China’s international standing. I doubt that anyone knows how this campaign is going to evolve or end, but anyone who tries to tell you they know what’s going on in China’s economy without putting it in this political context is whistling Dixie, as they say.

A lot of media attention is on the high profile officials Xi’s campaign is going after – I’ll refer to this also below – but the really important issues are why Xi has unleashed this major anti-corruption campaign, and how it ties in with the important economic transformation that China faces. Here’s what I’m going to explore. First, we have to understand the Marxist-Leninist concept of ‘party purity’, which Xi spoke in great detail about at the beginning of 2012, shortly before Bo Xilai was removed from office and several months before Xi formally took up the presidency, and leadership of the Party. It is clear that he knew exactly what he was about to unleash. Second, I’ll summarise key developments and issues in the anti-corruption campaign so far, and speculate a bit about where it’s going. Third, I’ll try and relate this all to what’s going on in the economy and its relevance to China’s prospects.

1. Party Purity: Xi’s 2012 shot across the bows

At the opening ceremony of the spring semester of the Party School of the Communist Party Central Committee in Beijing on 1st March 2012, its president, and Chinese Vice-President, Xi Jinping didn’t mince his words. He launched straight into a discussion about ‘party purity’. Marx and Engels were big on this concept when they established the Communist League in London in 1847, but it’s typically associated with Lenin, who was equally insistent on its importance as the Bolsheviks developed the Communist Party in Russia. Xi cited Lenin’s words that ‘Our task is to maintain our party’s steadfastness and purity. We must raise, raise, and raise again the reputation and effectiveness of our members’.

Xi went on to argue that Chinese Party cadres had to take Marxism, including Chinese theoretical advances, as their guiding ideology, ensure that they always implemented the programmes, regulations and policies of the Party, and that they should shun all interests save those of the working class and the broad masses. Sounds pretty archaic to Western ears. But when Xi discusses the term ‘party purity’, things come alive a little.

Purity, he said, is the guarantee of the Party’s advanced nature and vice versa. So, according to Xi, as China embarks on a critical period of building a prosperous society, reform, and changing its development model, China cannot afford to take risks with purity, that is, by permitting slackness, passivity and corruption to permeate the Party (my italics). Xi went on to emphasise that party purity meant opposing and struggling against all forms of corruption and defending the health of the Party. Echoing Comrade Mao, he insisted that leading cadres must possess a correct world view, a sound approach to exercising authority and carrying out their duties, and set an example of incorruptibility and self discipline. They must at all times, he said, display the honesty, uprightness and integrity expected of Communist Party members.

You can see where this is going.

He then went on to say, though, that some leading cadres had violated discipline, broken the law and fallen into the abyss of corruption and degeneration essentially because their outlook on life and the world went badly wrong and they lost all ability to resist temptation. All leading cadres should take heed of and be warned by these examples, and they must resist ‘money-worship, pleasure-seeking and extreme individualism.’

This speech was made on 1st March. Exactly 14 days later, Bo Xilai was removed as Party chief in Chongqing, and barely a month later, he was stripped of all his Party posts. As we know now, he was expelled from the Party in September 2012, and later faced trial, at which he was found guilty of corruption, bribery and abuse of power, and sentenced to life imprisonment.

After making remarks that seemed deliberately aimed at Bo, Xi went on to warn his audience, and more especially his adversaries, that leading cadres should not prioritise personal gain over carrying out their responsibilities faithfully, and that they must measure up to the standards of advanced thinking and purity expected of Party members. ‘If they work for the sake of appearances’, he said, ‘hanker after recognition, try to fool the public with claptrap, chase fame and money, plow ahead without thinking, not only will this harm the people’s cause, but it will also damage the party’s image and cause the people to lose trust in us’ (my italics).

In effect, Xi is telling the Party School cadres that China is going through a period of enormous economic change and that the Party’s primacy and integrity are sacrosanct. He is acknowledging that ‘elements’ in the Party have abused their positions, and that unless they are brought to heel, and the Party is restored, so to speak, it could be severely compromised by lack of trust when enormous economic and social changes are called for. Xi didn’t mention Gorbachev or the USSR at this meeting, but he did subsequently say at a Party meeting in Guandong Province in December 2012 that it was imperative for China to heed the deeply profound lessons of the collapse of the USSR, where, according to Xi, the failure to stick with Leninist discipline and Party purity allowed ‘political rot, ideological heresy and military disloyalty to undermine the governing (Communist) party’.

This endgame remains the Chinese Communist party’s biggest fear, and goes a long way in explaining Xi’s insistence on the need for Party purity. It’s worth pondering these remarks, better still reading the speech at to try and integrate properly what the anti-corruption campaign is all about. It’s probably not an exaggeration to say that Xi sees this as the Party’s do-or-die moment, as the insightful commentator John Garnaut has opined recently.


2. Anti-corruption broadside 

Xi’s campaign to weed out corruption and reform the Communist Party already looks totally different from anything that past governments have done since Mao died in 1976, the leadership passing to the spritely 74 year-old Deng Xiaoping two years later. After bringing down Chongqing governor Bo Xilai in 2012, who was seen as a renegade and importantly, a serious political rival to Xi, the campaign gathered huge momentum. By last year, roughly 182,000 people in an array of regions and levels of government in state organisations were disciplined for corruption. The major focus, of course, has been on the investigation of 45 top-ranking officials, or ‘tigers’ as they have been labelled, as opposed to ‘flies’.

Foremost among them are Zhou Yongkang, China’s security chief, a leading Party figure for over a decade, member of the Politburo Standing Committee (PSC), and associate of Bo, with strong ties to the oil and energy industries. He is the most senior leader to have been purged since the Tiananmen events of 1989. Supposedly, but hard to verify, 300 people close to Zhou, including family and former aides have been detained, and property with an estimated value of some 90 billion yuan, or roughly $15 billion has been confiscated. Zhou is being investigated and will be tried for ‘serious disciplinary violations’.

Zhou’s name has been in the frame since May 2012 when senior Party officials accused him of backing Bo and trying to revive the China of Mao, but the most recent high-ranking official to be banished from the Party, and face corruption charges is General Xu Caihou, former vice-president of China’s Military Commission, and one of the most powerful men in the People’s Liberation Army.

Bo, Zhou and Xu all developed their careers as proteges of former President Jiang Zemin, who served as General Secretary of the Party from 1989 to 2002, President from 1993-2003, and Chairman of the Military Commission from 1989-2004. His power base is Shanghai, and he has been an important behind-the-scenes figure, fixer, and power-broker ever since he relinquished his formal positions. He groomed and maintained a strong influence over his successor, Hu Jintao, and most recently, helped to steer Xi to the Party’s summit. But at the end of July, the Party’s Central Commission for Discipline Inspection (CCDI), whose Secretary, Wang Qishan is a close ally of Xi and member of the PSC, was sent to Shanghai for a 2-month investigation. It was announced recently that Wang Zongnan, former chairman of two SOEs in Shanghai, has been arrested for corruption. Doubtless, other Shanghai officials, past or present, will be scooped up in due course.

Every new development raises intriguing questions about what comes next. If the CCDI is undertaking investigations in Shanghai, the focal point for financial reform among other things, could it conceivably be looking at Jiang himself, or at least his entourage given that Jiang is 88 years old?  Since one of Hu Jintao’s proteges, Hu Chunhua, now Party Secretary in Guandong province and Politburo member, is on the anti-corruption campaign’s radar, is Hu Jintao, himself, at risk? If he is, what about Wen Jibao, the last Premier, whose family network, wealth and control over diverse economic and industrial interests is legendary, if by no means unique?

Trenchant questions which I can’t answer, and which most people can only speculate about. It seems unlikely that Xi will try to ensnare some of the biggest and most powerful families in China. There are too many of them, they are very powerful, and they are well-endowed to form serious opposition to Xi, and destroy hopes for serious economic reform and new governance and ownership initiatives in SOEs.

Regardless, we should assume ‘the show goes on’ and that more ‘tigers’ will be brought down. There are new reports all the time, the latest being of Zhang Dongsheng, a former director of the finance department in China’s powerful National Development Reform Commission, previously known as the State Planning Commission and the country’s top macroeconomic management agency. Zhang is being investigated for corruption in relation to the issuance of  medium- to long-dated corporate bonds issued by non-financial and non-listed companies over which the NDRC has responsibility. The bonds in question were issued in 2005, but this may only be the first ‘case’ arising from previous investigations undertaken of securities companies which have spilled lots of beans to the authorities. At the very least, one imagines that the campaign will continue to investigate and charge several senior people, while also sidelining others who may belong to factions or cliques that don’t ‘fit’.

One such senior person is none other than Premier Li Keqiang, the only Ph.D economist in the leadership and widely viewed as the principal proponent of market-oriented reforms and an activist policy of structural economic change. But for several months now, it has looked as though Li’s role has been downgraded, with Xi taking on the primary duty of steering economic reforms, as well as briefing international leaders on economic affairs. Many of Li’s pets, such as severing the economy’s dependence on credit creation, greater tolerance of defaults, urbanisation, the Shanghai Free Trade Zone, and local government governance reform have been caged, or at least been diluted significantly.

There are a couple of things we can deduce perhaps:

1. The anti-corruption campaign is not about to peter out, and will likely continue for the foreseeable future. If you’re in the optimistic camp, the persistence of the campaign is a sine qua non for economic reforms that could change China’s development model, introduce more market-oriented resource allocation mechanisms, and improve governance in State institutions and economic entities. All within the confines, of course, of preserving the dominance of the State in the economy, and the Party at its head.

But running a major anti-corruption campaign isn’t an engineering challenge with a neat beginning and end. So, if you’re more skeptical, you might see at least two problems: first, if anti-corruption only picks off a few rotten apples, it still leaves an essentially diseased tree intact, i.e. the systemic nature of corruption. Second, if the anti-corruption campaign is to be kept going, regardless, it’ll have to be refreshed continuously, and at some point, cadres at various levels of administration may develop their own campaigns, and momentum may then become difficult to control.

2. Xi’s campaign isn’t just a power struggle, although it is also that. It’s also about reclaiming ownership of the Party (for the princelings, or progeny of the original revolutionaries), and, as Xi has said, restoring Party discipline to enhance legitimacy in the face of the masses and a weakening economy at a time of structural change.

But how can even a purer Party with stronger authority and legitimacy spread prosperity to a rising middle class while it insists on the primacy of (economically and politically stifling) state institutions, and the subjugation of the rule of law, and real security for all with regard to property rights?

Interestingly, the Fourth Plenum, which will take place after the summer, has already been earmarked to focus on the rule of law. But when the Party speaks of the rule of law, it really means strengthening the effectiveness of rule by law. In a system that subordinates the role of the judiciary and legal system to that of the State, and in turn, to that of the Party, rule of law is a meaningless concept. We might expect initiatives to try and improve the efficiency and sensitivity of local and provincial government courts and legal processes, and make them succumb more to Beijing’s wishes. We might expect some attempts to reform the laws governing local government financing and accountability.

But you have to be an unbridled optimist to imagine that the rule of law, as is commonly understood, can plant roots when dissent, internet and social media outlets, and calls for universal justice are suppressed. As a further example of dogma that is wholly incompatible with the rule of law, only last year, university teachers and professors were given instructions to avoid classroom discussion of seven topics, termed the ‘7 Don’t Speaks’, which comprise universal values, freedom of the press, civil society, civil rights, the Communist Party’s historical errors, crony elites, and judicial independence.

Cynically, rule of law may simply be a ruse to underscore the ‘don’t speaks’, and or to intensify the campaign against corruption in the police and security forces associated with Zhou. We shall see later this year what emerges, but best not to imagine that China is about to undertake comprehensive reform of the legal system and, for example, establish a system of independent legal judgement and neutral contract enforcement. It’s just not going to happen.

3. And as for the economy…..

I won’t examine here the short-term cyclical performance of the economy, which I have written about elsewhere on the website. Suffice to say that I continue to see a pattern of continuous downgrades to China’s economic prospects. The IMF’s World Economic Outlook isn’t known for its outrageous or wacky forecasts, and so we can take its projections as representative of private sector consensus. The last time it was forecasting double-digit growth on a five year horizon was 2009. Since then, the intermediate term economic forecasts have been revised down steadily from close to 10% to now, around 6.5%. I expect this pattern will continue to reflect a) the secular fade in the leading edge role in growth played by China’s real estate and construction sectors and b) the inevitable slowdown, sooner or later, of credit creation and debt accumulation. During Xi’s period in office, which runs to 2022, I expect China’s GDP growth to slide to 4-5%, and there may be periods when growth doesn’t even make it to this level.

Everyone can agree though that the anti-corruption campaign is going to have a meaningful impact on China’s growth prospects. I’ve heard optimists argue that even if anti-corruption measures are dampening down ostentatious consumption now, they will ultimately have strong, positive effects on economic growth. Simply put, if the Party and state institutions increase their legitimacy and effectiveness, and become more compliant, then economic reforms and ‘marketisation’ will be more successful, resources will be allocated more effectively, people will become better off, and China will be able to circumnavigate the middle-income trap into which most such countries have lapsed.

But this is political rhetoric, not economics. It doesn’t ask why China’s economic model isn’t working well any more, where China is in its development path, and what sort of economic structure China needs to build in order sustain growth and rising living standards. Equally if not more importantly, this sort of argument says that Party purity will be an elixir to make everything work better, without asking what sort of institutional changes to avoid the infamous middle income trap, and whether those changes are compatible with the Party’s philosophy and raison d’etre.

So here’s a more searching assessment that begs a lot of questions.

The first thing is it is simply not going to be possible to sustain economic growth at 7-7.5% while the economy is rebalancing. The secular downturn in investment growth, especially of real estate and construction, and the inevitable unwinding of credit creation and debt accumulation, sooner or later, will affect economic performance negatively long before policy reforms possibly lead to higher productivity growth.

Real estate and related construction investment account for about 16% of GDP, and while transactions volumes are in the process of falling significantly, prices are not falling that sharply yet. Even so, it will be a surprise if property and land prices do not fall further. Even if households are shielded by virtue of the relatively low share of mortgage debt in relation to income and GDP, land and real estate account for about two-fifths of the collateral behind all commercial bank assets. So, the knock-on consequences of the fade in real estate investment are likely to permeate the economy for some time, even if the banks themselves are at little risk of a Western type liquidity crisis (because the People’s Bank will presumably make good any shortfalls). In any event, the de-leveraging process is still at a very early stage and we would probably need to see several quarters of declining transactions volumes in real estate, defaults, and falling credit to GDP before judging that the sectoral unwind was complete.

Credit growth is certainly slowing down from rates of 30% or so in the not too distant past, but growth in total social financing (which slowed precipitously in July after a feisty June) is still rising at about 17% per year, more than twice the rate of money GDP growth, so that the debt to GDP ratio continues to increase. At roughly 250% of GDP, non-financial debt has already breached levels normally associated with countries with China’s income per head. As it continues to increase, China’s financial and economic stability will become increasingly compromised. Contrary to some views, it won’t be easily ‘fixed’ by regulations and a stronger ‘purity’ among SOEs and local governments because credit (debt) creation is now how China’s economy keeps going at 7-7.5%. This isn’t to say that regulations and purity have no function, but as Michael Pettis has argued tirelessly, debt has to be paid for via losses and write-offs, losses assigned, and recognised in the balance sheets of households, and or private and public enterprises, and or the state. As he says in a recent blog ‘The key point is that we cannot simply put the bad debt behind us once the economy is ‘reformed’ and project growth as if nothing happened’. In any event, what he’s saying is that the debt has to be accounted for, it doesn’t just disappear (unless it’s inflated away, which begs new stability questions), and the reform is still a very early work-in-progress.

Time is becoming more important because China’s economic and financial transformation can’t wait while debt and balance sheet issues fester. The longer the wait, the greater the build up in debt, and the harsher the downturn in economic growth is likely to become.

Implementation of policies is always important in China. The Party’s post-Deng pragmatism is renowned, but reform and policy implementation, as laid out in the Third Plenum’s many broad goals are not comparable to the challenges faced by China’s leaders in the 1980s or the 1990s. The country is richer, more complex, and nurturing a rising middle and entrepreneurial class with stronger political aspirations in an environment of ubiquitous communication and social media.

Economic reforms have to go much further now that China can no longer derive growth from the deployment of physical labour, or from limitless capital accumulation, which is precisely the opposite of what rebalancing demands. They have to encourage a different sort of economic growth, based much less on the dominance of state institutions, and more on innovation, higher educational attainment standards, stronger productivity, and entrepreneurship. It’s worth noting also that technological change is driving China (and everyone else) to look to these solutions, not least because automation, including AI, robotics and 3-D printing processes are slowly and surely undermining the advantages conferred by plentiful and low-cost physical labour. In any event China’s demographics are changing so fast that the working age population share of the population is already declining, and rising wage costs are already sending producers ‘home’ if productivity- adjusted costs warrant, or to even lower cost, traditional manufacturing nations in Asia, such as Vietnam, Cambodia, and Bangladesh.

The key for China is to build inclusive institutions and government, and widespread governance reform. This much China’s leaders understand well. The point is whether the challenge, at least in some important respects, is incompatible with the central philosophy of Party. In this blog, I’ve tried to argue why President Xi insistence on Party purity is so important to him and the leadership, and the economic outcomes for China. I’ve also tried to emphasize that even a purified Party isn’t the answer to China’s economic problems and challenges, and that changes in economic structure may well require purity AND changes in political structure that the Party can’t deliver.

Purity is fine as far as it goes, but alone it isn’t enough. Taken too far, it can lead to a dictatorial style based around the prestige and personality of the leader, fear or inertia among officials, politically over-active cadres and other things that end up impeding change and initiative, rather than encouraging them. In any event, Xi doesn’t look like he’s going to falter at this point. While we’ll watch the economy, investment and credit trends closely, and monitor reform initiatives in any case, we should not lose sight of the economic causes and consequences of the most important political campaign in China for 25 years.