Waiting for the Plenum

Michael Pettis

It is hard to overestimate the importance to China's near-term and longer-term prospects of the 17^th Plenum in two weeks.  These meetings, held every five years, are the main events of China’s political cycles and it is during these meetings that the big promotions to senior positions within the Party and, juiciest of all, membership in the Standing Committee of the Politburo are made.  The Standing Committee consists of the nine men (previously seven, and there are not completely credible rumors that it may be reduced to seven again – the decision has everything to do with factional fighting) who are the ultimate source of power in China today, and is headed by President Hu Jintao and Prime Minister Wen Jiabao. 

Although the deliberations are secret, the months leading to the congress are rife with factional infighting, sweetheart deals, attacks on frontrunners, corruption scandals, and the all-important maneuvering for promotion.  Unfortunately, on the assumption that that any serious contender must at all costs avoid doing anything that may give rise to criticism before the promotions are decided, the period before the meetings tends to be a time in which very little, no matter how urgent, gets done.  For this reason, although the government is watching with terror China's rising inflation, after the last interest rate move little has been done except to freeze a number of prices, and this latter is rumored to have been done almost solely to prevent rising prices from ruining the feel-good ambience that is always required to permeate the national congress meetings.

Once the congress is over – we expect that to occur around October 22 or shortly thereafter. – the financial authorities have some very serious problems to deal with.  Logan Wright, a Beijing-based analyst who regularly writes excellent reports on China’s financial system for Stone & McCarthy, puts it this way in a September 27 report called “China's Perfect Storm? Food Price Inflation and a Possible PBOC Policy Shock:” 

First, at the same time that pork prices have driven August CPI growth to 6.5%, China has also been ravaged by unusually harsh floods in the south and droughts in the north. As a result, the autumn harvest, which comprises around 70% of total annual grain output, could produce a significant negative surprise, accelerating the rapid rise in food prices. At the same time, global food prices and futures continue to trend higher based on a series of bad harvests around the world, just as China may need to increase imports to supplement its own supplies. Secondly, signs of weakness in the housing sector spilling over into U.S. consumption are developing, and this could have consequences for China's exports, which have been a critical engine of China's growth and a safety valve for domestic overcapacity in several industries. Third, and perhaps most significantly, inflation is more salient politically in China than in other nations, because of its tendency to produce social unrest that challenges the legitimacy of the Chinese Communist Party's rule. Support for the CCP depends heavily upon improving standards of living for Chinese citizens. This means that the Chinese government is very likely to react quickly and strongly in response to a potential threat of escalating inflation. 

I think that one very important change that has happened this year is the very belated recognition, beginning all the way from the top with Wen Jiabao (about whom, unfortunately in my opinion, there are lots of rumors about his wanting to retire), that the arguments about excess monetary expansion and overheating are no longer widely resisted.  It has taken far too long, but I think that the leadership has finally recognized how out-of-control China's monetary and trade policies have been and how dangerous the next few years will be.  In spite of this recognition, there has been precious little done to address the root causes of the imbalance, and I would guess that an important part of the reason has been the reluctance politicians have always had to taking tough measures during promotion time.  Whatever the risks, it is still safer to do nothing now, and pray, then to take the kind of actions that will be needed to address the overheating problem. 

After the meeting, my guess is that we are going to see an acceleration of programs and proposals to slow the economy down, although the fear of creating problems before the Olympics may continue to slow down the process of reform.  What will they do?  I have always believed that the currency regime is at the heart of China’s trouble, and as long as the leadership fails to see this and change the currency regime directly, I am afraid the measures they impose will be more of the same ineffective measures – interest rate changes, administrative measures, etc. – the have failed to slow things down during the past three years. 

I am not enough of a political insider to say what is likely to happen and who will drive policy over the next few years, but there are two individuals who are rumored to be among the candidates being considered for the Standing Committee whose promotion may give some indication of where things are likely to go.  Bo Xilai, the current Trade Minister, has a great reputation for his grasp of economics, his openness to the rest of the world, and his understanding of monetary policy.  Zhou Xiaochuan, the Governor of the People’s Bank of China, is another extremely strong and very smart candidate who is rumored to have been among the most vocal supporters of a faster RMB appreciation.  Generally speaking I don’t think many of the current leaders – whose backgrounds are predominantly in engineering and who are not particularly well-known for their imaginative approaches to new problems – have been able to understand how imbalances are being built up within the economy and banking system, and it is good that so many of the rumored “promotees” are supposed to have stronger backgrounds in economics. 

If either of Bo or Zhou are promoted onto the Standing Committee, I think we may end up seeing smarter and more preemptive activity in dealing with China’s monetary imbalance.  If inflation figures for September and October stay above 5% or even accelerate I think we may see an acceleration of RMB appreciation even earlier than expected.  This is all speculation, but like a lot of people in China I will be following the congress rumor mill very closely.