China: The Third Plenum

China’s economic journey: growth, challenges, and outlook

Since opening up to the world 1978, China’s economy has grown remarkably, averaging 9% annual growth, lifting 800 million people out of poverty, and becoming a global trade hub. This success was driven by state-directed industrial policy and market-oriented reforms, known as “socialism with Chinese characteristics”.

The Chinese growth model leveraged a cheap labour force and state subsidies to attract foreign companies, leading to technology transfers and investment. Export income was invested in infrastructure following decades of underinvestment. However, following the Global Financial Crisis, the model came under pressure.

To offset global trade contraction, the government embarked on a debt-financed spending spree focused on ever more infrastructure and real estate. At the same time, China’s export competitiveness eroded as it moved into higher value-added manufacturing, wages rose, and trading partners became less tolerant of subsidies and intellectual property theft. All this led to slowing growth and rising debt.

This was particularly pronounced in the real estate sector which went on to dominate Chinese investment and GDP during the last 15 years. Once it became clear that developers could not reliably meet their existing liabilities, the government began a managed deleveraging of the sector. This has led to numerous developers defaulting on debt, construction halts, and most importantly, a sharp drop in real estate prices. Since Chinese citizens had most of their wealth tied up in either real estate or opaque wealth management products tied to real estate this has caused a notable drop in consumer confidence which has still not recovered. This remains the key short-term headwind to Chinese growth.

The government has chosen to tackle this growth malaise with limited supply side stimulus aiming for a growth target of around 5%. The results are mixed. While growth seems to be on track to meet the target, a deeper look reveals a more complex situation. Consumption remains chronically weak while manufacturing overperformance conceals the structural flaws in the Chinese economic model.

Weak domestic demand means China needs to sell more of its industrial production abroad. However, the international environment is becoming increasingly resistant to cheap subsidised Chinese products that saturate global markets and eliminate competition. The resistance is particularly noticeable in light of Xi Jinping’s heightened geopolitical posturing. Both developed and developing economies are increasingly implementing trade barriers to safeguard their domestic industries while seeking alternative trade partners to reduce their dependency on China.

This trend is especially evident in emerging industries where China has accumulated significant advantage, such as electric cars, batteries, and solar panels. The result is an accumulation of inventory, capacity underutilization, and a drop in prices, pushing the economy towards the edge of a deflationary spiral.

In the medium-to-long-term key headwinds China faces are:

• increased competition from other low labour cost countries for its exports,
• an aging population,
• high youth unemployment,
• increasingly strained trade and diplomatic relationship with the West, and
• concerns about its regulatory and governance approach towards free enterprise.

On the other hand, China remains the global manufacturing powerhouse and is making great strides in technologies of the future, from batteries to AI. It is against this backdrop that the Third Plenary Session of the Central Committee of the Chinese Communist Party (“Third Plenum”) takes place.

What is a Plenum?

The Central Committee is the highest organ of the Party when the National Congress is not in session. The Committee, elected by the Congress, comprises provincial governors, government ministers, and other high-ranking Party officials. Over a five-year term, the Central Committee convenes for seven Plenary Sessions, or Plenums, where they develop and implement the high-level policy agenda set at the Congress. Although there’s no fixed schedule or official guidance, Plenums typically follow a pattern in their policy focus throughout the term.

In reality however, the real power rests with the Politbureau and its Standing Committee. Still, Plenums play a crucial role in building consensus, fine-tuning policy, and communicating it to the public. It is incorrect to view them merely as rubber-stamping policy since Party cohesion on key policy issues is vital for successful policy implementation.

Historically, the Third Plenum has been dedicated to major initiatives addressing the risks and challenges associated with China’s long-term social and economic progress. For instance, it was at the Third Plenum of the 11th Central Committee in 1978 that Deng Xiaoping decisively broke with Mao’s legacy and initiated the economic reforms that transformed China into what it is today.

At President Xi’s first Third Plenum in 2013 markets were given a “decisive role” in the economy’s resource allocation, sparking hopes of further liberalising reforms. However, this was reversed in 2018 when the constitutional term limit was abolished, enabling Xi to run for third term and centralise power among his loyalists.

“New Productive Forces”

This year’s Third Plenum was highly anticipated by policy analysts and investors alike, who were keen to assess the government’s commitment to its growth and reform agenda. While the messaging was positive, the details on how to achieve the ambitious goals outlined in the document were sparse. Moreover, the document largely reiterated the current administration’s established talking points, such as “Common Prosperity”, “New Productive Forces,” and “National Self-sufficiency.”

The key to these aspirations is “Chinese Style Modernization” which aims to elevate China to the GDP per capita levels of wealthy countries by 2035. This goal is to be achieved by harnessing the “New Productive Forces” and deepening structural reforms in the relevant sectors by 2029. These sectors include green technologies like electric vehicles, batteries, and solar panels, where China has already established a significant advantage. The plan also includes ambitions to establish a fully domestic advanced semiconductor supply chain and become a leader in AI.

To realize these goals, private firms will be given a larger role in major scientific research, technological development, and infrastructure projects. To facilitate this, financing will become easier to access, and intellectual property and antitrust regulations will be enforced more consistently. A key distinction from previous similar pledges is that this package of policies will be formally put into law.

Local government financing reform

The other key pillar of the policy agenda is to solve the problem of local government financing caused by the real estate sector meltdown. While the central government runs fiscal surpluses, local governments are running large deficits and are often de facto bankrupt. This will be addressed by fiscal and regulatory reform.

Currently, the main sources of financing for local governments are land sales and bond issuance, resulting high levels of debt and corruption while being unsustainable in the long run. On the fiscal side of things, a redistribution of consumption tax income share from central to local authorities should allow them to have a more stable and sustainable source of financing for day-to-day operations and social programs necessary to reach “common prosperity”. On the expenditure side, central government will undertake a larger share of fiscal expenditure.

On the regulatory side of things, each city will be given full autonomy to regulate its real estate market. Focus will be on establishing a housing system that encourages purchasing or renting together and larger provision of social housing. This is a longstanding personal goal of Xi’s who pronounced even before the real estate sector crisis that “housing should be for living, not speculation”.

Addressing the fundamental imbalances in the Chinese economy

While the abovementioned reforms, if implemented correctly, will no doubt benefit the economy, there is a noticeable absence of measures to address China’s structural issues. The government has reaffirmed its commitment towards supply side stimulus to maintain the industrial lead over other countries but offered little in terms of stimulating domestic demand. As long as this is the case, it is hard to see a path towards sustainable high-quality growth in China.

As previously discussed, the strategy relying on continued export dominance is running into diminishing marginal returns through an interplay of internal and external factors. Resolving the real estate crisis will certainly improve consumer sentiment, but the absence of a genuine social safety net and the persisting high youth unemployment due to a skills mismatch will continue to be issues. The announcement that retirement age will incrementally increase from the current 60 years for men and 55 for women was necessary as China’s population grows older.

What to make of it all

The outcome of the Plenum, compared to expectations, is underwhelming. While the communique emphasises private enterprise and structural reforms investors have good reason to be sceptical. After all, Xi Jinping promised to give market forces a greater role in the economy and deepen reforms at the 2013 Third Plenum, only to expand the state’s footprint in the economy and centralize power over the subsequent decade.

The trend towards more centralisation was evident from a separate readout published under Xi Jinping’s name, which highlighted national security and the strengthening of state enterprises as key elements of China’s future development plan. Additionally, the Plenum confirmed the purges of Foreign Minister Qin Gang and Defence Minister Li Shangfu and pledged to “explore and establish a national unified population management mechanism.”

In summary, the outcome of this edition of the Third Plenum is not a game-changer. However, if implemented, the announced reforms could have a slightly positive impact in the long term. To achieve sustainable, high-quality growth, a more ambitious set of reforms is needed to address the structural imbalances within the economy. In the meantime, the near-term economic slump is likely to persist, and the hostile stance towards “capitalist excess” will continue to dampen investor sentiment both domestically and abroad.