China's crisis may have finally turned a corner

A week after two consecutive People's Daily articles clearly spelled out the authoritative word on economic reform coming from Xi Jinping in Beijing, the global economy finds itself uncomfortably dependent on a strongman's ability to enforce his edicts. Even so, China's crisis may have finally turned a corner: at the very least, it's clear now who's pushing the badly needed but extremely painful changes (Xi and his central party henchmen), who's actively blocking them (SOE managers and their local government patrons), and who's caught in the middle (Li Keqiang, the State Council, and ancillary central government ministries). And we can be pretty sure who has the upper hand - ultimately - in this power struggle.

Thus far, provincial and local governments have rendered Xi's "supply-side" reform agenda little more than theoretical curiosity in most of the real economy throughout the country, keeping numerous "zombie" SOEs alive with additional credit (debt) that should have been used for retiring idle capital and transitioning redundant workers. China's fate - and possibly that of the entire global economy which has come to depend on it - now absolutely needs this pattern of disobedience to stop. The following chart speaks for itself.

The international consequences of this failure to meaningfully reduce crippling industrial overcapacity are growing, even if a financial crisis and contagion remain relatively distant threats: Europe has rejected "market economy" designation for China after months of hand-wringing over cheap Chinese steel imports apparently tipped the scales in Brussels against what would have been a coup for Beijing in its geostrategic competition with Washington.

So now Mr. Xi can point the finger at recalcitrant party bosses - they're not only delaying China's economic modernization, but in the process also delaying the dream of national rejuvenation on the world stage.

Fortunately (or unfortunately?), the most powerful communist leader since at least Deng Xiaoping has won a small round against the vested interests: credit growth slowed dramatically in April, possibly at his direct urging (and definitely with his strong sanction).

And as I've written, Xi hasn't wasted this crisis to further consolidate power, whether it's purging provincial party bosses or fending off a challenge from Li Keqiang, who has unwittingly emerged as defender of the bloated SOE sector if only because, as head of the State Council (i.e. the central government), he's still officially responsible for implementation of the party's economic policy, and the slow pace of reform on the ground is automatically interpreted as enabling of or even collusion with opposition.

Going forward, then, there's good reason to expect a gradual but steady progress in the kind of supply-side restructuring that's been dubbed "Xiconomics" - which is really Xi's appropriation in 2015 of what back in 2013 was originally "Likonomics", but which fell out of relevance once it became clear that the premier didn't have the political heft to implement his program and was conspicuously overshadowed by the new "central leading groups" of the party created and headed by Xi, even in day-to-day economic management.

In fact, the nuance of the current situation easily makes it appear worse and more unstable than it probably is. It's not as if Xi's simply against credit easing and Li's for it: the $1 trillion first-quarter stimulus could only have been possible if both leaders agreed on the need for monetary and fiscal accommodation to prevent growth from collapsing. But what disturbed Xi more than the sheer size of the package was how much of it was more bad debt to roll over existing bad debt in the redundant heavy-industrial sectors; this he could no longer brook, and because Li's reliability and even loyalty were now more in question than ever before, it was time to come down hard from the very top of the party hierarchy.

In any case, Xi has won - or at least it's clear how he'll win. The good portions of the $1 trillion stimulus are likely to power real economic growth all the way until the 19th party congress in late 2017; the bad portions will fizzle out well before then. With his complete control of the military and security services, Xi can now remove the party's vested interests more easily and has already done so where practicable; his personally driven administration is sufficiently secure now such that even a likely increase in resistance in the near future - inevitable as "old China" stalls further where it's still clung on to life - can conceivably be disposed of without much drama. As the futility of continued intransigent defiance of Beijing becomes apparent, more local party bosses will fall in line, as well. In this way, despite a long and drawn-out battle, few zombies are likely to survive the culling of economic waste that promises to incrementally but steadily accelerate in the next 18 to 24 months, to reach its final completion probably early in Xi's second term (2018-19).

It's a war of attrition, no doubt - and Xi intends to outlast his enemies. Having secured the center, he's now consolidating it as well as putting more of his own pieces in place all over the map. That's why, against all appearances, it's likely that China's crisis - and its transition - has finally turned a corner.