Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

I recently attended the China Development Forum (CDF), a high-level annual gathering for China to showcase itself to the world. Organized by a think tank linked to the Chinese government, the forum is attended by corporate CEOs, investors, policymakers, and academics from around the world.¹ This year’s conference, titled “China in a New Era,” came on the heels of sweeping changes to the Chinese government: removal of presidential term limits, the establishment of a new branch of government, and consolidation of several government ministries, including a new financial super regulator.

2018 marks 40 years since the start of China’s economic reforms, an anniversary that was frequently noted by participants. Chinese leaders have celebrated the 40^th anniversary with no lack of self-congratulations for past achievements and statements of a renewed commitment to reform. What reform means in practice may take on a very different form when compared to the past.

Reform Has A New Meaning

Reform in China increasingly means strengthening the control of the Communist Party (the “Party”) over all aspects of decision making. China’s steady progress towards establishing separate spheres of responsibility for the Party and the government has officially ended. In the era of President Xi Jinping, the Party is ascendant and the government has been demoted to the role of implementer.

Importantly, this does not mean the end of policies to promote the development of markets and the growth of private companies. Chinese policymakers continue to value the efficiency, dynamism, and innovation brought about by markets. The rise of the Party, however, does suggest the possibility that state intervention will remain ever present. Firms, whether private or state-owned, that further national policy objectives will be encouraged and have access to financial support. Those that do not, will face an uphill battle against increasingly coordinated and emboldened economic planners.

Official policy calls for markets to play a “decisive” role in the allocation of resources in the economy. In today’s China, this is only half true. Inputs, ranging from commodities to capital, currently have market-determined prices; yet, there is a reluctance to allow prices to determine final outcomes. China’s current fixation on supply-side reform means that policymakers use administrative fiat to target reductions in industrial output and debt levels. It’s the approach of an engineer, rather than an economist, to solving economic imbalances.

A Central Bank Shakeup

The marching orders for China’s technocrats this year are called the “three critical battles.” These include fighting pollution, alleviating poverty, and defusing financial risks. In the short run, the focus on addressing financial risks will have the largest impact on the economy. China’s ratio of debt to gross domestic product (GDP) has stabilized after several years of runaway growth, which was no easy feat. Chinese policymakers remain focused on addressing weaknesses in banking, insurance and the capital markets. Financial institutions that defy regulatory guidance to reduce risks face severe consequences, as shown by the Chinese government’s recent seizure of Anbang Insurance Group.

Complicating China’s current regulatory blitz is a dramatic bureaucratic reshuffle. The banking and insurance regulators have been combined into one entity, a reflection of high-level dissatisfaction with the growing risks in the insurance sector. At the same time, the People’s Bank of China will take a greater role in fighting systemic financial risks. The central bank’s new governor, Yi Gang, is a steady-hand and represents continuity in monetary policy, having served as a deputy to Zhou Xiaochuan, China’s central bank governor for the past 15 years.

Yi’s authority, however, will not match that of his predecessor. In a break from tradition, Yi was not named as the Party secretary for the central bank. That position was given to Guo Shuqing, the head of the combined banking and insurance regulator, who has stronger political credentials than Yi. Guo will have final say over high-level policy and personnel appointments. This unusual structure is a perfect representation of a large shift happening across China, the Party’s reassertion of control over the government.

Trade and Technology Tensions

International affairs captured as much attention at the conference as China’s domestic developments. Chinese leaders remain fully committed to the Belt and Road Initiative (BRI). Chinese private companies and state-owned enterprises are eager to demonstrate their support for the initiative, both to curry official favor and receive BRI-linked financial incentives. BRI represents a substantial shift towards an international leadership role for China. This shift sits somewhat uncomfortably with China’s continued self-identification as a developing country and its reluctance to shoulder the same level of international responsibilities as the United States.

With respect to the United States, worries about a trade war loomed large at the conference. Chinese leaders took great pains to present themselves as stewards of a multilateral system, opposed to unilateral tariffs, but unafraid to respond to American provocations. Despite the rhetoric, there is a growing recognition in China that certain aspects of the economic relationship between the U.S. and China need to adjust. Policies that force U.S. firms to partner with local companies and share their technology in exchange for market access are increasingly untenable in an era where Chinese firms are striving to be market leaders in many sectors.

This tension is felt most noticeably in the technology sector. Many U.S. tech giants have a negligible presence in China due to a web of market access barriers. At the same time, China’s domestic tech companies are at the forefront of areas like mobile payments and artificial intelligence (AI). A Chinese tech leader outlined why he thought China would win the global AI race: an enormous pool of data from domestic Chinese internet users, supportive government policy, and less concern about data privacy relative to other countries. That last point generated fierce public criticism in Chinese social media, indicating that not everyone agrees with such a laissez-faire approach to privacy.

China’s Economic Future

During the conference one Chinese official boldly claimed that China is now the greatest collection of human resources and talent in the world. This statement is startling, both because it is likely true and because it would have seemed far-fetched until very recently. Despite all of China’s achievements, a host of difficult economic problems still remain. There is a huge gap in economic outcomes for those born in rural areas compared to those born in cities. Urban migration is now slowing and the productivity gains from migration will fall as a result. An aging populace will put pressure on underfunded social safety nets, while the shrinking labor force increasingly constrains growth. Environmental damage left by the breakneck pace of industrialization will require massive resources and generations to reverse.

China has undoubtedly made significant progress over the last 40 years and this year’s China Development Forum rightfully celebrated those achievements. The road ahead, however, is full of both political and economic uncertainty. If I can hazard one prediction, it is that the next 40 years will be as eventful and momentous as the last.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of March 31, 2018 the Seafarer Funds had no economic interest in the entities referenced in this commentary.

1. The China Development Forum was organized by the China Development Research Foundation and sponsored by the Development Research Center of the State Council of China.