China’s market crash presages coming political crisis

A financial typhoon from China has sunk stock and commodity markets across the globe. This is neither temporary nor just economic. It represents an existentialist political crisis for the Communist Party of China.

Till now, the party has combined authoritarian politics with steady but limited economic reform to produce the fastest GDP growth in history. Its heterodox policy has been called the “Beijing Consensus” as distinct from the orthodox Washington Consensus. It has succeeded stunningly for decades. China has skyrocketed from low-income to upper-middle income status, and now dreams of becoming an economic superpower. That, it believes, is its destiny.

Towards that end, China has started creating organisations to rival the World Bank and IMF — the Asian Infrastructure Investment Bank, the BRICS Bank and Contingent Reserve Arrangement. Its One Belt One Road strategy aims to make it the leading financier and builder of infrastructure across Asia. China wants its currency, the yuan, to become an international reserve currency on par with the US dollar, euro, yen and pound sterling, and be a formal part of the IMF’s SDR basket of reserve currencies.

That might seem a dazzling prospect. But it means China must open up its financial markets. Reserve currencies have to be fully convertible, along with open financial systems and economies. But full convertibility means opening up China to the full blast of international winds, from which the Beijing Consensus has so far protected it. It will mean an end to tight government control of the economy, and substantial surrender to the vagaries of markets.

Liberal democracies view the boom-and-bust of business cycle as normal, indeed as a nasty but fundamental market process that helps weed out the least productive companies and create space for more productive ones. But boom-and-bust will mean the end of the Communist Party’s iron grip on the economy, and abandonment of its strategy of placing social harmony above everything else, to protect the very legitimacy of Community Party rule. It will mean formally abandoning the Beijing Consensus, allowing foreign investors to stampede in and out of financial markets, allowing foreign industrial and service companies to compete more or less on par with domestic companies, and making many domestic rules and norms subservient to international ones.

Liberal democracies are happy to allow markets to perform their creative destruction, and have neither the capacity nor desire to eliminate economic fluctuations that cause much short-term pain through recessions and bankruptcies. Communist and socialist planning aimed to replace the cruelty of boom-and-bust with steady planned growth, but this proved everywhere to produce worse outcomes than markets, warts and all.

Hong Kong fared so much better than Mao’s China that Deng Xiaoping decided the market was the way to go. He proceeded down that path cautiously. For decades, this gave him seemingly the best of both worlds — the heady growth of markets plus stable communist rule.

But China has now come to a fork in the road, and so President Xi faces a deep crisis that is being cloaked by the current stock market drop. Forget the short-term issue of whether China can stop the current outflow of money from stock and property markets. This matters, no doubt, but is a short-term issue.

Please also set aside the medium-term challenge China faces in shifting from an export-oriented, investment-led economy to one more dependent on domestic markets and consumption. The so-called “middle income trap” means that the strategy for moving from low income to middle income is very different from that for moving from middle income to high income. Many countries have failed to make the transition, and China has to prove it can meet this economic challenge.

But far more important than economic issues is the political one. China’s market collapse shows, for the first time, that liberalized markets have finally become too powerful to be tamed by the muscle of the Communist Party. This loss of political control will deepen with every step China takes towards making the yuan a fully convertible reserve currency.

Liberal democracies can take this loss of power to markets in their stride. But the very ideological and moral authority of the Communist Party will be compromised if it can no longer offer social harmony, with steadily rising living standards. Social disharmony can mean political turmoil and a Party split.

But it seems impossible to put the genie of liberalization back in the bottle. China wants to be an economic superpower. If so, it cannot abandon the path of making the yuan a reserve currency, a symbol of Chinese strength. Yet going down the reserve currency path means opening up the economy to global winds that could conceivably blow the Communist Party off its feet. Interesting times lie ahead.

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