Michael Pettis is Professor of Finance, Guanghua School of Management, Peking University, author of The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy,  Avoiding the Fall: China’s Economic Restructuring and The Volatility Machine: Emerging Economics and the Threat of Financial Collapse. This morning, Michael Pettis sent his latest missive on China and political reforms – below we excerpt a small portion (with permission) on that topic.

Michael Pettis

Also read Michael Pettis On The Dilemmas Of Chinese Devaluation and China Re-balancing: Michael Pettis On The Six Different Paths

Michael Pettis: Third Plenum reforms will be strongly refused

It is far more likely, in other words, that the reforms proposed during the Third Plenum will be strongly opposed. This was similar to what Deng Xiaoping faced in the late 1970s. The Deng reforms were classic liberalizing reforms, and were strongly opposed by the much of the Party elite, but Deng was able to pull them off, even without the benefit of soaring asset prices. Deng pulled off the reforms mainly because power was highly centralized, and he seemed to have the loyalty of the military. This allowed him to overcome otherwise powerful opposition, although as late as 1992 his famous Southern Tour was aimed at overcoming continued resistance to further reform.

This is the dilemma the Xi Jinping faces. After many years in which the elite benefitted spectacularly from a growth model that was no longer creating wealth for the economy, Xi needed to make reforms that would sharply reduce, or even eliminate, the extraction of rent that is their main source of wealth. With real estate markets already expensive, a small stock market and a weak global environment, there may be nothing else to replace the government as the great source of wealth, and so Xi was always likely to face tremendous opposition in implementing the reforms.

Michael Pettis: Aggressive expansion of credit to solve structural problems

But with debt growing so quickly, he had little choice. In the dry words of the PBoC’s August 1 quarterly policy statement, “It is inappropriate to rely on aggressive expansion of credit to solve structural problems.” Credit has been the pump that created growth in spite of structural constraints on domestic demand, but as debt surges to dangerous levels, it is more and more urgent that Beijing turn off the credit pump.

This will clearly be politically difficult, which is why I have always argued that while economic rebalancing and slower growth need not create turmoil among ordinary Chinese, it must create turmoil at the level of elite politics. This, I think, is the context within which we must understand the anti-corruption drive. It is true that the anti-corruption drive was always likely to be highly popular with a population fed up with naked greed and corruption, but more importantly, it was necessary to ensure that Xi’s team held all the levers of power and that vested interests had become too intimidated to create serious opposition to Xi.

How will this affect the political system?

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Michael Pettis: Political uncertainty in China

I recommend that investors embed a lot more political uncertainty and variance in their projections. I continue to expect that over the next several years growth rates will drop in an orderly way by 100-150 bps a year (although the decline might not always be recognized in the numbers) so that over Xi’s 2013-23 administration we are unlikely to see growth rates much above 3-4% on average, but I think the chances of a “surprise” might be higher than we expect.

One potential surprise is an unintended consequence of the uncertainty on local governments.  As Caixin put it in a recent article, “When coupled with administrative reforms and the government’s no-holds-barred crackdown on corruption, more and more officials have adopted the attitude of doing as little as possible to avoid making mistakes. This bureaucratic lethargy is especially evident in local government departments.” Peking University’s Li Chenyang explains in another, earlier Caixing article:

The premier, Li Keqiang, has sent out inspection teams to supervise the implementation of reform measures passed at the third full meeting of the party’s 18th Central Committee. They found that local governments have put up quite a lot of resistance to the measures, reflecting some deep-rooted causes.

Michael Pettis: CDIC’s reforms not implemented by locals

My field trips have also shown that the CDIC’s reforms have not been implemented by many local authorities. Local party committees used to have all power to themselves without supervision. Now they are required to hand over supervision authority. They must be unhappy.

…More research and exploration is needed to determine the future of the reform. The Communist Party must remain the country’s ruling party. Without challenging the bottom line, is it possible to decentralize power within the party? If so, what checks and balances should there be? Is it possible to effectively supervise and restrain the power of local party committees without overthrowing the old system of governance? These are challenging questions that will take a long time to answer. To implement such a political reform in China is extremely difficult, especially when some high-level party officials oppose it.