China Loses Control of the Economic Story Line

China's growth story wains. Aivars Lode

By Andrew Browne

SHANGHAI—Sentiment on China among global investors has always veered between exaggerated optimism and excessive pessimism.

Even so, the latest bout of gloom is unusually severe. The economic slowdown doesn’t properly explain it. Although the official 6.9% growth last year was the slowest in a quarter century—and many economists believe the real number is more like 6%--China is still expanding faster than almost any other major economy. Banks are flush with savings. The government retains plenty of financial firepower. Unemployment is low.

The reason for the startling mood swing this time goes well beyond the performance of the economy. It’s fundamentally about leadership—how the world’s second-largest economy is run. 

When President Xi Jinping rose to power in 2012, investors knew the economy was ailing—“unstable, unbalanced, uncoordinated and unsustainable,” as former Premier Wen Jiabao famously described it in 2007. His blunt diagnosis of China’s broken growth model was also a kind of confessional; Mr. Wen, together with President Hu Jintao, recognized the problems early but made them much worse with wasteful government investment in heavy industry and infrastructure.

Mr. Xi pledged to do vastly better. Styling himself as a reformer on a par with Deng Xiaoping, he unveiled a 60-point plan to roll back the state and cede a “decisive role” to markets as China set out to switch from investment to consumption-led growth.

Yet entering year four—out of an expected 10—of Mr. Xi’s administration, the reforms are largely on hold.

Capital flooding out of China is one sign that some investors are giving up the wait.

Today’s disillusion is focused largely on China’s future prospects, not its current condition. Absent the reassurance of reform progress, the expectation is that growth will stall. Only the timing is in doubt.

Why the delay? Some say Mr. Xi has been too busy consolidating his power, or that he’s been consumed by his anticorruption campaign. It takes time, they point out, to build consensus on controversial overhauls to rejuvenate state-owned enterprises, open the financial system to greater competition and liberalize land and labor markets.

But evidence is building that reforms have stalled for a more basic reason: Mr. Xi, despite the early hype, sees only a limited role for markets.

There’s been some obvious backtracking on market principles, notably last summer’s crude intervention to rescue the Shanghai stock market when a government-induced bubble burst. Authorities forced brokerages to buy shares, barred large investors from selling and blamed speculators, journalists and even “hostile foreign forces” for the mess.

An offhand approach to markets has had global spillover: International Monetary Fund leader Christine Lagarde, among others, has expressed exasperation with how China spread financial panic by changing its currency regime last year without adequate explanation. For decades, the Chinese leadership countered pessimism about the myriad problems that inevitably beset an emerging economy the size of China’s by spinning a narrative on how market forces would triumph over challenges to growth.

Deng himself was a master storyteller. When investors fled the country after the 1989 Tiananmen Square massacre, he lured them back by journeying to Shenzhen, the cradle of his reforms, in a blaze of publicity. To underline his commitment to markets, he opened the Shanghai and Shenzhen stock exchanges in the early 1990s.

Later that decade, the Asian financial crisis became the prelude to a wave of market overhauls whose momentum has carried to this day. Then-Premier Zhu Rongji negotiated China’s entry into the World Trade Organization—a move intended to shake up state firms by introducing foreign competition—and kicked the military out of business. He also slashed the bureaucracy and championed the private sector.

Mr. Xi faces a far more complex set of challenges at the helm of a $10 trillion-plus economy.

But his big moves to date suggest he thinks he can still effectively control its direction through administrative engineering and state planning. A good example is the way he is merging government enterprises to create even more powerful monopolies. A plan to allow private companies to invest in these Goliaths hasn’t gone very far.

If ever there was a moment when foreign investors needed a strong reform story to lift their spirits it’s right now. Currency speculators are attacking the Chinese yuan in Hong Kong. The financier George Soros thinks China’s economy is already crashing. “I’m not expecting it, I’m observing it,” he told an audience in Davos.

The U.S.-China Business Council, an industry lobbying group, issues a regular scorecard on the progress of Mr. Xi’s ambitious reforms that testifies to dismay among its members. Even though Beijing frequently boasts about its success in cutting red tape and streamlining a notoriously complicated licensing regime, a council survey showed 77% of companies see no progress at all in those areas.

Without a convincing narrative to offer hope of improvement, investors are drawing an increasingly bleak conclusion: On reform, Mr. Xi’s administration is losing control of the plot.