China’s new leaders are bad news for the global economy

One of the big stories of 2012 so far has been China's slowdown.

Up until this year, China bulls argued that growth would never slow below 8% a year, because the party wouldn't let it.

Yet the growth target was officially lowered to 7.5% earlier this year, as it became clear the economy was slowing. And with demand weak across the globe and the Chinese banking system carrying huge bad debts, it could get far worse.

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So you might be inclined to feel a bit sorry for Xi Jinping. He's the new leader of the Communist Party. He takes over from the previous president, Hu Jintao, just as the Chinese economy faces perhaps its biggest challenges yet.

The bad news is that what China really needs is some radical reform. Unfortunately, it's not likely to get it under Xi. And that could be grim for the global economy too.

China needs change

Economic reforms in 1979 kicked off China's boom as the country was able to use its vast supply of cheap labour to grow rapidly. But in recent years, rising wages and soaring transport costs have reduced its cost advantage. Meanwhile, the large numbers of state-run firms are unable to compete with Western rivals on quality.

What's the solution? More reform would help. A World Bank report suggested earlier this year that the state should stop directly running companies. Over time, subsidies should be reduced, and some firms sold off. Given that the report was prepared with the help of a major Chinese think tank, it looked as though this change might be endorsed.

And some of the most conservative politicians have fallen out of favour. Bo Xilai, who wanted a return to the Mao era, saw his career implode over corruption allegations.

There have even been rumours that the leadership was planning for China to move much closer to Singapore's political and economic system. While the Communist Party would still retain power through indirect controls, the hope was that greater openness would cut corruption, while private enterprise would be encouraged.

But change is not what China is going to get

However, these hopes may have been premature. Outgoing leader Hu will still have a large amount of influence, even after the transition is complete in March. So it matters that Hu, in his last speech, put the emphasis on stability, not reform: "We must unswervingly follow the path of socialism with Chinese characteristics". He even suggested that control over the press should be increased.

"The Party leaders have decided that China's political system will remain Communist, centralised, disciplined from the top-down and un-Western," says John McCreary of KGS Nightwatch. Anyone expecting reform has "misread badly the Communist leadership".

For one thing, Xi played a key role in shaping China's response to the financial crisis. That involved printing money to spend on infrastructure and subsidies for state firms. So Xi is hardly a big fan of the market economy.

He won't have a free hand in any case. He will have to get agreement from the Politburo Standing Committee for most major decisions. The most influential of these leaders are opposed to radical change, or have vested interests in keeping the state at the heart of the economy.

Why this matters for you

China is the second-biggest economy in the world. With the developed world still fragile, many people are pinning their hopes on China to drive growth in future.

But reform is needed if China is to move towards being a consumer-led economy. It can't keep relying on pumping money into infrastructure, or selling cheap goods overseas. That model is exhausted.

Yet its new leaders don't look likely to deliver China the kind of change that it needs. That increases the chances of an outright crash. And even if it doesn't, growth could continue to be disappointing.

As we've said before, a slower-growing China will be need fewer raw materials. This is bad news for industrial metals producers and commodity intensive countries such as Australia, which we'd avoid.

But there are potential opportunities. If the Asian giant remains stuck with a sclerotic political system, it will be less of a threat to countries such as Mexico. Mexican firms are already seeing American companies choose to locate their offshore factories close to the border, rather than thousands of miles away.

Meanwhile, other parts of Asia also look more promising than China. My colleagues James McKeigue and Lars Henriksson examine opportunities in both Latin America and emerging Asia in our free weekly email on emerging markets, The New World. You can sign up for it free here.