“What we should and can reform, we will resolutely reform. What shouldn’t be reformed and cannot be reformed, we will resolutely refrain from changing.” Not the tone optimists had been hoping for from Chinese President Xi Jinping, speaking this week 40 years after the launch of Deng Xiaoping’s “reform and opening up” policy, which ignited China’s economic miracle.

Real economic reform in China isn’t dead, but its economy may need to get significantly worse before the leadership is convinced it has no other choice.

Given the severe stress China’s private sector is under, with bond defaults at an all-time high and huge amounts of equity pledged as collateral for loans, Mr. Xi’s speech was remarkably light on signals that Beijing is committed to turning things around for private companies.

The speech did urge “unwavering” support for the private economy, but only after calling for “strengthening and developing the state-controlled economy.” Mr. Xi’s speech mentioned the market only around one-fourth as often as President Hu Jintao’s speech on reform and opening 10 years earlier, according to Capital Economics.

That all fits with a Xi administration that has embraced a vision of “reform” without much opening or markets. “Supply-side reform,” has mostly meant shutting down private factories to help state-owned competitors reap higher margins. On debt, regulators have shied away from allowing banks to freely compete for deposits with higher rates, which would force them to lend more to productive private companies, rather than safer state enterprises, to preserve margins. Instead, state-owned conglomerates have benefited from debt-to-equity swaps, while the campaign against shadow banking has starved the private sector of funding.

The good news is, that approach probably isn’t sustainable. Private investment has rebounded modestly in 2018, but mostly due to the bubbly property market, which is likely to stumble in 2019. Profits are weakening and so is the labor market. And corporate leverage has rebounded to 164% of total output after leveling off in 2017, a sign that Beijing’s heavy-handed approach to debt control isn’t working. Administrative efforts to boost private companies and, thus, growth have mostly failed.

That could hand ammunition to economic reformers, particularly since the slowdown is coinciding with President Trump’s pressure campaign. Scattershot new openings for foreign investors such as UBS and Tesla could be replaced with broader concessions on foreign ownership in finance, health care, entertainment and other key sectors, and even on sticking points such as intellectual property.

Much depends on how deep the downturn is next year, and how hard Mr. Trump’s negotiators push. That creates a paradox for investors: Good news on China’s opening is only likely to follow bad news on China’s economy, which would hit global markets hard. Economic reform is overdue but could be surprisingly painful.

ByNathaniel Taplin

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