Road to the Chinese Dream? Xi Jinping’s Third Plenum Reform Plan

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A year after Xi Jinping took the reins of the Chinese Communist Party, the path that he is setting for the country is coming into view. Soon after Xi became Party Secretary last November, he announced his vision of the Chinese Dream, or the “great rejuvenation of the Chinese nation,” encompassing the goals of transitioning to a moderately well-off society by 2020 (the centennial of the Party’s founding) and to lift the country to developed nation status by 2049 — the centennial of the People’s Republic of China. This November, the 18th Central Committee’s Third Plenum meeting culminated in a sweeping 60-point blueprint for economic, social and legal reforms to launch China on the road toward this dream.

The plan, titled, “The Decision on Major Issues Concerning Comprehensively Deepening Reforms,” turned out to be “far more detailed, far more ambitious, far more unreservedly pro-market reform than many outsiders expected,” says Avery Goldstein, director of the Center for the Study of Contemporary China at the University of Pennsylvania. Adds Pieter Bottelier, senior adjunct professor of China studies at Johns Hopkins University’s School of Advanced International Studies in Washington, D.C.: “This is by far the most ambitious, comprehensive reform plan that I’ve ever seen — it goes beyond the reform plans of 1978 or 1993” under late Chinese leader Deng Xiaoping.

Highlights of the reform package, to be implemented by 2020, include the loosening of China’s one-child policy, the end of labor camps, a declaration that the market plays a “decisive function in resource allocation,” financial and fiscal reform, greater land rights for farmers, the reform of the “hukou” household registration system, and changes to the judicial system, as well as the formation of a new National Security Council presiding over internal security, and a small, elite government body to further reforms.

“The real turning point would have been if they had taken a serious turn to political reform. That is not in the cards, but [these reforms] may unintentionally lead to that.” –Avery Goldstein

The changes are designed to transition to an economy less dependent on massive government investment and more driven by consumption, innovation and market forces, while improving social justice and quality of life. If successful, the reforms would usher in a more sustainable economy and a more mature civil society, putting China within range of other modern, developed countries, say experts. “It’s a quantum change, if all of this is going to be implemented in the next five to 10 years,” notes Bottelier.

Still, the reforms fall short of transformative, Goldstein adds. “The real turning point would have been if they had taken a serious turn to political reform,” he says. “That is not in the cards, but [these reforms] may unintentionally lead to that.”

No Time to Waste

Indeed, by undertaking this plan to address some of China’s most pressing problems, the Chinese Communist Party is attempting to ensure its own longevity, and there is no time to waste, according to experts from Wharton and elsewhere. “So many things in the economy are approaching breaking points,” which, in turn, could threaten social stability, notes Marshall Meyer, a Wharton professor of management.

“If I had to pick [between] fear and greed, the motivation behind the bold language of the reform package is fear — fear of a Soviet-style train wreck,” he says. “I’m absolutely confident Beijing understands the precarious combination of investment-driven growth, indebtedness, and declining GDP growth, productivity and corporate profitability. Starting in 2009, when China started injecting money into the economy [in the wake of the global financial crisis], almost all those lines are going downhill.”

In its rush to modernize since the Deng era, China succeeded in pulling 680 million people out of poverty between 1980 and 2010, providing double-digit economic growth rates while becoming an export engine and factory to the world. But now that economic growth and productivity are slowing, fissures created by the fast growth years are becoming more visible. Particularly after the global financial crisis in 2008-2009, China has increasingly fueled growth through government investment, which has propped up frothy local real estate markets and large, often inefficient state-owned enterprises (SOEs), many led by family members of the Party elite.

The well-connected few are getting richer, while most are still left behind without an adequate social safety net, living in an environment growing more toxic from industrial pollution, experts point out. Xi himself lists many of China’s challenges in the document accompanying the 60-point reform, running the gamut from this type of unbalanced economic growth, irrational industry structure, and weak scientific and technological innovation, to the urban-rural income gap; shortcomings in education, health care, social security and housing; food, drug, and workplace safety; and environmental degradation.

With rising wages, an aging population, declining productivity and an increasingly bloated and inefficient state-owned enterprise sector, China needs a new economic model to achieve the Chinese dream and to avoid the so-called “middle-income trap.” The term refers to a scenario in which fast-growing developing nations get stuck in a rut of slow growth, unable to compete with lower-wage countries and innovation-led economies, leaving them in what the World Bank defines as the middle-income range (having a per capita gross national income of $1,026 to $12,475).

Other East Asian economies, such as Japan, Taiwan and Korea, beat this trap by replacing investment as a source of growth with domestic consumption and exports. In China, the need is even more acute — with investment running above 50% of GDP as compared to a 35% peak in the other countries during their development phases, according to an October report by David Dollar, senior fellow at the John L. Thornton China Center at the Brookings Institution in Washington, D.C., and former U.S. Treasury Department emissary to China and World Bank China country director.

Indeed, each renminbi (RMB) of investment is producing less output in China now — in part due to the larger size of the economy, but also to post-financial crisis stimulus spending, experts note. In the last decade, one RMB of investment created an equivalent amount of nominal GDP growth. Now, it takes three RMB of investment to generate one RMB of GDP growth, according to IHS Global Insights. In a November 2012 paper, the International Monetary Fund concluded that China needs to lower its investment by 10 percentage points of GDP to ensure its most productive use.

Living the Dream?

Yet, for all its urgent needs for a more sustainable social-economic model, China prefers a deliberate, cautious pace of change, and the Third Plenum plan offers few details on the sequencing and time table for reforms leading up to the 2020 deadline, say experts. “Don’t expect the Chinese government to make a radical departure from the past anytime soon,” notes Wharton marketing professor Z. John Zhang. “Xi Jinping said China cannot make any fundamental mistakes. They have to make sure they’re doing it right.”

“It’s a quantum change, if all of this is going to be implemented in the next five to 10 years.” –Pieter Bottelier

Given the number of reforms and the many parties vested in the status quo, experts question whether China can achieve these goals. The last time the nation launched a major wave of reform under Deng Xiaoping after the fall of Mao’s Gang of Four, “Deng walked into a situation where almost all vested interests were destroyed,” Meyer states. “Now, the vested interests have accumulated and will fight back.” They include members of the Party elite, state-owned enterprise bosses and local officials who benefit most in the current economy.

Derek Scissors, resident scholar at the American Enterprise Institute in Washington, D.C., notes that the reform plan reflects unsettled debate among the leadership. For instance, while the plan emphasizes the key role of state-owned enterprises, such as the big banks, it also calls for the liberalization of interest rates, a difficult undertaking when state-owned banks account for 96% of banking assets, he points out. “When interest rates are all controlled by the same people, you can’t possibly get market rates out of that,” he adds.

But, says Dollar, “the need for reform is pretty acute, and there is a good chance that China will succeed.” Still, he notes, “There’s a significant chance China will have an economic downturn in the next five years before they succeed. Then, the important question is whether the country’s leadership takes the lesson that it needs faster reform or allows the opposition to say the whole program is a mistake.”

When times get tough, the reform plan still serves as a lodestar, says Bottelier: “Even if it is not all implemented, they are setting a benchmark to monitor their own performance.”

Unseating State-owned Monopolies

Reform of state-owned enterprises will provide a test for Xi’s mettle, according to experts. The Third Plenum report contains few direct measures for SOEs, besides a new requirement for them to hand over 30% of their dividends to the state. But, says Bottelier: “If you read between the lines, [SOE reform] is pervasive.” For example, giving the market a “decisive,” rather than a “fundamental,” role in resource allocation as “the major theoretical principle” of the plan is aimed at reducing monopoly power, he notes. Furthermore, financial reforms setting market interest rates for loans and deposits would reduce government-subsidized, low-interest loans to SOEs. Xinhua, the country’s official press agency, also reports that the government will issue more SOE reforms early next year.

In addition, Meyer says that allowing private investors in SOE ownership “could lead to representation of private interests on [SOE] governing boards.” So, “without sacrificing the principle of state ownership, this is a way of bringing private market discipline to bear,” he states. Dollar adds that the proposal to “open up oligopolized sectors to foreign and other investors may be single most important change to create a competitive environment where SOEs have to become more efficient, as their super-profits are competed away.”

Narrowing the Rural-urban Divide

Many experts point to plans to close the rural-urban gap as some of the most important and perhaps most immediate reforms to undertake. The measures include granting farmers greater land rights and loosening China’s “hukou” or household registration system, which dictates permanent geographic residency for citizens and the social services they receive. Migrants working in big cities without permanent urban hukou have no access to social services provided by the city. The reform would allow rural residents to move officially to smaller urban centers, though it would still restrict them from large cities, such as Shanghai and Beijing, for fear that those areas would be overwhelmed by migrants. Land reform would allow farmers to rent or sell their land, giving them the financial resources and freedom to seek more productive livelihoods in towns.

“Don’t expect the Chinese government to make a radical departure from the past anytime soon. Xi Jinping said China cannot make any fundamental mistakes. They have to make sure they’re doing it right.” –Z. John Zhang

Experts applaud these moves for their impact on both social equity and economic growth. “For the longest time, Chinese economic growth was based on support from the agricultural sector,” says Zhang. “At this point, for the sake of income equality and social stability, peasants need to be compensated fairly for use of their land and to have a good chance to make a living in the urban environment.” Moreover, freeing farmers to pursue more beneficial work would increase overall productivity, and their higher incomes would encourage consumption, experts note.

Hukou and land reform can also provide the spur for needed fiscal reform, according to Bottelier. “Urban China is a bifurcated society. Of the 700 million Chinese who live in cities, 400 million have urban hukou, but some 300 million are without permanent urban hukous and have no access to schools, hospitals and pensions,” he says. “Migrants save every penny, because they have no access to the social safety net. If you successfully reform the hukou system, you [create] enormous pressure to drive fiscal reform,” so localities can support social services for all. Moreover, giving farmers property rights also helps stem rampant corruption where local officials confiscate land for sale in inflated real estate markets, adds Dollar.

Scissors underscores another silver lining: Hukou and land reform “will free up labor as China’s population ages, encouraging private sector activity. “Unless you give workers the right to move around [to all cities], it’s not going to work,” Scissors says. Though the current reform is a modest first step, Dollar predicts that “China could thoroughly reform hukou in five years,” allowing migrants to move into large cities, too.

Building a Firmer Fiscal Foundation 

Closely tied to hukou and land reform is the need to fix the country’s fiscal system, say experts. The Third Plenum plan calls for the creation of more sources of local government revenue, including property taxes, to help municipalities shoulder the many responsibilities mandated by the central government. Championed by Finance Minister Lou Jiwei, these plans have a good chance of implementation, Bottelier notes.

When Deng started his economic reforms in 1978, China had to create a fiscal system from scratch, setting up accounting standards and a tax collection system, Bottelier adds. Today, China operates under a system that has been in place since 1994 in which the central government distributes revenue to the provinces, he says. Yet, the central government continues to heap responsibilities on local governments without giving them access to more revenues. “The unfunded mandate problem is especially acute at the county government level, [which is] responsible for 70% of the country’s social spending for health, education and pensions,” Bottelier notes.

Meanwhile, China’s property market has boomed, enabling local governments to raise revenues from land leases. “Local governments, on average, depend on land leases for 40% of their revenues,” says Bottelier. “It is the largest source of corruption and social unrest,” with local officials confiscating and reselling property, engaging in secret agreements with developers to rezone agricultural land for non-agricultural uses and the like, he adds. “Property tax reform is the obvious way to go to reduce the dependence of local government on long-term land leases and to open up the way to significant rural land reform, giving better protection to farmers and migrants.”

Liberalizing the Financial Sector

Financial sector reform, long championed by People’s Bank of China Governor Zhou Xiaochuan, is also likely to move forward, if in stages, says Wharton finance professor Franklin Allen. Low government-set interest rates on deposits rob ordinary households of returns on their savings, experts note, while fueling low-interest borrowing by state-owned enterprises. “It encourages wasteful investment and discourages consumption,” Dollar states.

Plans “to liberalize interest rates and to build out the yield curve in the government bond market are exactly the things they need,” Allen adds. China may start on this path by first instituting deposit insurance to protect household savers when deposit and loan rates are liberalized. Eventually, China needs to liberalize its capital account toward a fully convertible renminbi, he says.

In addition, overhauling the system for initial public offerings (IPOs) will help private sector companies gain the capital they need to survive in the marketplace with well-funded SOEs, Allen notes. Currently, companies need government approval for IPOs. Reforms would enable them to register their offerings, a practice that is common in other major securities markets.

 

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