The Trouble With China's Reform Plan

The Chinese leadership’s 60-point reform plan announced two days after the close of the Communist Party of China’s third plenum on Nov. 15 went way beyond most expectations. It proposes sweeping changes across broad swathes of the economy, dealing with all of the critical issues and challenges facing China as it reaches for the next stage of development.

The plan’s overarching goals hit all the right reformist notes: “The core issue is to handle the relationship between government and the market”; “In allocating resources the market must play a decisive role”; China “must actively and steadily push forward the breadth and depth of market-oriented reforms,” and “vigorously develop a mixed-ownership economy” (meaning the private sector along with state-owned), says the document, formally called the “Decision on major issues concerning comprehensively deepening reforms.”

The optimists, who have long said the new leadership would meet their lofty expectations and deliver a new vision at the plenum, clearly have been vindicated. The plenum also shows that the new leaders, and Party Secretary Xi Jinping in particular, have decided that major reform is necessary for the continued growth of the Chinese economy. (We already knew that’s where Premier Li Keqiang’s allegiances were.) Good news indeed.

This, however, doesn’t change what has always been true: Defining what specific policies will be adopted to carry out these sweeping reforms, and even more, implementing them, will be extremely difficult. Each of the reforms will have costs for, and adversely affect powerful players in, the Chinese system. The party leaders have set the year 2020 as a target for implementing all of this, presumably in a nod to how tough it will be. And, of course, there’s no guarantee that these reforms won’t be delayed or even abandoned, as the scale of the obstacles ahead becomes more and more apparent.

Very quickly the reforms will come head to head with vested interests that stand to lose huge power. Those include state enterprises, local governments, banks, well-connected princelings, security authorities, and ultimately the party itself.

That is the central paradox of what has been proposed: On the one hand, China can’t continue growing the way it has, and indeed risks social and economic fracture if these reforms aren’t carried out. On the other hand, by pursuing these reforms the party is diluting its control in multiple ways: its privileged role controlling the purse strings, if more and more lending is to go through non-state banks; its leading position guiding the economy’s development, if the private sector starts to move into areas long controlled by state enterprises; and increasingly its sway over the people, as the party loosens the hukou and allows migrants to move more freely where they want, and as it gives farmers more power over the land they occupy. (All with the associated possibility of greater social unrest if huge new numbers of people flow into the cities and feel less inclined to be quiet when they feel the state has mistreated them.)

That quandary probably explains why the party throughout the plenum document seems to be saying it wants it both ways. It wants to move boldly enough with reforms to transform and give new life to its slowing economy; but shows its hesitance toward really giving up control, in the partial, only piecemeal policy reforms it suggests. That becomes abundantly clear when you start to look closely at what it’s proposing in each of the reform areas, and is perhaps most apparent when it comes to state-owned enterprises.

On the one hand, state enterprises are to face more competition. Prices are to be liberalized in oil, gas, power, transportation, and telecommunications, all areas where government-owned companies have dominated. And the role of private enterprises is to be expanded and strengthened. On the other hand, what has been proposed really doesn’t seem to challenge their privileged position directly. Indeed, much language was expended in the document explaining how Beijing can better strengthen state enterprises so they are better able to maintain their dominant position.

A sample: “We must unswervingly consolidate and develop the public economy, adhere to the dominant position of public ownership, with the state-owned economy to play a leading role, and constantly enhance the vitality of the state economy, its dominance and influence.” And the party must “promote state-owned enterprises to improve the modern enterprise system.” (The concept of the “modern enterprise system” was introduced two decades ago to strengthen the state sector and ensure it had continuing relevance.)

The dividends policy, too, could be seen as a bit outdated—party leaders have pledged that state-owned enterprises will hand over 30 percent of their profits to the state by 2020, compared with up to 15 percent today. But the big issue is not getting the state companies to send a little more money to the central government, which can then divert it to good causes like paying social welfare costs. (The hope is paying higher dividends will also force more financial discipline on enterprises, and so improve their efficiency.) The bigger issue is ensuring the SOEs don’t continue to get their very favored access to funding, and maintain, officially or not, their dominant status across key markets.

When it comes to plans to introduce more private capital into the banking system, the document, too, is clear that it will happen only with small and midsize banks—not the larger ones that still dominate lending. And the call made to “accelerate interest rate marketization,” with hopes it will quickly be extended to deposit rates, is not new at all. And it will continue to face the same obstacle as before: Banks rely on the ceiling on deposit rates to maintain profitability; keeping that cushion, too, is even more important now, while bad bank loans are growing.

With the one-child policy, while many hoped for a full abandonment of the policy, what has been proposed is pretty small bore. Before, both parents had to be single children to have permission to have two children—now if one parent is a single child, then the couple can have two children. It’s also worth noting that a relaxation (or better yet outright end to the policy, although that is far from what officials are proposing) is the right step to take, and will help alleviate the serious frictions the policy generates between rural Chinese and local officials.

On the other hand, it will do little to help China overcome the demographic challenge of a rapidly aging population. China has already reached an income level where people simply aren’t interested in having large families anymore. Local governments, by the way, are loath to give up the financial benefits they get from collecting the fines levied on those who break the family planning policy.

On hukou, or the household registration system, while everyone knows it must be liberalized for China to transform its economy into a more consumption-driven one, there is huge resistance from the cities that would then be required to pay the housing, education, health, and increasingly the retirement costs of new urbanites. An easy solution to that problem: Only open up those cities that rural Chinese don’t want to go to.

That explains why household registration reform has long been centered on liberalizing new residents’ access to towns and small and midsize cities, but kept the larger cities off limits. That ensures the costs are relatively low because a much smaller proportion of migrants choose to seek full urban status in towns and smaller cities. Disappointingly, the plenum again promises to liberalize hukou first in smaller towns and cities, with timing on opening up big cities unspecified, but presumably many years in the future. “Strictly control the scale of the population in especially large cities,” the reform document says.

A prerequisite for any of these reforms succeeding is first adjusting the financial and fiscal relationship between the central government and the localities. And the fact the plenum doesn’t move more boldly here is a huge problem. If party leaders don’t ensure localities have more diverse sources of financing, resistance to these reforms will be even stronger. That’s because most of the changes will cost money: paying for a migrant worker’s child to go to an urban public school after liberalizing the hukou policy, for example, or expanding pensions and health care to cover rural Chinese more fully.

Many of the reforms the leaders in Beijing intend to pursue will take away a source of existing revenue from the local governments that are supposed to pay for other reforms. That’s the case with giving farmers more rights to their land, for example. That reform is very much needed for China to succeed in moving to a more consumption-driven economy and to deal with growing rural unrest. But it will erode a principal source of local government revenue, the purchase of farmland at rock-bottom prices and the resale of the land to developers. Ditto with requiring state enterprises to remit more money to the center—that will leave the SOEs with smaller funds for paying local taxes.

The present system of fiscal relations was put in place by Zhu Rongji and other leaders in 1994, and was then hailed as a victory in reasserting Beijing’s powers over a then-economically fragmenting country (he forced the localities to return a much larger share of their tax revenue to the center); today it’s seen by many as the root of the problem, where localities are tasked with paying much of the social welfare and other local development costs, but lack the finances to fully do so.

This causes huge problems ranging from land seizures from poor farmers and overinflated property prices as local governments go into real estate, to corruption in education (teachers and administrators end up relying on “red envelopes,” or under-the-table payments from parents, for their personal income and to run the schools) and even drug-resistant diseases (doctors rely on payments from drug companies to get by, and therefore massively overprescribe).

In one of its references to the fiscal relations issue, the plenum document says China will “establish a mechanism that links fiscal transfer payments with population movement, when rural migrants become city residents”—that’s the “portability” issue for social welfare funds Chinese officials have been talking about for years, and recently has been raised, related to efforts to expand coverage of the pension system. The problem is, there’s little explanation what that mechanism might look like, and efforts to promote portability have made limited progress in recent years. And it doesn’t answer the question of where the money will come from.

The plenum document also says broadly that China will introduce more stable revenue sources for local governments, but again without answering clearly what those will be. Beijing has partially dealt with this problem in the past, by ordering rich places like Shanghai to hand over a portion of their tax revenue to poor places like Ningxia—the document mentions that this transfer process will be more standardized in the future.

Plans to expand a now-experimental property tax that to date has only really been tried in Shanghai and Chongqing—a real no-brainer, as it would both lessen localities’ reliance on land sales revenue, which causes many problems, and help cool overheated real estate markets—still look likely to move at a slow pace (the tax is hugely unpopular for everyone who already owns or sells property, not surprisingly). According to the plenum document: China will “accelerate legislation on the property tax and proceed with reform on the tax in a timely fashion”—that has been the general line for several years now, with only very slow progress made.

Party leaders do mention the possibility of giving local governments the right to issue bonds—something in most cases they can’t do now. Without that channel, many instead turn to unregulated shadow finance. That would be an important step in the right direction, but something they have been talking about for years already. Overall, the language used is not encouraging. The plenum document says officials intend to “maintain the stability of the existing structure of local and central government finances”—that suggests a less-than-enthusiastic attitude toward change.

Meanwhile, the document does its share of proclaiming sweeping goals, without providing any road map at all for getting there. For example, it says that China will aim for a “balanced allocation of resources in urban and rural compulsory education,” while the reality, as we have written, is a rapidly widening gap with schools in the countryside falling apart and being outright closed. And it says China intends to ensure there is no focus in the future on developing so-called key schools in the cities, which benefit from far more funds and higher-skilled teachers. In fact, the disparities between the average public school and these elite institutions are only rising.

Of course, there is much to celebrate in the plenum’s push for comprehensive reforms. We now know that at least at the top of the government, officials have reached a consensus on the need for radical change. The party has put down an important marker, saying China is now at a point where it must make a vast shift in economic priorities. We now know that the leadership has a very good idea of what the obstacles are and, broadly speaking, how the economy must change. And limited though many of the proposed steps for reform may be, a strong argument can be made that moving slowly at first might be the best way to avoid failure. First allow private capital into small banks, first allow migrants into small towns, for example; the bigger banks and cities can come later.

Still, the question remains: Does this group of leaders, unlike all of its predecessors, have the will to preside over the dismantling of a system that has brought them so much benefit? Are they really going to push these radical reforms, even as it becomes increasingly clear how it will undermine their own power and privilege? Can they push sweeping economic reforms without touching political ones, such as allowing real opposition parties and allowing people more say in how they are governed?

Today in China most attempts to push political reforms are quickly squashed. Xi has presided over a big step backward when it comes to allowing larger space for Chinese civil society, with crackdowns on activists and human-rights lawyers. Also telling: While Xi and the party have said battling widespread government corruption is a top priority for all of society, individuals who have led grassroots efforts to fight graft, for example by demanding local officials disclose their assets, have been thrown in jail.

Judging from their statements, the leadership sees economic reform as important because they believe it will shore up the party, and help them maintain their grip on power. That rationale was made clear in a long explanatory note by Xi Jinping, released in tandem with the reform “decision” on Nov. 15. He makes the argument that economic reform is a necessary tool to ensure the longevity of the present political system, and uses Deng’s famous “southern tour” to Shenzhen, where the paramount leader tried to resurrect then-flagging reform almost two decades ago, to make his point.

“In 1992, during Comrade Deng Xiaoping’s speech in the south, he said: ‘We cannot adhere to socialism, without having reform and opening up. If economic development does not improve people’s lives, we will only reach a dead end,’” writes Xi. “Looking back, we can remark on Comrade Deng Xiaoping and reach a deeper understanding. Therefore, now we can say that only socialism can save China and only reform and opening up can develop China, socialism and Marxism.” Xi and the rest of the leadership may be in for a rude awakening.

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