31 January 2015

Why reforms are so important in China now


China’s slowing economy will need to rely on reforms to give it another boost. In the past few decades, reforms have been a potent development tool, stimulating the economy whenever it has hit a plateau. And yet, the progress of China’s reform program has been less impressive than its design and announcement. The problem is akin to one in which the surgeon has to operate on himself.

Unlike many other developing countries, China’s miraculous growth has been in no small part due to periodic reform programs. A large part of the economic growth experienced before the 1990s came from agricultural reforms. In 1978, almost 70% of the total work force was employed in the agrarian sectors. Labor was oversupplied and wages depressed. Through a series of reforms beginning in the late 1970s, that share of agriculture employment plummeted to 30% by 2007. Labor was reallocated from the ultra low-return agriculture sectors to the high-return non-agriculture sectors; productive use of labor led to significant aggregate productivity, and in turn, GDP growth.

As the growth momentum slowed down in the late 1980s, the government launched another set of radical reforms — intensifying the pace of privatization. By 2005, the share of employment in the state sectors was at a mere 13%, in contrast to the initial 52% in 1978. The reallocation of labor from low productivity state sector to the high productivity private sector was a critical source of rapid growth over that period. As the effects of privatization gradually waned by the late 1990’s, and the economy started seeing a growth plateau, the government launched a third set of important reforms: joining the WTO. Growth rates quickly reverted back to the double-digit levels of the mid-1990s.

So, reforms are a powerful stimulus for a country like China –  distortion-ridden, misallocations galore. At present, as the economy slows down and vivacity is lacking elsewhere in the world, key reforms can be critical. For example, distortions in capital markets remain untouched, and significant efficiency gains can result from financial reforms. The prerequisite for the financial sector reform is to dismantle the system of government-controlled resource allocation. It is crucial to sever the ties between the government and finance, and to break down financial monopoly. The Chinese financial sector is dominated by the state-owned banks, which account for 60% of the total assets of the banking sector. Each of the four major banks claims assets over 25% of the GDP. The state-owned banks in turn, transform household savings into the revenues for the state institutions and the government.

The incentives among government bodies are often not aligned. For example, interest rate liberalization is considered a major step towards setting up a fully- functioning financial sector reform based on market economy. But interest rate liberalization most certainly reduces the spread for the major state-owned banks and squeeze their profits –  and as a corollary –  the revenue to the government. Lifting the control on the deposit rate is likely to lead to fierce fighting for deposit, and state-owned banks will have to relinquish their comfortable positions and face greater competition. Thus, it is not surprising that state banks have warned the government of the inherent risks that interest liberalization may bring about to the financial system. Prudence and caution, and lessons learned from the Western financial crises become convenient excuses for delays in this regard.

The challenge to implementing the recently proposed reform package has been the impediments imposed by the interest groups within the government, and the internal conflicts of interest. These interest groups are ubiquitous. They could be provincial, municipal or county governments; they could be line ministries and regulatory bodies in the central government such as the SASAC and the State Council, and they could also be state-owned-enterprises (SOEs). Often, the institutions in charge of reducing the power of SOEs are the very ones that feed off of their prominence. The SASAC, which are in charge of SOEs, and also in charge of breaking down state monopolies, have no incentives of so doing precisely because it also harbingers the eventual erosion of their very institution. Similarly, SAFE, which controls all the foreign exchange transactions of the commercial banks and households, derives power from being able to intervene in foreign exchange markets and control capital flows. Their incentives to welcome capital market liberalization –  one of the most anticipated and important financial market reforms is weak at best.

It’s been a year since the 18th third plenum. Over this period, the reform committee met 6 times. The state council met 23 times, 18 of which have focused on decentralisation of administrative intervention. The goal has been to reduce 632 administrative approval items, but until now, almost no nullifications have taken place. There have been many “letting go’s” of empty powers, of small and insignificant tasks, but none of the important controls were given up. The vested interest don’t openly dismiss it or reject the reform plans, but instead employ various methods to deter it: inciting the large inherent large risks associated with reforms, and coming up with all kinds of excuses as to why the reforms cannot and should not be undertaken.

Until these inherent conflicts of interests among government bodies and the misalignment of incentives are resolved, the reforms will remain an ambitious dream, a dream than can pacify an increasingly discontent society only in the short run. Thirty five years ago, Deng Xiaoping launched a radical reform program and met with equal resistance among revolutionary ideologues. He was able to brush aside opposition and keep reforms on course. It is time again that China needs a radical rethinking about its future. State capitalism is likely to remain a quintessential feature of China’s economy, during transition and perhaps even in the long-run, but if the government can’t loosen its grip on some fundamental matters, China’s growth slowdown will become an increasingly bitter reality that will have ramifications for all.

Keyu Jin, a professor of economics at the London School of Economics, is a World Economic Forum Young Global Leader and a member of the Richemont Group Advisory Board.