Economy

China’s great reform act

The Chinese economy must reform or stagnate says the World Bank

I like your report, Mr Zoellick: China's Vice Premier Li Keqiang with the World Bank’s boss

The pages of the People’s Daily rarely make for gripping reading, but occasionally they do flag a significant shift in Chinese policy.

In June 1966, for example, it became clear that the Cultural Revolution had gained official sanction when the newspaper wrote: “Facts have eloquently proved that Mao Zedong’s thought becomes a moral atom bomb of colossal power once it takes hold of the masses. The current great cultural revolution is immensely advancing the socialist cause of the Chinese people.”

A new epoch had begun.

So it was significant last week when the People’s Daily again published an ideological editorial (although admittedly not quite a ‘moral atom bomb’ moment) and this time it was on the highly-charged theme of economic reform.

As WiC has indicated in recent issues, the Party’s pro-market wing has been making a lot more noise lately, using the 20th anniversary of Deng Xiaoping’s southern tour as an opportunity to argue its case (see issue 136). And the sense that the market reformers may be in the ascendant was also conveyed by the People’s Daily article last Thursday, which also referred to Deng’s famous 1992 trip.

“Although reform is risky, with no reform the Party will be in danger,” the editorial warned, falling back on some of Deng’s own advice of 20 years ago: “Do not be afraid to take some risks, since we have developed a capacity to take risks.”

After more than 30 years of ‘reform and opening’, China had entered “a new historical position,” the editorial further argued. More, not less, reforms were required. “If the reformers hesitate, or pass the buck – to protect certain interests – they are making the problems chronic,” it postulated.

Why have reforms stalled? “Those with vested interests will use advantageous voices to hinder reform,” the editorial went on. The “mirage of instability” was also used by enemies of change as an excuse to suspend more “progressive” measures.

In a clarion call against these venal interests, the newspaper argued that “imperfect” reform was better than “the crisis caused by no reform,” and ended with the hope that the “reforming spirit” would “withstand the storms”.

Were this an isolated piece of rhetoric it would be less persuasive. But what makes the timing of the article more powerful is that it coincides with action by senior figures with a reform agenda.

In last week’s issue, we wrote about the debate stirred by incoming securities regulator, Guo Shuqing who has suggested that the IPO approval process be overhauled. Rather than have bureaucrats suggesting who is allowed to IPO – a system which has skewed the flow of capital towards politically-connected state firms – Guo has indicated a preference for letting the market decide who can list.

Following on from that were articles penned by a central bank research group on the need to make China’s currency convertible. The first appeared last week in the China Securities Journal; the second appeared this week in the widely-read Caijing Magazine .

As policy measures go, making the currency freely convertible would have a series of radical consequences. It would mean, for example, that a Beijinger could walk into his bank and transfer his entire savings balance to New York in dollars. In short, it could lead to massive capital flight and a crisis in the banking sector. So it’s of special interest that the People’s Bank of China seems confident such a measure could be carried off.

In the Caijing article, the report’s authors argued the economic benefits of fuller convertibility. Yes, the measures would mean the end of capital controls. But that would be no bad thing, wrote the central bank, since “capital controls mean government intervention in the market, which is a disguised form of financial protectionism and prone to moral hazard.”

In other words, by constraining the movement of capital, lending tends to be abused (state banks lend ing huge amounts to shadowy local government vehicles is an example of one recent excess, where bad loans have been the outcome).

Another positive: “Capital account liberalisation is beneficial to both Chinese enterprises’ investment abroad and their acquisition of foreign enterprises.” The central bank team argued that Western enterprises’ are currently trading at “low” valuations (in Europe average price-to-earnings ratios are about 10 times, far below the 17.6 times of Shanghai and 31.8 times of Shenzhen, it calculated). This was a “rare market opportunity” for Chinese enterprises to scoop up foreign blue chips on the cheap, and go global.

A further upside, the internationalisation of the renminbi would see it become an international reserve currency.

Besides, the central bank reckoned the “effectiveness of capital controls has been declining, so expanding the liberalisation [of the currency] may be the ultimate choice”.

In fact, money continues to flow out of China illegally, the report noted. Nor were the sums small – using the ‘net error and omissions’ figure as a proxy for the illegal capital flight, outbound flow had grown to $59.7 billion by 2010, it calculated.

Of course, the proof in the policy pudding comes with concrete measures taken to accompany many of these observations. The central bank doesn’t specify any dates or timetables for its reformist worldview, beyond acknowledging that measures will need to be carried out “prudently”.

But the report reiterates that China first committed itself to the goal of a freely convertible yuan in 1993. That goal is still a clear one and the authors of the article concluded: “We should seize the opportunity to actively promote basic liberalisation of the capital account, to promote the transformation of China’s economic development mode.”

There is good reason why these articles have caused a stir. A freely convertible currency would have major ramifications (a subject WiC discussed in detail in our ‘Rise of the RMB’ Focus issue, downloadable from our website).

In brief, governmental influence in the economy would be vastly reduced (China would also be far more exposed to the sort of financial crisis that hit Asia in 1997). That would trigger wider political repercussions, which makes the timing of the central bank’s articles all the more striking. On Monday, the National People’s Congress (NPC) convenes for its annual session. The Chinese legislative body – or parliament – discusses and approves policy changes (for an explanation of its workings see WiC6) and with political leadership set to change in the coming months this NPC will be more closely watched than usual.

Will it present a mood reinforcing the call for reform or seek to bolster the policy status quo?

At this point, reformists seem to have the upper hand in forcing the policy agenda. Their case was strengthened this week by the release of yet another report, this one co-authored by the World Bank and the Development Research Centre of the State Council (China’s cabinet). On Monday, the report’s findings were then endorsed by Li Keqiang, currently a vice-premier but tipped to replace Wen Jiabao as prime minister.

The study – China 2030: Building a modern, harmonious and creative high-income society’ – said the country must continue “its transition to [becoming] a market economy”. China, it suggested, has little choice but to change its current economic model, which is capital-intensive, environmentally-destructive and largely state-led. Without reforms to foster the private sector and boost innovation, China risks being caught in the “middle income trap”, the World Bank warned.

As the Wall Street Journal summed up, the report was a surprisingly direct critique of Chinese state capitalism. But the World Bank’s dim view of the current model was founded on the notion that “more than one in four state enterprises makes a loss. Besides being less profitable, state enterprises are all less dynamic than private sector firms.”

As a result, the report proposes that a series of radical moves be phased in (albeit gradually). These include “an autonomous central bank” and the liberalisation of interest rates.

In fact, the number of reforms proposed is too many to mention. But in totality – with their emphasis on land rights, the rule of law and the primacy of private enterprise – they would make China look a lot more like a liberal, free market economy, such as Britain or America.

That view does not go unchallenged. After all, less than three years ago, the Chinese were celebrating their own economic model as keeping them out of the worst of the global credit crunch, as well as the subsequent economic crash. And this week, there were others who were ready to eschew the World Bank’s advice. During Zoellick’s Beijing press conference, one protestor caused a scene, telling the bank’s president that the recommendations would harm Chinese interests.

“We don’t want to be exactly like the US,” he insisted. The man – Du Jianguo – also said he was against the privatisation of state firms.

Still, the media has also been picking up on signals that a wider reform process has aready begun. The Economic Observer reported earlier this week that the city of Beijing would soon be following Shanghai in implementing major tax changes. The so called ‘VAT Reform’ is specifically designed to help companies in the services sector.

The Economic Observer has also suggested that rule changes could permit foreign companies to acquire heavy industrial firms in China. Three years ago, the sale of privately-held Delong Steel to Russia’s Evraz (for nearly $1.7 billion) was rejected by the Ministry of Commerce on the grounds that it “endangered industrial safety”. But the Ministry of Information and Information Technology now seems to have signalled a new approach, with the EO reporting that officials want to open up sectors like steel and heavy equipment, permitting acquisitions by foreign buyers.

Previously such sectors had been off-limits.

Also significantly, the State Council announced plans on February 23 to make changes to China’s household registration system, the ‘hukou’. WiC has been predicting reform of the hukou for quite a while (see issue 88). But Xinmin Daily says the newly-formulated measures will be tested in small cities first, allowing migrant workers to get an urban hukou if they can prove stable employment in the city for more than three years.

Currently millions of migrant workers live in Chinese cities but have little access to the services that accrue to city-born hukou holders. Notes China Daily in an editorial: “Migrant workers who have made great contributions to the development of the cities where they live and work are justified in seeking to enjoy the same social benefits as their urban counterparts. It is also reasonable that there should be an adjustment in policies to favour the disadvantaged.”

Apart from the question of social justice, hukou reform also has the potential to unleash new sources of demand. That’s because migrants with new access to basic pensions and health facilities, or able to send their children to local state schools for the first time, will need to save less. The hope is that they will then spend more, boosting domestic consumption.

Hukou reform is one of the many recommendations listed in the World Bank’s report too.

The various reports and announcements have all contributed to a context in which the dominant policy mood seems to be a reformist one (the US-based MarketWatch website even comments a “reform blitz” could be underway).

The Global Times noted too that the topic of reform “is very hot lately.” The newspaper added: “The greatest consensus around the reform is the judgment that ‘we must reform’. That judgement comes from the benefits of the past 30 years of reform in China, and also from the lessons of some other countries that have refused to reform or reformed late, thereby resulting in ‘revolution’ and even national disintegration.”

And the reformist wave also feeds into another major story we have covered recently in WiC – the frenetic political speculation unleashed by the detention of Chongqing’s former police chief Wang Lijun (see WiC138).

Wang’s dismissal and subsequent departure to Beijing has been interpreted as a defeat for those in the Party who advocate the Chongqing model of state-led capitalism and interventionist government. Wang’s former patron Bo Xilai – a candidate for election to the elite Politburo Standing Committee – is also said to have been damaged by the case, probably to the advantage of one of his main political rivals, Wang Yang, who is more often cast as a market reformer.

Wang has been getting more vocal too. According to Nanfang Daily, the Party Secretary of Guangdong recently told a provincial social development meeting: “We must speed up the construction of a small government and a great society”.

Candidates in the Republican primaries couldn’t have put it any better…


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