Are China’s Economic Reforms Coming Fast Enough?

It is not a question of “fast enough.” Marketizing economic reforms are arguably not happening at all, perhaps save in one area—the 20 or so amendments to the Environmental Protection Law that were ratified in April. In my opinion, something is not eligible to be counted as a reform until it is backed by detailed, approved, written regulatory guidelines or, better yet, attendant laws. On this basis, the Shanghai Pilot Free Trade Zone (SPFTZ), for example, would not yet count as a reform. Instead, as of now, the SPFTZ is a “concept” that is, in effect, not actionable for true private sector firms that operate on the basis of market factors and transparent rules in China, and not on factors related to political privilege. Given the well-known difficulties in reform implementation and rule enforcement in China—a.k.a. “the top makes policy, the bottom makes counter policy” phenomenon—the definition I assert of what constitutes reform progress might even be considered too generous. Nevertheless, even on this basis, one would necessarily conclude that China’s government has achieved very little on the “marketizing” reform front for many years. There have been few changes that would see markets play a bigger role in the economy, and see market-based competition play a bigger role in driving innovation and productivity gains. Much of the “stuff” now being called reform—permitting State banks to issue preferred shares, for example, or permitting insurance companies to invest minority stakes in State banks, or allowing Chinese cities to raise bonds—are not reforms. Instead, these are tweaks to the existing system that in fact more readily permit money to flow from one pocket to the next within the State sector, and provide the State even more leeway in directing capital and investment flows in non-market ways. They do not achieve or facilitate the much-needed higher levels of marketization in the Chinese economy and business system.

All this said, there do appear to be other “reforms”—we might say “important changes” instead—happening at the top levels of government. Specifically, there appears to be a major re-centralization and shift of policymaking power into the top echelons of the Party, and a corresponding de-institutionalization of top policy processes within the civil government. These “reforms,” however, are not marketizing in any Western sense. It is too early to tell whether they will yield more marketization in the future, or clear a path to more marketization. There is arguably no tangible evidence yet to support an optimistic outlook, but nor is undue pessimism justified. It is simply too early to telll.

Even if reform measures are successfully implemented as designed, China’s medium term economic growth prospects would still be shaky. Reform will surely boost China’s economic growth potential in the long run. But implementation takes time, and in the meantime China faces several demand-side factors that would constrain its growth through 2020.

Reform measures need time to show impact. Previous reforms required less institution-building than this time. For instance, China’s accession to the WTO required minimal domestic institution building while creating a dynamic manufacturing industry from which thousands of Chinese firms benefited. But this time is different. Take the liberalization of the deposit interest rate for example. One of the necessary features before liberalization is creating a deposit insurance system, but that has moved slowly so far. More challenging issues such as moral hazards in the finance and banking sector could take even longer to solve. Deposit insurance would theoretically address and prevent potential bank runs, providing more confidence for depositors. However, such a measure alone does not address excessive risks in the banking sector, including the recent accumulation of debt and potentially bad assets. If banks—particularly systemically important ones—expect the government to consistently step in and bail them out, a free banking system might be even more destabilizing than the current one. So implementing the reform measures is difficult and requires more sophisticated thinking on sequencing and how to mitigate instability to the system. Moreover, once implemented, making sure the measures work as intended is even more daunting. Finally, reforms in areas like banking and capital control could backfire and be a drag on growth if not executed properly.

There is a dark side to China’s past double-digit growth. Looking back, China’s previous growth performance not only has a lot to do with reforms and good macroeconomic management, but also loose monetary and fiscal policy. As a result, China’s corporate and local governments are now burdened by high leverage ratios, which also endanger the stability of the financial system. China’s authorities are well aware of this issue, and try to rein in the growth of debt. But China’s economic statistics are not in their favor. As a result of economic slowdown, inflation has been subdued across the board. In other words, goods are selling for less, which translates into higher real debt (debt measured in units of goods). And China’s effort to rein in credit makes it hard to refinance existing debt. We have reason to doubt whether the current policy is the most efficient one in reducing the debt-to-GDP ratio, since tighter credit reduces debt and GDP at the same time. One possible long-term solution would be to increase the usage of equity, which currently amounts for less than one tenth of debt financing.

China must face the weak global economy. A simple accounting exercise could show you that the majority of China’s recent economic slowdown is due to shrinking current account surplus. There is a supply and demand story behind that. On the supply side, thanks to rising labor and land cost, China has been losing its comparative advantage in low-skill sectors. On the demand side, after the global financial crisis, consumers in the advanced world got busy rebuilding their balance sheets and scaling back their demand for Chinese goods. The future will probably be even worse. China has a large exposure to Europe and Japan, which are both fighting stagnation. Not only will they demand fewer Chinese goods, they will also compete with Chinese firms in the high-end market. Developing countries from Africa to Southeast Asia are integrating into the world economic system, and hundreds of millions of additional workers are joining the world’s low-end manufacturing sector. In short, exports will no longer be an engine of growth for China.

I’d like to address this question from a different angle.

I think it’s generally agreed—including among China’s leaders—that unless changes are made soon, we’ll find some pretty ugly things happening to China’s economy, with dire implications for the rest of the world. That said, China has laid out a very ambitious reform agenda which entails significant adjustments to not only the economic growth model, but also to the mindset and approaches applied to governance and the web of vested interests already embedded throughout the system.

For example: To what extent is the Chinese leadership willing to relinquish its control of the economy and allow the market to play a truly “decisive” role as encapsulated in the Third Plenum outcomes? Is there the political will for meaningful reform of state-owned enterprises? (As Daniel Rosen and other analysts note, a negative list indicating which sectors are off-limits would be a good start—although the concept of negative lists in itself would require a mindset change among Chinese policymakers.) How will the Chinese leadership strike a balance between a continued commitment to reform and maintaining growth targets amid a slowing economy? And most importantly for foreign investors, when will a level playing field be created for foreign and domestic firms alike?

I believe that the Chinese leadership knows what it needs to do, and Rosen’s report describes various steps that have been taken in the right direction, especially in the areas of fiscal, financial, and environmental policy reform. But I agree with David Hoffman’s point that the devil is in the details; legislation and regulations will certainly help institutionalize reforms, but the critical, second piece of the puzzle will be appropriate enforcement of those laws and regulations at all levels of government. One issue, I think, is that China has taken a very “Chinese” approach toward instituting the reforms, from creating the appropriate framework and conditions to the tried and true policy philosophy of starting with the easy things before moving on to the harder issues (先易后难). (This includes politically—I view Xi Jinping’s moves to consolidate power and clamp down on corruption as attempts to advance those objectives). This approach is not illogical, given the scale, scope and complexity of the stated desired reforms. The challenge will lie in aligning it with domestic and international expectations of progress.