China's risk from timid reform
China’s leaders are likely to disappoint those hoping for sweeping economic reforms at the next big meeting of Chinese leaders - the third plenum of the 18th Communist Party congress.
|Louis Kuijs, Chief China Economist at RBS|
Luckily, the Chinese economy is sufficiently robust that growth will not be derailed by a failure to tackle a series of intractable problems. Not for now at least. Where there is little resistance to change – for example on financial and monetary reform – we should see real signs of progress at the meeting between President Xi Jinping and top party officials. Broad agreement within policymaking circles means we may also see the plenum endorse higher state spending on health, education and social security.
But the gathering is unlikely to deliver a clear mandate on other issues China must address to rebalance its economy. And, even where it does address problems, the plenum only sets objectives and direction. It is the government’s job to the implement these guidelines.
Expectations for economic reform ran high when a new party leadership was appointed almost a year ago. Many analysts expected Xi Jinping and Prime Minister Li Keqiang to usher in major reforms to direct the economy onto a different growth track.
However, it is far from clear whether China’s new leadership is able to forge a consensus on major reforms in some important, but politically difficult areas. The chances of a breakthrough are not helped by a decision-making system that requires a galaxy of ministries, agencies and interest groups to sign off reforms. That will naturally lead to a more cautious and less ambitious reform agenda.
This does not mean that China’s economy is set for a hard landing, or worse, any time soon. Its economy and financial system are much more robust than the skeptics would have it. But neither does it mean there are no problems or risks along the way.
The danger is that if politically tricky, but crucial, reforms are ducked, China’s overall reform programme could veer away from essential measures to raise productivity and efficiency. The technocrats may succeed in rebalancing the economy but it may be placed on an unnecessarily slow track and one with higher risks to China’s financial stability.
So what policies are likely to emerge from the plenum?
Broadly speaking, the government is aiming to rebalance the pattern of growth more towards domestic demand, consumption and services and the upgrade of its industrial structure.
Specifically, we should see action on the pricing of resources like land, energy, water and electricity to remove what had become effective industrial subsidies. The plenum should support administrative measures to eliminate outdated capacity across a range of industries – despite the poor track record of such attempts to date – and encourage new sources of domestic demand in areas such as information services, care for the elderly and green and energy saving technology.
Decent progress on simplifying government regulation may also emerge.
However, in other areas progress is likely to be limited. The burden of taxation is likely to remain on labour rather than capital. And the advantages enjoyed by state-owned enterprises (SOEs) will remain largely intact. China needs SOEs to pay higher dividends that can be channeled into the central government budget and to level the playing field between SOEs and other companies. It should seek to do that by removing barriers to entry, fostering truly independent regulators and generally making clear the separate roles of state and market.
It is in financial and monetary policy where we may see more progress. We expect the leadership to encourage greater competition within the domestic financial system, a monetary policy with a greater emphasis on interest rates, more flexibility in exchange rates, and a more open capital account.
Policymakers should be careful though. Some senior officials have suggested they want to start opening up the capital account before entry barriers in the domestic financial system have been lowered and the exchange rate has been made flexible. International experience has shown that this raises the risk of financial instability and could direct even greater amounts of capital into relatively unproductive uses, especially if domestic distortions remain unaddressed.
China cannot rebalance its pattern of growth until the millions of migrants who arrive in China’s cities every year have better access to services and housing and are active consumers and workers. Nevertheless, while the plenum will pay attention to improving the nature of urbanisation, there is little chance of major reform of the hukou system - China’s controversial residency system. Nor are we likely to see a substantial change to rules governing the conversion of rural land for urban use any time soon.
To fix the fiscal system, China needs a wholesale reform of relations between central and local government. It should introduce stable sources of income for local authorities, do better at redistributing wealth from rich and poor areas and give local authorities greater incentives to provide public services to migrants. Yet these are thorny issues politically and it would be surprising if the plenum provided a clear mandate in this regard.
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