Executive Summary: The Third Plenum Roadmap

Avoiding the Blind Alley: China's Economic Overhaul and Its Global Implications

In part three of the executive summary, Daniel H. Rosen describes the redefined mission of government and nine clusters of reform proposed in the Third Plenum reform program. For more on this topic, read Chapter 2 of the full report.

Analysts inside and outside China were skeptical that President Xi and his governing colleagues would move boldly on economic reform at the November 2013 Third Plenum of the Party Central Committee, the occasion at which new economic thinking is traditionally unveiled. They presumed that Xi, like his predecessors, harbored mixed feelings about reform and would shrink from the potential backlash against an attempted overhaul. They were mistaken: the Party issued a bold call for economic reform and attendant regulatory re-wiring that exceeded expectations. The core document, Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening Reform, or simply the Decisions, was accompanied by personal Explanatory Notes under President Xi’s name alone. With this, the president was asserting his power and intention to drive economic change, rather than settle for a speed limit imposed by consensus. Xi’s program set a hard date of 2020 for completing a broad slate of reforms.

At the highest level, the Decisions is a manifesto on modernizing governance. Typical Third Plenums stick to economic work, not political affairs. Yet like its 1978 predecessor, the November 2013 Plenum called for changes in all cones: political and security, as well as economic. The Third Plenum points to the need to fix the balance of power between levels of government (central and local), between state and Party, and between government and governed. The absence of political adaptation doomed economic reforms to failure over the past decade and is thus why the current program is more promising. A revised mission statement for government is the first important element of the Decisions, instructing that economic work be focused on eight tasks:

  • Maintain macroeconomic stability
  • Strengthen and improve public services
  • Safeguard fair competition
  • Strengthen oversight of the market
  • Maintain market order
  • Promote sustainable development
  • Promote common prosperity
  • Intervene in situations where market failure occurs

These objectives are echoed through the Decisions, as well as corresponding instructions to withdraw government from other activities that do not serve these purposes, such as running businesses in competitive industries, requiring unnecessary approvals, and preventing normal restructuring of markets. In short, the Third Plenum set out to make China more of a regulatory state, with regulators and regulatory institutions powerful enough — and well defined enough — to discipline the moneyed special interests that are a natural and even desirable result of economic modernization. China’s new mission statement is generally consistent with advanced-economy concepts.

The Decisions presents well over 300 instructions in 16 idiosyncratic groupings that are hard to decode. We reorganize these instructions according to their principal purpose, and we find that in essence nine clusters of regulatory focus are at the heart of the program.

Center-Local Fiscal Reform

Center-local relations are at the core of China’s fiscal affairs, tax policy debates, resource allocation concerns, and many other developmental matters and are, in fact, the true bellwether of China’s direction. An imbalanced division of power and responsibility between central and local authorities has given rise to pressing misallocations of resources and provincial resistance to central reforms. The Decisions pledged to address this, but in general terms, not specifics, leaving readers uncertain following the Third Plenum. But in a pattern we identify in most other regulatory areas as well, evidence of follow-through was apparent in 2014, confirming that the Decisions was a starting point, not an empty text. Most importantly, in June 2014 Party leaders approved a top-level national plan for deepening fiscal and tax reforms; specifying reform priorities and tasks; and, to the surprise of some, setting an interim deadline of 2016 for “basically” finishing major tasks. Finance Minister Lou Jiwei elaborated on implementation plans at his Ministry, emphasizing measures to reform budget management, improve the taxation system, and rationalize the center-local fiscal system to align responsibilities with resources. Center-local reform was one of the first areas of work cleared for action by the Party leadership because it is foundational to many other areas of reform.

Competition Policy Reform

Robust competition policy enforcement is a hallmark of advanced market economies, which works to ensure that competition is maximized rather than the gains of certain privileged competitors. With China’s Decisions pledging to withdraw government from much of its traditional intervention, it is natural that competition regimes will be strengthened as well. At each level of China’s economy, special interests opposed to competition are common, and the Third Plenum calls to change that. But regulators have been told to act before the government has solidified institutions responsible for protecting due process and evenhandedness, leading to a difficult start in this area. In practice, competition authorities have used new tools in a manner that strikes many in China and abroad as discriminatory, especially to foreign firms. This could be the best of times or the worst of times for creating a pro-competitive environment: Beijing needs to demonstrate whether it is committed to extending due process to all market players.

Financial System Reform

Control over the financial system helped China manage growth for decades, but at the cost of slow progress toward domestic efficiency, and consumers are paying the bill today. Key financial variables remain government determined, including deposit rates, access to banks and lending, exchange rates, equity and debt issuance, cross-border portfolio capital flows, and countless decisions about insolvent assets. Officials speak at length about the importance of systemic reform, and much was already happening prior to the Third Plenum. The Decisions rounds up most of the work remaining: authorizing private small and medium banks, restarting the market for new equity listings, completing exchange rate and interest rate marketization, and much else. In terms of implementation, the exchange rate band has been widened, IPOs have restarted (but in an on and off manner), and shadow banking has been squeezed while new online banking businesses have been permitted. A plan for insurance sector rationalization with interim timetables has been issued. The governor of China’s central bank, the People’s Bank of China (PBOC), has expressed hopes of completing deposit rate liberalization by 2016; the Ministry of Commerce has withdrawn almost entirely from policing outbound direct investment flows; and by the end of 2014, regulators intend to implement a deposit insurance scheme. There has been pushback against many of these goals, and the PBOC softened somewhat its rhetoric about monetary discipline in light of pressure to provide some stimulus. Overall, few people doubt that financial system reforms are proceeding, but many worry that action might be too slow to stave off mounting liabilities.

Foreign Trade and Investment Reform

China is deeply connected to the world economy through goods trade; inward direct investment; and, increasingly, services trade, outward direct investment, and two-way portfolio investment flows (investments in stocks, bonds, and other securities). Early in the development process, China stood out for its embrace of foreign trade and investment, but as it has risen to middle-income status as the second-largest economy in the world, the goal posts have necessarily moved. Foreign partners expect more reciprocity today because China is a peer, and the Decisions sets out the goal of further trade and investment reform because it is in China’s economic self-interest to do so. There are pledges to enforce the same laws and regulations on domestic and foreign investment, and to put market forces at the center of the economy except in exceptional cases. Rules are to be fair, open, transparent, and conducive to providing a level playing field for all firms. Progress so far has been mixed. The Company Law and its onerous registered capital requirements have been fixed, and reform to the three foreign invested firm laws is on the horizon. The Shanghai Free Trade Zone and other next-generation pilot free-trade zones have been rolled out, but poorly and with much disappointment. Opening for some cross-border investment flows has been completed. However, progress toward local negative lists that explain which industries are to be withheld from decisive marketization has been scant, and a national negative list is not yet in sight. More generally, dark clouds have thickened over the foreign invested business community, where even long-time China boosters believe that the pain of inevitable adjustment and re- regulation is being directed to non-Chinese business disproportionately and discriminatorily. So while there is forward progress, it is watered down with misgivings.

State-owned Enterprise Reform

State-owned enterprises (SOEs) and state shareholding are a smaller part of China’s economy today than in the past, but these sectors still dominate the marketplace in many ways. State-owned firms permit Beijing to steer growth in terms of projects, industrial policy, and aggregate demand, and they generate needed revenues for the Party and the government. Observers outside China perceive little interest in drawing down the role of these SOEs, and prior to the Third Plenum, Chinese reformers feared that SOEs would scarcely be addressed. In the end, the Decisions called for meaningful SOE reform, though it is mixed with counter- indications that require clarification. The goals include dilution of state shareholding through the introduction of private shareholders; extracting more profit from SOEs to finance public expenditures; specifying which industries legitimately require state control; and making clear that when the state remains a non-controlling shareholder in a competitive industry, normal market competition should apply.

Readers of the Decisions were skeptical that these changes would be implemented — or could be implemented, given the power of these firms. Reviewing efforts to date, we note that Xi’s team has successfully gone after recalcitrant management at many of the most powerful SOEs, raised SOE dividend payouts to the government, cut executive compensation, and sent auditors to smoke out corruption and special interest dealings. By late August 2014, the State Asset Supervision and Administration Commission (SASAC) in Beijing was broadening implementation of governance reforms at central SOEs, and more than 20 provinces had published SOE reform plans that involved listing or selling off assets in up to 70% of provincial SOEs by 2017. While the end point of this process is not clear — at minimum Beijing surely intends to retain significant stakes in certain firms — change is underway that exceeds expectations and demands careful tracking. The Third Plenum deliverable we consider first in importance, a national negative list explaining where government control will endure, has not been produced; until it is, observers must reserve judgment in spite of other positive movements in this area.

Land Policy Rationalization

In advanced economies, the topic of land reform seldom rises to the attention of policy makers today. In China, it is as important a source of future growth potential as any other factor. Without land reform, it will be difficult for Beijing to realize its goal of bolstering the urban labor pool with as many as 300 million permanent new workers, 200 million of whom are already in towns and cities but are reluctant to relinquish their ties to rural land and commit to urban futures. In recent years, poorly governed local expropriation of land to finance budgets has fostered an unsustainable fiscal system, while displaced tenants are a source of constant social protest. While most foreign observers think little about these links, the Decisions addresses them at length. It pledges to discipline local government’s stranglehold on villagers’ ability to lease out and otherwise employ their land, not just keep small farmers at the till — although those wishing to do so will have their rights protected — but to offer them fair prices, creating an incentive to transfer their rights to more efficient farm operators and seize the opportunity to move to towns and cities. Land policy advocates, long accustomed to sluggish reform in this area, are not holding their breath for implementation. However, a comprehensive land registration system announced in August 2014 is encouraging, with interim deadlines for 2014, 2015, and 2016 along the way to a complete national database by 2017. This system would help improve the foundation for property rights and due process and get incentives to urbanize back on track. Ultimately, fast overall marketization that drives the growth of household income and hence farmers’ wages for their products is the most important support for rural development, and there are limits to what land policies per se can accomplish.

Labor and Shared Welfare

China’s demographics were positive for GDP growth through the Communist era: from 1982 to 2013 China’s working-age population (15 to 64 years old) increased by 375 million people, to just over 1 billion — a marginal increase equivalent to two and a half times the entire U.S. labor force. Today, this demographic dividend has run its course, and China’s labor force size is on the brink of long-term shrinkage. At the same time, 35 years of steady income gains and absorption of surplus rural workers into cities have brought China to a turning point with profound implications for competitiveness and social stability.

The Decisions addresses labor and shared welfare in many respects: education, health care, worker rights, minimum wage, and income inequality. Encouragingly, efforts focused on improving the dynamism of markets and private job creation are being emphasized, and the connection to the importance of safety nets including unemployment insurance is drawn. Reforms to the hukou system, which ties all Chinese citizens to their home addresses for access to public services and benefits, and has constrained internal migration by workers since the 1950s, will be implemented, and the One Child Policy will end for one-third of the population. Beijing also pledges to establish something so basic that it is remarkable that it still needs doing: real public statistics on unemployment rates to guide macroeconomic policy making.

We identify new steps on education and vocational training, insurance, and health care, but action to date remains meager compared to what is needed. Evidence of a real entrepreneurial takeoff is apparent — the number of new business starts, overwhelmingly private, more than doubled in the first half of 2014 to more than 2 million — but labor and shared welfare policies need to be ramped up just as steeply.

Environmental Policy Reform

After 1978, Beijing’s permissive stance toward environmental pollution made it financially easier to build an industrial economy, attract firms that faced mounting environmental compliance costs overseas, and generate outsized profits for firms because of China’s low operating costs. The negative impacts of that stance are now eating into GDP, let alone broader measures of economic well-being that reflect quality of life. The imperative to reform China’s environmental management is stated in the first sentence of the first decision in the Third Plenum manifesto. Promoting sustainable development is one of the eight missions of government, and this necessity is cited to justify SOE reform, tax reform, judiciary reform, and numerous other overhauls. A full tenth of the Third Plenum program is dedicated to environmental concerns. The program promises to put environmental criteria ahead of GDP growth in scoring local officials for promotion and to make polluter emissions transparent to the public through reporting, a tried and true method used in advanced economies.

Though Chinese conditions are likely to get worse before they get better because of the lag between policy changes and environmental gains, we identify some important implementation moves. Populist steps to tear down polluting plants have been publicized, the environmental protection law was amended to allow non-government organizations to bring public interest lawsuits, and tens of thousands of industrial firms are seeing their emissions disclosed to the public on smartphone apps. On the energy front — the biggest source of emissions — meaningful steps to manage coal production more systematically are underway, again focused on public information registries. China’s environmental problems are probably the worst the world has seen, and it is easy to be pessimistic about the prospects for change. However, the advanced-economy world offers many promising examples of livable, appealing places where conditions were noxious not long ago.

Innovation Policy Reform

Land, labor, and capital are finite. Innovative capacity is infinite and constitutes the real difference between high-potential and low-potential economies. China has a storied history of innovation over the millennia, and Chinese people make great contributions worldwide. Yet modern China has emulated more than invented, and recent decades have been fraught with tensions between China and foreign governments over lax intellectual property rights (IPR) protection. As with environmental protection, loose IPR regulation may have added to China’s GDP growth in earlier years but is likely subtracting from growth today. The Decisions emphasizes greater empowerment of market mechanisms to improve innovative capacity in China. It also stresses improvements to the culture of education and the importance of making publicly supported R&D results more widely available. The document goes further and notes that defense sector integration with civilian innovation is important, and that China’s public sector must be attractive to global talent. As for implementation, greater legal support for innovators, including due process and regulatory attention to protecting IPR, is being pushed, though after years of assurances in this area more demonstrative results are needed. Steps to modernize the outmoded reliance on a single national college admissions test — the dreaded gaokao — have been rolled out for 2017 implementation, but habits of rote teaching will take time to alter. The chilling effect of recent pronouncements about national security is palpable, especially in the information technology sector and on the way people communicate online. China, like many nations, is clearly challenged in finding the right balance between security and innovative potential.

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