The True Value of Reforms

If aggressive overhaul continues, China could establish a stable GDP and position in the global economy

As we reach the one year anniversary of the 2013 Third Plenum meeting and the presentation of the 60-point economic reform program, many observers remain skeptical of its significance. There are a number of reasons for that.

First, the program is difficult to compare with advanced-economy models of regulatory reform. Second, as with earlier reforms, the 2013 program leaves room for experimentation, and the final design of regulations is generally not specified. Third, some commitments were promised and not delivered. And fourth, full implementation of the principles set out – such as a decisive role for market forces in allocating resources – portends a greater transfer of control over the economy than thought to be palatable to China’s leaders. Therefore, rather than bringing about a sea change in business and policy expectations about China’s course, this new agenda has simply amplified debate in China and abroad.

This uncertainty has left policymakers and businesses sitting on the fence, hoping for greater clarity before deciding how to respond. If China is indeed proceeding with a game-changing reform initiative, indecision at this point would be a grave mistake. To gauge whether that’s the case, a new study authored by the Rhodium Group in collaboration with the Asia Society – Avoiding the Blind Alley: China’s Economic Overhaul and Its Global Implications – systematically reviews the design of China’s reforms, the motivation behind them, and indications of movement toward implementation in year one.

Meaning within the manifesto

Embedded in China’s reform manifesto, we find a redefined mission statement for government. A positive list of legitimate objectives for government is set out, one which makes clear that there is no competing Chinese model of the role of the state in a modern economy. These objectives include maintaining macroeconomic stability, strengthening public services, safeguarding fair competition, strengthening market oversight, maintaining market order (a murkier goal), promoting sustainable development and shared welfare, and intervening in situations where market failures occur. A number of these imperatives could of course be bent to protectionist aims, but the 60-point “decision” also includes a range of negative statements about what government must stop doing, such as withholding business approvals without reason, and preventing market exits by failing firms. This high-minded manifesto is not sufficient to ensure reform, but it is certainly necessary to that end.

Reorganizing the 300-plus admonitions in the reform plan, we can discern a few major clusters of regulatory overhaul. Across the board there is design coherence and a recognition of how various reforms interact. Steps toward financial system liberalization, including exchange rate and interest rate reform, financial account liberalization, and new market entry in banking to foster competition, are ongoing, and despite some injections of credit into the economy in 2014, by and large central authorities and the central bank are insisting on adjustment to lower rates of GDP growth rather than trying to prop up activity just for the sake of hitting a target. Central-local fiscal relations are also being revised significantly for the first time since 1994 in an effort to eliminate the perverse incentives which have impelled many localities to over-rely on shell company debt and over-requisition of land for selling off to developers. A meaningful plan with interim deadlines toward that objective was issued this June.

Skepticism

In other reform domains, reforms have been stepped up but the lack of checks and balances, due process accountability, and other aspects of governance reform have perverted outcomes. Competition policy reform seems to be the best example of this. Just as it took the advanced western economies decades to perfect such regimes, China will not succeed overnight, but forthright acknowledgement of the dangers from senior leaders is needed to demonstrate awareness of the risks. In border trade and finance reform, state-owned enterprise reform, land reform, labor and welfare reform, environmental policy reform, and innovation policy reform, significant if piecemeal steps forward are underway. Compared with expectations a year ago, progress has been rapid, though if viewed in light of how far there is to go, the outlook is more disconcerting.

A principle basis for skepticism about reform is doubt as to why the Communist Party would even consider devolving power. The answer, we conclude, is that they recognize that without reform, China’s GDP growth is headed for a fall; in fact, that it is already falling. Demographic dividends, ample returns from voluminous capital outlays, and productivity gains from past institution reforms and technology deepening all propelled China’s growth after 1978. Today, returns on investment are shrinking, the demographic dependency ratio is increasing and a new round of systemic reform is needed to stoke productivity. We calculate that with the reforms suggested above, China can generate 3 percent annual growth from investment growth in 2020 and another 3 percent from productivity improvements (labor growth is at best a zero), for a maximum 6 percent potential GDP growth – still very strong. Failure to implement regulatory reform would eat up those productivity gains, and capital would sit on the sidelines, leaving the nation with 1 to 3 percent growth.

We prefer the 6 percent projection because we observe initial departures toward implementation in each reform cluster, and because the dangers of not reforming are more disconcerting to the Party than the risks of moving forward. Others are not so hopeful, and expect reform efforts to get bogged down. We don’t rule that out. We propose paying close attention to a range of real outcomes in the marketplace to build confidence about implementation.

The next decade

Our analysis of GDP prospects along with the detailed assessment of regulatory reform intentions colors in the implications for foreign trade and financial flows with reform – and without it. Reform that permits China to stay at its growth potential will deliver $5 trillion in GDP growth through 2020, for a total economy of $14.4 trillion in that year. That expansion will support export growth but even bigger import growth, finally moving China into a trade deficit offset by growing income inflows from foreign investments seven years from now. Financial flows, which have been more limited by restrictions than trade flows to date, will see even bigger gains. The stock of inbound plus outbound financial holding will grow by $10 trillion (yes, trillion) by 2020, as Chinese savers diversify into a global portfolio.

These increases in economic activity are the biggest story in global growth over the coming decade and worth getting excited about. However they will come with major disruptions to business, both for Chinese firms bearing the brunt of China’s reforms and for the foreign firms trying to maintain their position amidst reform, nationalism, and the temptations of protectionism that boil up in China, as they do in other nations, when hard economic times set in.