China's future relies heavily on ability to accommodate reform

Flexibility and not allowing interest groups too much influence are the way forward, writes Zhang Jun.

China's "Two Sessions" - the annual gatherings of the National People's Congress and the Chinese People's Political Consultative Conference held every March - have always drawn global attention. But the meetings this year seemed particularly significant, owing not only to the country's leadership transition but also to its economic slowdown amid calls for deeper reform. How, then, will China's new leaders respond?

The problem is simple: no one can predict accurately how long the slowdown will last. The authorities, lacking confidence in their ability to restore pre-2009 rates of annual gross domestic product growth, have lowered the official target to 7.5 per cent.

Many economists are becoming even more pessimistic, pointing to Japan as evidence that, after three decades, China's breakneck growth may be coming to an end. Japan's economy, they point out, achieved more than 20 years of sustained rapid growth; but, in the 40 years since 1973, annual growth has exceeded 5 per cent only a handful of times, and output has stagnated for the past two decades.

But today's pessimists need to account for some fundamental differences between the two economies. For example, Japan was already a high-income country in 1973, with per capita income (in terms of purchasing power parity) at roughly 60 per cent of the United States' level. The "Four Asian Tigers" (Hong Kong, Singapore, South Korea, and Taiwan) experienced a slowdown in GDP growth at a similar relative income level. By contrast, China's per capita income is only about 20 per cent of the US level. In other words, we should not underestimate the Chinese economy's potential to converge towards developed countries.

The pessimists, however, doubt that China can maintain catch-up economic growth. They argue that the present growth model, if not the economic system more broadly, is driving the country into a "middle-income trap". Attributing problems to systemic causes is a typical habit of thought in China. But can a system that has sustained 30 years of hyper-growth really be worse than those systems adopted in Japan and the Four Tigers?

China's economic system, which developed from the institutions of central planning, must have had some merits during this period. But the development and ultimate structure of economic institutions are closely related to a country's income level or stage of economic development. If some aspects of the present system cannot be adapted to support further economic development, they could end up hindering it. What really matters for economic growth is not whether a system is the "best" but whether it can be adjusted to serve a new phase of economic development. From this perspective, it is vital to ensure that an economic system is open to institutional reform.

No economic system, however "optimal", can sustain long-term growth once it is no longer reformable. After its extraordinary post-1945 economic miracle, Japan fell into a pattern of ultra-slow growth because it lacked the flexibility to adapt its institutions for a new phase of economic development, characterised by heightened global competition. By contrast, South Korea has maintained its growth momentum since the Asian financial crisis of the late 1990s. Western economists often criticise its economic system, but the key point is that its institutions are flexible and open to change, which implies a high degree of economic resilience.

Why is one system amenable to reform, while another is not? In recent years,research has indicated that vested interests and powerful lobbies distort economic policies and cause governments to miss good opportunities. A system receptive to reform requires the government to have greater power or wealth than any interest group, thus enabling it to pursue long-term policy goals and ensure the success of reform.

For example, Yao Yang of Peking University has argued that the Chinese government is able to decide the right policies at critical points because it is not unduly swayed by any interest group. It is this neutrality, he says, that explains the success of China's economic transition and its three decades of rapid economic growth.

But what about now? China is entering a new phase of development, and reform in key areas - particularly the public sector, income distribution, land ownership, the household registration system, and the financial sector - has become imperative. Obviously, reform is more difficult now than it was when China began its economic transition. State-owned enterprises, for example, now account for 40 per cent of total corporate assets but only 2 per cent of all firms, which implies significant policy influence. But China seems unlikely to go the way of, say, Russia. On the contrary, the accumulation of wealth in the Chinese government's hands should enhance its ability to press ahead with reform.

Institutional flexibility has been the key to China's economic transition and rapid growth over the past three decades, and it is vitally important that the Chinese government remains neutral and avoids being captured by interest groups. In short, the authorities must ensure that the system remains open to change. Successful implementation of further far-reaching reform depends on it.