There are few reforms in China's great aspirations

China is in need of market-based reforms, but a genuinely competitive economy will only be achieved if the dominance of its state-owned enterprises is wound back.

The key word everyone wants to hear from Chinese leaders these days is ‘reform’. From a widespread expectation a few years ago that China could defy economic gravity and grow at double digit rates for generations, the same bulls who treated any criticism of the Chinese growth model as Western economic chauvinism and envy now sagely tell the world that this same growth model is in desperate need of ‘reform’.

In addressing the National People’s Congress last week, Chinese Premier Li Keqiang spoke more about his determination to maintain growth at 7.5 per cent than he did about reform. The Premier did say that “reform is the top priority for the government”, and offered some examples of seeming reform. For example, idle factories will be shutdown. Private investment is to be encouraged. The environment will be improved. Government red tape will be cut. The economy will be powered by consumption rather than fixed investment. Are these mere aspirations, genuine reform, or something else?

Most will say that whatever these are, it is at least a good start. Perhaps, but I would argue that what the Premier is getting at should not be counted as reform. They may be aspirations, or they may even be solutions to current problems. But they are not instances of reform.

First of all, what is ‘reform’? More precisely, what is ‘market-based reform’ which is what Chinese leaders say they are committed to?

In my view, there are only two kinds of ‘market-based reform’. The first is encouraging, supporting and entrenching genuine competition between firms and individuals. The second is building and improving institutions that are required for fair and even transactions between economic entities for competition to flourish, and for ‘creative destruction’ of underserving economic entities to occur.

Let’s look at these in turn.

Take competition. A genuinely competitive environment allows firms and individuals to thrive if they do at least one (if not both) of two things. Either they are more efficient at doing something (they produce more output using the same capital/labour inputs than other competitors,) and/or they are better at offering goods and services that the market wants.

In China’s case, this means winding back the special opportunities, privileges and other aid offered to state-owned-enterprises in order to allow merit-based competition to thrive. I have written about this elsewhere (in The Australian and The American Interest), so I won’t go more into the SOE issue now. But it is clear that almost all of the so-called ‘reforms’ introduced tend to offer tactical fixes to the problems created by the dominance of SOEs rather than seek to wind back or dilute SOE dominance in the Chinese economy itself.

Take the measures to encourage consumption, such as increasing the social safety-net for some residents. This will never be enough to significantly raise consumption to a level required for it to be a driver of economic growth. In order to dramatically raise household incomes across-the-board, the best thing Beijing could do is to strip away the advantages offered to SOEs so that far more opportunity and access is available to millions of more deserving private firms. This would spread opportunity away from the approximately 144,000 SOEs in favour of the millions of private firms.

Indeed, the suite of policies designed to favour SOEs directly suppress consumption in order to promote investment by SOEs. Interest rates are kept artificially low in order to provide cheap capital to SOEs in fixed investment dominated sectors. The capital account is closed meaning that Chinese households have to deposit their savings in state-owned banks. And they receive an artificially low rate of interest in return.

Or take the Premier’s support for the rise of a small private banking sector. The hope here is that private banks will increase lending to capital starved private firms. But without winding back the advantages afforded to SOEs that simply won’t happen. Because SOEs are given so many advantages, and are implicitly guaranteed by the state, any bank – private or state-owned – will be more inclined to lend to an SOE rather than a private business. In other words, private firms are short of capital because of China’s state-led model of development. Any change that does not wind back the dominance of SOEs is simply just change or at best a tactical fix, not market-based reform.

Note that in assessing the market worthiness of firms, profit is not the proper criteria in China’s political economy. Many SOEs tend to be profitable because of the advantages given to them – not because they are more efficient or better at offering goods and services that people actually want. Indeed, multiple studies show that private firms are at least 50 per cent better in terms of their use of capital and labour inputs than SOEs in the same sectors. Some surveys indicate that private firms are 2-3 times more efficient.

Or take environmental destruction. China has flirted with the idea of erecting taxes on pollution and other measures designed to help the environment. Yet the low cost of capital and privileged market access for many SOEs means that they can easily cover any environmental tax or levy. Beijing will find it difficult to resort to an effective market-based mechanism to dissuade SOEs from polluting since the cost of their inputs is so artificially low. 

Let’s turn to institutions. Here, I mean anything that promotes fairer and more transparent transactions, stronger rule-of-law including property and intellectual rights, and any processes that support price signals being based on the market rather than by fiat or regulation.

This all sounds straightforward and Chinese officials would claim that they are strengthening such institutions. But in important respects, genuine institutional reform as described above have grinded to a halt after rapid advances in the 1980s and 1990s.

To be sure, there have been advances. For example, urban residents are reasonably secure in their long-term land-lease rights for the property that they own in zoned areas. Contract law principles between firms are generally enforced.

But problems arise when the state, or SOEs becomes involved in disagreement with private sector entities or individuals. One hears little about the winding back of state control over commercial and administrative courts and tribunals.

When it comes to property rights, it has been estimated by Chinese Academy of Social Science researchers that at least 40 million rural residents have had their land seized by local officials conspiring with developers to make a killing in the property markets (where rural land is seized, re-zoned by officials as ‘residential’ and then developed into residential apartments.)

Using one’s land to raise household income is the fastest way to poverty reduction in rural areas and raising disposal income in those areas, as the reforms of the 1980s demonstrated. Instead, Beijing now has to pour money into rural China in an attempt to address the urban-rural imbalance created partly by its own poor enforcement of land rights in rural China.

There are many other examples of ‘change’ designed to fix problems that fall far short of pro-market ‘reform’. Bear in mind that this is not a bias of Western economic reasoning that these reforms need to occur: China’s leaders are as adamant about the necessity of these as Western economists.

China may or may not grow at 7.5 per cent over 2014. But working out whether change is genuine reform is a better indicator of whether it hits a wall when it becomes a middle-income country, like all but a handful of countries in the Americas, Western Europe and Asia have failed to do.

Dr. John Lee is the Michael Hintze Fellow and Adjunct Associate Professor at the University of Sydney, non-resident senior scholar at the Hudson Institute in Washington DC, and a Director of the Kokoda Foundation.

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