18 September 2018

Did China fail its plenum test?

The market was overly optimistic about the potential for reform from the Central Committee’s third plenum, so it was disappointed by a communiqué released on Nov. 11 that was short on both promises and specific details.

The market has reason to be skeptical about China’s reform outlook because the announcement’s positive implications were overwhelmed by its disappointments. The communiqué outlines Beijing’s intention to reduce income inequality, pursue judicial reforms to make the system free from local political intervention and set up a committee to coordinate and supervise reform implementation. These are crucial steps in rebalancing China’s economy.

However, despite upgrading the market from a “basic” to a “decisive” role in the Chinese economy, Beijing has kept the emphasis on the “dominant” role of the state, including that of state-owned enterprises (SOEs). This means no major SOE reforms can be expected for the coming decade.

The communiqué only mentioned land reform briefly, and offered no hints about interest rate and capital account liberalization, changes to the one-child policy or a shift in the household registration system.

More reform details will follow in the coming weeks but don’t expect any breakthroughs because the inherent obstacle to deep and quick structural changes is the lack of political reform, something Beijing had ruled out even before the plenum.

It would be naïve to think that the new leadership can force the bureaucracy to comply with its wishes. Given the central government’s well-known inability to enforce its policies at the local level and the prevalence of tight-knit patronage networks in China’s provinces and cities, it is unrealistic to expect the leadership to deliver deep reforms quickly. Meanwhile, a non-convertible capital account is a sturdy shield against shocks and buys time for the reforms to take shape.

Compared with the 1978 and 1992 reform breakthrough eras under Deng Xiaoping, President Xi Jinping faces a different environment and a much tougher challenge. Opponents of Deng’s reforms were ideologically driven and had no personal stake in the political economy. Defeating them required building a consensus in the party, discrediting the communist ideology and rallying public support. Deng achieved these aims by providing economic incentives.

Today, however, members of the ruling elite (including SOE bosses) have benefited immensely from economic reforms in the past three decades under the state-dominated economy. This “state capitalism” has created enormous rent-seeking opportunities for making these privileged groups rich and powerful. Leveling the competitive playing field through deeper market-oriented reform would hurt their interests and reduce their privileges. In short, further structural reforms are rent-destroying measures likely to attract fierce opposition.

Only by mobilising pressure outside the party-state can these insiders be forced to accept some of the decentralizing and liberalizing reforms that China’s economy badly needs. This means political reform. Without it, China’s entangled economic-political ties cannot be unknotted; any technocratic reform proposals will only treat the symptoms of China’s economic malaise, not its fundamental causes.

Beijing can also invoke market discipline by liberalizing the capital account and the renminbi, which is another way of mobilizing external pressure, to help push through some changes. That is why it is crucial for China to use RMB internationalization as a means to an end (i.e. the completion of structural reforms) but not an end itself. However, full capital account and currency convertibility will force political changes, which will then become a roadblock to convertibility itself. China is stuck between a rock and a hard place of structural reforms and full capital account convertibility.

These are difficult issues to resolve but not impossible. There is hope that China will grind through its structural changes over time, and the third plenum communiqué has shed some directional light on future reforms. Upgrading the market to a decisive role in the economy implies that private capital and the stock market will play a bigger role in resource allocation. The key to institutional reform is to redefine the boundaries between the state and the market. If this process continues and is implemented properly, it will help increase productivity and sustain economic growth.

Beijing’s intention to improve the social security system to reduce income inequality, and to unify the rural and urban land markets as an initial step to land reform, should help urbanization and consumption growth by improving household wealth and confidence. All this favours a strategic allocation of investment to the “new China” sectors, including IT, health care, services and consumption.

In the absence of a political reform strategy supporting structural reforms, China has arguably failed in its plenum test. But all may not be lost. A lot depends on the leadership’s resolve and ability to confront powerful vested interests and overcome their entrenched resistance to reforms. Realistically, the only change we can expect is gradual.

Chi Lo is senior strategist at BNP Paribas Investment Partners (Asia) Ltd. and the author of “The Renminbi Rises: Myths, Hypes & Realities of RMB Internationalisation and Reforms in the Post-Crisis World”, Palgrave Macmillan 2013. The opinions expressed here are the author’s and do not necessarily reflect those of BNP.



Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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