Three Obstacles to Reform

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Jun Xuan Li's picture

The Third Plenum of the Eighteenth Central Committee of the Chinese Communist Party marked a new phase of reform in China, with the will to sustain her economic miracle in the past thirty five years. The reform is so extensive that China will be vastly different if it is implemented successfully, and since it is so large in scale constraints the reform faces is equally knotty. In my opinion, three factors will determine the success of implementation; they are the local government, state-owned enterprises, and external environment.

 

Before discussing the three factors it is worth putting a benchmark for evaluating the implementation of the economic reform. It is quite amazing that there are many different interpretations to the reform from famous economists. This may because the reform involves so many perspectives, different economists come up with different area of focus. However, I think the primary purpose of the reform is to change the structure of economic growth, from a labor-intensive, low value-added, investment-driven growth to capital-intensive, high value-added, consumption driven growth. The need for such a change is urgent since the economy is approached to the middle income trap and Lewis’ turning point, so that the current source of growth is unsustainable in the near future. From this perspective, detailed plans like price reform, fiscal reform, financial liberalization, etc. are means to fulfill the end. Therefore to set the benchmark for the success of reform, it shall be the real change in economic structure that keeps the economy grows at a fast speed.

 

Implementation of the reform must rely on the support of local government, but it is doubtful whether local government will commit themselves wholeheartedly to the plan of the central government. Local cadres have conflict of interests with the proposed reform in at least the following two ways. First, evaluation of the performance of the local cadres is positively related to local GDP growth, the faster the local economy grows the higher chance of getting good appraisal and promotion. As a consequence of this evaluation system, local government will try to avoid measures which may possibly slow down the economy, and it is obvious that the reform pill must take a few years to swallow, and inevitably lower the economic growth in the transition period. Therefore local government may not support the reform. The second reason for objection is that the reform will directly hurt the grey income they currently enjoy. It is a general believe that corruption in China is serious nowadays, though the true figure is unknown, general estimates is high. Here is the theory accounting for the high income of corruption in China. Corruption is a means to alter allocate resource when market is imperfect. The value of corruption has a positive relation with the market imperfectness. Market imperfection in China arises from the various price regulations, like energy, land and interest. The power of authority is overextended so that local cadres can enjoy high grey income. With the remarkable claim of the reform that market shall play a decisive role in the future, the power as well as the grey income enjoyed by local cadres is expected to fall sharply, which their response will then very likely to be objection. Even if we assume local cadres are working for the interest of general public rather than their personal being, it is very risky for the local economy to change its current economic structure. The 4-trillion stimulus package in 2008 fueled the investment boom of the local economy, since then local government cannot stop relying on investment to boost the economy. However, investments made in these years were mainly financed by debt through shadow banking system, which has accumulated faster and faster. Local governments rely on tax revenue to repay the debt, and if local economies slow down, many of them may become insolvent as tax income slump. If the local governments default on its debt, it may induce a chain of reaction and probably evolve into a financial crisis and disturb the reform. The problem of local economy and cadres will be a key factor affecting the implementation of reform.

 

The second obstacle the Chinese government will face when launching their reform is the objection from state-owned enterprise. The problem of state-owned enterprise is apparent: low efficiency, monopoly, unsatisfactory rate of return, risk-prone operating strategy, etc. State-owned enterprises have forced the retreat of private enterprise with their scale advantage and special treatment made by the government and state-owned banks. Reform on the state-owned enterprise is to control its domination, give way to private enterprise, and visible hand of the government be taken over by invisible hand. However, reforming state-owned enterprise also involves conflicts of interest, not only economic interest but also political interest is concerned. In the case of economic interest, revenue from state-owned enterprise has contributed an important part in tax revenue of the central government and local government, and the reform must involves a reduction in the profitability of state-owned enterprise, which is not in the interest of Chinese government. More important is that state-owned enterprise involves the interest of respective political power behind the scene. The relation between the political power and state-owned enterprise is so deep-rooted that current CPC politburo standing committee may not be able to implement the reform. Fortunate enough if the Chinese leaders have that right, the elimination political linkage of state-owned enterprise may takes few years to complete, precious time will be wasted, and uncertainty of external shocks will increase, these will all affect the implementation of the reform.

 

The last but not least factor will affect the success of reform is the external environment. One key concern is the monetary policy of the US, which is expected to normalize and finish its Quantitative Easing at the end of 2014, and start its interest rate uptrend in mid-2015. This normalization will cause a capital flow from emerging to developed countries, and China may be affected by capital outflow. However, if the US economy can recover as anticipated, China will be benefited from export improvement, in such case the effect of US is neutral. However if the Fed make mistake when tapering, resulting in either high inflation or economic downfall, Chinese economy may be adversely affected, growth slows more than normal circumstance, putting excess pressure to the implementation of reform. Apart from the US, relationship with Japan is also another matter of concern. Currently China and Japan has a poor relationship, which many predicted that the two countries may inevitably engage in small-scale warfare. No matter how small the scale would be, warfare must distort resources and focus of the reform, and most likely result in large amount of economic losses. I think the possibility of warfare is quite low, but if the economic performance of Japan cannot be rescued by Abenomics, Japan might have sufficient incentive to start a war to boost the economy. Also if the relationship between two countries does not improve in the future, the prolonged instability of the area may discourage foreigners’ investment and working in China, which may cause instability of the internal economy. Therefore, the external uncertainty arise primarily from the US and Japan.

 

To conclude, the latest plan of reform is so comprehensive that once it is succeeded will bring about profound effect to Chinese economy, and it is exciting to witness how it is unfolded. However, the Chinese leader must not forget about three major obstacles which will hinder the implementation of reform, and should pay special attention to those problems throughout the reform to ensure these problem are carefully handled.