What factors will determine whether the proposed economic reforms in the recent Plenary meeting are ever implemented?

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Natalie Wong's picture

The recent Third Plenum concluded last November, first under the new Chinese leadership led by President Xi Jinping and Premier Li Keqiang. In the major communiqué, the ruling party of China calls for the decisive role of markets in resource allocation, implying that China will have to limit the control of government regulations and adopt an innovation driven approach in economic development. While some media and columnists see hope in China’s future economy, some are skeptical about the reform. Xia Yeliang, Professor of Economics at Peking University, doesn’t expect much from the plan, quoting, “simply trying to do something that was promised 20 years ago but had never been done.” There is certainly a lot of juggling between political dominance and free markets, which both affects social stability to a certain extent.

SOEs vs SMEs

China has a long history of stringent regulations. These policies were aimed to protect the interests of state entities, but at the expenses of the privately held firms. However, such private firms are crucial for allocating limited resource efficiency under the competitive market economy, and only by securing their interests can China let the market adjust for resource allocation. Although the Party has been gradually relaxing the tariffs, quotas, legal fees and such to foster a more open market, the existing battle between the state-owned enterprises (SOEs) and the small and medium enterprises (SMEs) challenges the feasibility of surrendering further government control.

Chinese economy has long been dominated by the SOEs, which function under the dictates of the political regime. These spoiled children used to get subsidies from the government and have easier access to credit. Yet they could not assume economic leadership, given their deep-rooted deficiencies and inefficiencies. It would be disastrous to have them fend for themselves in such a competitive global economy, where they will be losing their “monopoly position” with minimal government backup. The government could thus face considerable opposition from the SOEs. In addition, China’s SOEs stretches across industries involving national security, stability and natural resources, such as military, aviation, telecom – economies that contain China’s state secrets and would not want to fall into the hands of other countries. Though the Party announces plans on reforming SOEs, diversifying ownership and welcoming private investors to acquire 10-15% an SOE’s equity, foreign investors believe that it is a pretense for the government to acquire funds, given the increasing corporate leverage of SOEs – the government still takes a majority control.

On the other hand, the cumbersome compliance costs deter the influx of foreign direct investments (FDIs).  Since FDIs are in effect catalytic agents to strengthen local businesses and to fund SMEs, they bring in technology and management systems China lacks. Such SMEs thus play an important role in a competitive yet sustainable market economy. Despite their importance, the favorable credit allocation SOEs still receives not only breed extravagant spending behavior, but also starves SMEs from credit. After the SME credit crisis, China Banking Regulatory Commission (CBRC) implemented policies to support SME specific loans and encourage commercial banks to raise deposit rates. However, SMEs are still unable to collateralize land effectively - such impedes contract enforceability and hinders chances of taking out larger loans. It is thus quite difficult for SMEs to prosper under the credit crunch.

Fiscal & Monetary Policies

In addition, it is dubious whether China’s banking and currency are resilient enough for running a market economy.  

After the financial tsunami in 2008, Chinese banks have since been pressured to extend loans. These funds were mainly special purpose vehicles authorized by the local government to assist SOEs, regardless of their creditworthiness and financial viability. The lender forbearance has greatly increased the banks’ risk, with China’s financial system having bad loans worth as much as 30% of GDP. The opening up of markets further amplifies the significance of banks while increases potential losses, as the SME loan business inevitably poses more risks to banks. Furthermore, the differences in loan-to-deposit interest rates will be reduced if the economy is to adopt the market-based interest rates. With diminishing profit margins and no details on the local government financing vehicles (LGFVs) reform, the stability of China’s banking system is questionable – any mismanagement in restructuring the banking sector may cause a recession.

The government also intervened the currency market through suppressing Renminbi value. China has been labeled as a “currency manipulator”; the accusation is that China manipulated its currency in order to raise competitiveness of its exports. In spite of such allegation, the People’s Bank of China (PBC) has in fact raised the autonomy of China’s monetary policy. The Chinese Renminbi has been appreciating by 30% in the last ten years. Current exchange rate policies state that the rise and fall of Renminbi against US dollar cannot exceed 1% of the middle rate, and if it does, trading on the market freezes. The Third Plenum reform seeks to lift such restrictions and broaden the daily trading range, which will likely induce a series of economic and social consequences. The appreciation already has profound impact on China’s current account surplus, dropping from 10% to 2.6% from 2007 to 2012. If Renminbi exchange rate increases drastically, investors will relocate their production lines in other regions with cheaper factors of production, causing China’s export factories to face bankruptcy and subsequent rampant unemployment among migrant workers. Other countries may also use the opportunity to reduce their reliance on China. US goods, in particular, are relatively cheaper than before, will boost up its exports to China in a way to improve its trade deficits. If the currency rate plunges, the absence of PBC’s intervention might send China’s economy into capital flights and financial crises. Unless Renminbi maintains a stable growth and at the mature stage, speculative appreciation in Renminbi will create huge fluctuations in currency exchange rate, prompting PBC to implement protective measures of large and small.

Social Structure & Demographics

Another primary issue addressed was reforming China’s economy to a knowledge-based one. China’s old economic model was based on exporting low margin products from a high volume manufacturing. Over time, its overreliance on exports causes China’s labor force to loose competitiveness, satisfying its stint at low skilled, low technology, labor-intensive industries. In addition, the diminishing labor supply, as a result of the one child policy, further exacerbates the problem. In general, thriving economies require greater manpower to establish a new economic system. Even though the Chinese government relaxed the policy by allowing families to have two children under specific conditions, an aging population still exists in the coming 20 years, causing escalating labor costs.  Education and hence retraining costs are required to facilitate societal transition from the existing dominant secondary industry sector to a tertiary industry sector.

On the contrary, China’s emerging middle class comes as a promising factor for further SME support, as these middle class people own the majority of SMEs. Furthermore, they are those who can afford and be willing to pay a premium for quality, not just for basic necessities, but also discretionary goods. The middle class will thus play a significant role in shifting China’s economy from an investment and exports mode to a consumption mode. As intellectuals, these middle class people would certainly promote their basic human right and urge the government to implement economic reforms, fostering a favorable environment for SMEs to prosper.


Political liberalization and market economy are the twins of the economic development. In consolidating their power in the new term of Chinese Government, China is facing the dilemma of choosing only one of the twins – the prosperous economy only but not the openness of political reform. Worst still, market economy also leads to a lot of problems, i.e. unequal distribution of wealth, improper business ethics, corruption, and the like. The ruling elite is trying to strike a balance between economic growth and yet not to elicit too much extreme people movements. Hence, the Chinese Communist Party stresses “harmony” and to sacrifice a smaller “human right” for the sake of a bigger national interest of economic development. As the former premier Wen had said, “ to feed up all the Chinese people is not a simple issue, not to mention the others.” This has hinted that all the others should give way to “stability” for the sake of economic growth.


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