Economic Reform in the Third Plenum: Balancing State and Market

China’s top leadership met this November to set a course for the country’s next wave of reform. President Xi Jinping promised a “comprehensive approach” to reform prior to the plenum and the official “Decision on Major Issues Concerning Comprehensively Deepening Reforms” largely delivers on this promise in the economic realm, where large changes in fiscal policy, competition policy, factor pricing, and state-owned enterprise reform are outlined. (The “Decision,” made public November 16, serves as the main source for this article). The document sets out an impressive list of declared goals for economic reform, but the true test will occur when implementation runs up against the power of vested interests.

At its core, the strategy for reform revolves around creating and a more market-based and competitive economy. The key challenge to achieving this goal is establishing a proper relationship between government and the market. To reach the next state of economic development, the Chinese government recognizes that it must become comfortable with allowing a greater share of economic activity to occur outside the scope of government influence. A reduction to government interference with factor pricing, removing regulatory barriers to investment, and reforms to state-owned enterprises are all outlined necessary reforms.

The call to adjust the state’s relationship to the market echoes a speech given by Premier Li Keqiang this March on the need to cut regulatory red tape and for the government to focus on proving public goods. The move to restrict the government’s role in the economy represents a major shift in attitude and ideology for a government historically defined by interventionist impulses. The plenum report calls for the government to relax the approvals process, give enterprises independence in making investment decisions and for the central government to avoid regulating micros issues and focus on macroeconomic coordination.

The plenum report calls for the market to play a “decisive role” (juedingxing zuoyong) in the allocation of resources in the economy. This represents an elevation from previous party documents, which assigned the market a “fundamental role” (jichuxing zuoyong) in resource allocation. This change in language reflects a step forward in the continued reduction in the number of official price controls. Areas that are specifically targeted in the report include the prices of water, oil, natural gas, electricity, transportation and information technology.

Related to the goal of increasing competition and reducing government interference in the economy, the plenum report affirms the critical role of the private sector and companies of mixed ownership in the economy. Critically, the report identifies the non-state firms as an important part of the socialist market economy system in China. This is representative of a continued evolution in official thinking towards embracing and fostering the growth of the private sector. The report calls for establishing equal rights, rules and opportunities for non-state firms in the economy. Achieving this goal will mean finding a way to inject more competition into the state-dominated areas of the economy. Private and mixed ownership firms have become the dominant source of growth in the Chinese economy and the future of economic development will rely on creating more space and equality of opportunity for these firms to grow.

One of the most specific goals called for by the report is the allocation of a greater share of state-owned enterprises profits to the national budget. This is a progression of the goal for a higher rate of dividends to be paid, set out in the income inequality plan released by the State Council in February (Caixin, February 6). The plenum report calls for 30 percent of SOE profits to be paid to the state budget by the year 2030. This is a large change from the status quo: according to an IMF estimate, only 0.4 percent of SOE profits went to the national budget in 2011.These funds will provide much-needed resources for the government during a time of slowing revenue growth and should be targeted towards an expansion of the social safety net in order to facilitate economic rebalancing.

The plenum document calls for the relaxation of investment restrictions and further opening to international investment and competition. A specific example of this in the report is the call for an expansion of the negative list approach for investment approval. The adoption of a negative list approach would open up all areas of the economy not explicitly prohibited to investment. This is a significant improvement over the current positive list approach which requires investors to seek government approval. The key to the effectiveness of such a policy change is whether the scope of areas prohibited will be significantly reduced. Such a move would increase competition in currently protected areas of the economy and allow foreign investors to receive national treatment.

The Shanghai Free Trade Zone received a strong signal of support in the plenum decisions report. When the FTZ was officially launched at the end of September, no high-level Chinese leaders attended the opening ceremony, generating concern in the international media that Beijing had abandoned the project (The Economist, September 30; Wall Street Journal, October 7). Without high level support, the Shanghai Free Trade Zone would be destined to go the way of the other special economic zones created in recent years in Shenzhen (Qianhai) and Tianjin (Binhai), which have largely floundered. The plenum report removes any such doubts by identifying the Shanghai Free Trade Zone as a “major measure” by the government to promote further economic reform and experiment with policies which may be expanded to the rest of the country.

Fiscal imbalances between the central and local governments are also highlighted in the report as an area for reform. The report identifies the need for a rationalization of revenues distribution between local and central government based on their respective responsibilities. The core of the problem is the mismatch between revenues and expenditures for local governments. The plenum report calls for adjusting the system of transfer payments from the central government and improving the division of responsibility between localities and the center. These changes seem modest compared to the problem being addressed, a fiscal crunch which has led to an unprecedented local government borrowing spree. The growth rate of local government debt is unsustainable, and much of the financing has occurred through murky channels. The report calls for improved budget transparency and mechanisms to identify budgetary risks. Another important reform outlined is the expansion of the property tax, which could serve as an important source of revenue for local governments. A property tax was initially unveiled in Shanghai and Chongqing several years ago, but it has not generated significant revenue, nor been expanded to other cities. Presently, property taxes in Shanghai and Chongqing municipality account for less than one percent of local government revenue (Economic Observer, March 18). A wide-reaching property tax would provide a more sustainable source of revenue for local government and help deflate the property bubble.

The section on financial reform in the plenum report contained no major changes, instead calling for a continued implementation of existing reforms such as liberalizing interest rates, opening the capital account, increasing the proportion of direct financing in the economy, and establishing a deposit insurance scheme. These policies have been on the agenda for a while and the plenum report contains little in the way of specific implementation goals. The most innovative proposal in the document is the call for allowing private capital to establish small and medium sized financial institutions. If acted upon, it could help break the near-monopoly role the state currently plays in the allocation of capital. Unfortunately, private financial institutions are unlikely to make much progress as long as distorted interest rates lead banks to compete on market share rather than risk management.

Despite the numerous and wide-ranging call for economic reform, there exists a fundamental tension within the document that is difficult to reconcile. The communiqué calls for the strengthening the position of state-owned enterprises and reaffirms their leading position in the economy. This conflicts with the overarching themes of allowing the market to play a greater role in economic outcomes, increasing competition and ensuring equality opportunity for non-state firms. All of these policies would result in a further withering of the position of state-owned enterprises.

Since China adopted the goal of establishing a socialist market economy during Third Plenum in 1993, Chinese policymakers have struggled to strike the right balance the state and the market. The core tenet of the social market economy strategy is to use market mechanisms to improve the efficiency of the economy without fully transferring to a capitalist economic system. The strategy of the Chinese government has been to gradually reduce interference with prices and allow the market to determine an increasing share of economic outcomes.

The transition to a more market-based economic system has been difficult for state-owned enterprises. Burdened with large workforces, inefficient corporate structures, and the requirement to provide extensive social benefits, state-owned enterprises shrank in profitability in the 1990s. To rectify the situation, Premier Zhu Rongji embarked upon a massive reform effort in the late 1990s, restructuring some state-owned enterprises while shutting down others. The result was a considerable improvement in the health of many state-owned enterprises during the 2000s. Unfortunately, these trends have shifted in recent years with the efficiency and profitability of state owned enterprises once again falling far behind their mixed ownership and private sector counterparts (China National Bureau of Statistics (2013); for a discussion of the data, see “China’s Credit Boom: New Risks Require New Reforms,” Peterson Institute for International Economics policy brief).

At a fundamental level, the more the Chinese economy allows the market to determine economic outcomes, the faster the state-owned enterprises will slip away in to irrelevance. Chinese state-owned enterprises are likely to only remain dominant in the sectors where they have been granted administrative monopolies or where economies of scale lead to natural monopolies. Chinese policymakers must reconcile the fact that a modern market-oriented economy will not be one where state-owned enterprises continue to occupy the commanding heights. The politics of this transformation will be difficult as state-owned enterprises represent are one of the country’s strongest vested interests and wield considerable policy influence.

China’s third plenum was a strong herald for future reform and it proposes solutions to many of the most critical economic problems facing the country. The scope and scale of reforms decided by the plenum mostly meet the expectations set by the top leadership of a comprehensive approach to reform. Moving forward, the key indicator of progress will be the pace and detail of policy implementation documents due to be released over the next few months. The newly established Leading Small Group for Comprehensive Deepening of Reform may give the leadership sufficient power to force through some difficult reforms (See “Xi’s Power Grab Towers over Market Reforms,” in this issue). While the signs for economic reform are hopeful, vested interests in China are likely to resist many of the policies announced. Sustained momentum for reform from the highest levels of the Chinese government will be necessary to achieve the full potential of the third plenum.