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18 Reforms for the Party’s 18th Congress

China’s leadership handover comes at a critical moment for society and the economy, and changes are in order

China’s leadership handover comes at a critical moment for society and the economy, and changes are in order.

The 18th National Congress of the Communist Party this month comes at a critical time described by economist Wu Jinglian as “a tipping point for China’s economic and social conflicts.” Whether the new government makes the right decisions and restarts the reform process will determine whether China enjoys another decade of stable growth.

A goal for this new reform phase is to promote transformation of the economic development model, mainly in two steps: through a transition from manufacturing to innovation, and by transitioning from an investment-driven economy to one that is consumer-driven.

Over the past ten years, China has benefited as a member of the World Trade Organization. The world’s share of manufactured goods made in China has jumped from 7 percent to 15 percent. But we have found it difficult to break away from “low price, low cost, low quality” production.

We must look at what’s wrong with the system. Companies are entitled to maximize profits, and corporate behavior depends on paths set by a regulatory framework. The existing framework does not provide strong enough incentives to promote innovation. I can list at least five reasons why:

  1. Intellectual property protection is weak 
  2. State-owned enterprises have expanded rapidly based on their market monopolies, making it much harder to protect fair play in a market economy
  3. Prices for land, capital, labor, the environment and other factors of production are severely distorted. Some companies can simply profit by taking advantage of these distorted factor prices.  
  4. The government has controlled a large number of economic resources and approval rights. Rent-seeking has become the most efficient business model for companies with strong government connections.
  5. The rule of law is weak. Entrepreneurs see rent-seeking as the norm and lack a sense of security. Chongqing’s notorious campaign against organized crime demonstrated that entrepreneurs are vulnerable to abuse of power. That’s why rich Chinese have been immigrating.

Now let’s take a look at consumption. It’s a basic human need, and it should not have to be stimulated. The key is whether consumers have the right ammunition. China’s savings rate has risen to an all-time high of fifty percent. There have also been substantial increases in corporate and government savings. Behind the reluctance to consume is a sense of insecurity.

Although people’s incomes have increased, their share of economic growth continues to decrease. Between 1992 and 2008, the amount that individual disposable incomes represented as part of gross national income fell twelve percentage points.

In addition, because of long-term interest rate controls, Chinese can hardly preserve the value of their wealth against rapid inflation. Between 2004 and 2011, China’s average real one-year bank deposit rate was negative 0.3 percent. Multiplied by the current size, household savings of more than 30 trillion yuan, annual losses are in the hundreds of billions of yuan. Coupled with the fact that the messy stock market is not oriented towards value creation, people cannot share the fruits of economic growth through equity investment.

Another reason for low consumption is that housing prices are high. This will lead to a serious drain of personal income over the next twenty years. The middle class is deeply in debt.

And China’s development pace in the fields of medical insurance, education, and pension lag behind what’s needed and is troubled by historical burdens the public’s sense of security.

For the good of the economic transformation, here is a wish list for reforms that should be implemented after the 18th congress:

1. Interest Rate Marketization

The essence of a market economy is to use pricing to achieve optimal allocation of resources. Interest rates are the price of capital. Under the current interest rate control, lending rates are artificially low, which encourages excessive investment. On the other hand, because interest rates do not reflect supply and demand, a large number of small and medium-sized enterprises (SMEs) can’t get access to capital, which has led to growth in loan sharking, which now poses a serious threat to financial stability. Apart from this, interest rate controls are not conducive to increasing household wealth. Essentially, the people (depositors) are subsidizing the corporate sector (borrowers). The time to promote market-oriented interest rates is now.

2. Tax Cuts

According to a study published by Forbes, China ranks second in the world on the tax misery index. Where does the money go?

Fiscal revenues as a percentage of GDP fell from 31 percent in 1978 to 10 percent in the mid-1990s, but in recent years it has risen to 20 percent. Expanding government spending and the usual year-end rush to spend money on government projects have led to a public backlash. It’s not just about the money spent; local governments are involved in micro-economic activities, supported by all kinds of government projects, which undermines fair competition in the market.

The government needs to cut taxes immediately and significantly. It should and can do it. According to the Laffer Curve theory, when tax burdens are high, tax cuts can stimulate economic activity, broaden the tax base, and prompt growth in tax revenues, resulting in a win-win situation.

3. Introduce Inheritance and Gift Taxes

Competition in the market economy will eventually increase the gap between the rich and poor. For sustainable development, two conditions must be met: First, wealth is obtained legally instead of through rent-seeking. Otherwise, poor people will resent the rich out of hatred for corruption. Second, there should be a mechanism to narrow the gap between the rich and poor, especially via the inheritance tax.

The gap between China’s rich and poor is already too big, and more entrepreneurs are leaving their wealth to their children. By imposing an inheritance tax, the gap between the rich and poor will narrow. This is an essential step for building a harmonious society.

4. Break Up SOE Monopolies

Monopolies are the natural enemy of the market economy. Although China implemented the Anti-Monopoly Law in 2008, the country has since failed to make any headway in breaking the monopoly grip of state-owned enterprises.

In 2011, the National Development and Reform Commission conducted an anti-trust investigation into China Unicom and China Telecom regarding broadband access. But there were no further developments in the case. In fact, the essence of SOE monopolies is the administrative control of market entrance.

Although the State Council has issued several decrees designed to break up monopolies, a “glass door” still bars private enterprises. Breaking up monopolies and eliminating the discrimination of private ownership is at the core of building a market economy.

5. Reform SOEs

In the last round of SOE reform in the 1990s, joint-stock holding structures were set up and many were listed on the stock market. SOEs experienced a fundamental change, and their finances shifted from big losses to big profits.

However, studies show that SOEs’ profits mainly come from favorable policies they enjoy in obtaining land, loans, government subsidies, and other advantages. If one were to exclude these factors, then many SOEs’ books would be in the red.

The next round of SOE reform should involve several problem-solving efforts. They must withdraw from real estate and other competitive fields, and they must be separated from the government. In particular, the Party’s organizational departments should give up their right to appoint SOE managers and their boards of directors, eliminate SOE leaders’ official party rankings, and hire professional managers.

Steps should be taken to curb corruption and cut benefits for SOE leaders. At state oil giant Sinopec, former chairman Chen Tonghai could spend 40,000 yuan a day on “business activities.” The company has seen numerous scandals involving purchases of expensive chandeliers and liquor.

In 2008, SOE employees in monopolized industries such as energy, electricity, telecoms, and tobacco accounted for only 8 percent of the nation’s total employment. But their wages accounted for 50 percent of all worker income.

SOEs must stop functioning as an administrator and enjoying market monopolies. Instead, they need true corporate governance.

6. Close the Pension Gap

According to recent research published by Ma Jun, Deutsche Bank’s chief economist for Greater China, by 2013 China’s pension shortfall will reach 18.3 trillion yuan. As today’s elderly population increases, figuring out how to fill the pension hole has become a real challenge.

Fortunately, China’s SOE profits and high stock valuation can provide an important source of funding. Their profits should be used to fill empty pension accounts. The government should cash out stakes in SOEs and put the money into the pension fund, killing two birds with one stone. Not only would this step provide capital for the national pension fund, but it would also let the state exit SOEs.

7. Abolish the IPO Review System

The government’s IPO approval system is supposed to protect the interests of investors. But over the past twenty years, the system has not only failed to protect investors, but it’s also distorted relations between supply and demand, and has given rise to many problems, including rampant rent-seeking. It is indeed the source of chaos in the securities market.

Being listed on the market should be a company’s normal business activity. Instead, it has become a privilege connected with regulatory power. Limiting the role of securities regulators to keeping order—not selecting stocks for IPOs—would revive the stock market.

8. Allow Private Capital in Banking

Indirect financing dominates China’s capital market, accounting for 78 percent of the market. But banks are largely state-owned, and it’s incredibly hard for new banks to win regulatory approval. This has led to a “quasi-monopoly” in the banking industry, with “embarrassingly high profits,” according to Hong Qi, the president of Minsheng Bank.

To a certain degree, the banking system has become a burden for the real economy. The good performances of Minsheng Bank, Zhejiang Tailong Bank, and other private banks show the argument that private banks tend to have poor risk controls simply doesn’t hold water.

China should let private capital open banks. This would not only promote competition in the banking sector and add depth to the financial market, but also provide better services for small and medium-sized enterprises.

9. Encourage Overseas Investment

Bubbles are obvious in China’s housing sector and stock market. The major reasons are excessive money supply and capital account control. Large quantities of capital need investment places, but they are limited to domestic vehicles. This makes things difficult for anyone who wants wealth preservation and appreciation. Meanwhile, more than $3 trillion in foreign exchange reserves have been used to buy U.S. Treasury bonds and other low-yielding assets. The opportunity cost is enormous.

If the country would relax restrictions on citizens’ overseas investments, it would kill three birds with one stone by reducing the domestic property bubble and financial risks; bringing about diversification of wealth allocation and preservation; and reducing forex reserves while promoting global economic balance.

10. Protect Intellectual Property

In the early stages of China’s economic development, enterprises generally copied, and comparatively weak IP protection allowed them to grow quickly. But today, innovation and transformation have become a bottleneck for Chinese enterprises. A lack of IP rights protection has seriously weakened the incentive for R&D and innovation. Protecting IP rights is not only beneficial to transnational corporations, but it also spurs innovation.

11. Restrain Local Government, Inc.

Local economies are all about GDP growth, which has turned local governments into mega companies. They are obsessed with investment promotion, building infrastructure, and venturing into domains such as private-equity investment. Excessive involvement by local governments in economic activity destroys fairness in marketplace competition and creates corruption.

In addition, it encourages local government to consider their own interests instead of justly enforcing laws, and lets them turn a blind eye toward environmental pollution, food safety, and other issues resulting from reckless development. The forced demolition of homes and reallocation of land is already a fountainhead for mass incidents and public protests. The central government urgently needs to define borders of local authority and rein in the Local Government, Inc.

12. Financial Democratization

Local governments sit atop an astonishing amount of financial resources. Over the past few years, while tax revenues have rapidly increased, financing from land transfer fees have risen as well. In 2010, governments took in 2.9 trillion yuan in land transfer fees.

The checks and balances are weak and government budgets are opaque, contributing to corruption. The central government’s 4 trillion yuan stimulus plan of 2008 further exacerbated risks to local government financing vehicles. Only with public exposure of financial spending and taxpayer supervision can we ensure efficient and good use of financial resources.

13. Environmental Protection

In a drive for GDP growth, environmental protection and law enforcement are increasingly marginalized. With the rapid rise of manufacturing, environmental pollution has become widespread. The cost of water and air pollution, according to a World Bank report in 2007, accounts for 5.8 percent of GDP in China. Over time, the problems caused by environmental pollution have become increasingly apparent, and if we do not improve environmental protection, more social conflicts will erupt.

14. Corruption and Housing

In recent years, a surge in housing prices has triggered a public outcry because the price-salary ratio in so-called first-tier cities can be more than twenty times. Against this backdrop, many local officials are found to be hoarding houses. Cai Bin of the Panyu Urban Management Bureau in Guangzhou has twenty-one pieces of real estate; Luo Yaping the former director of land resources in Fushun, Liaoning province, owned twenty-seven houses; Hao Pengjun, director of the coal bureau in Puxian County, Shanxi province, had thirty-six, most in Beijing; Kang Huijun, deputy director of Pudong District in Shanghai, had twenty-nine pieces of real estate; Tao Jianguo, the deputy head of the Pudong Free Trade Zone, had fourteen.

Corrupt officials are the real reason for high housing prices. There are a large number of vacant houses, but resources concentrated in the hands of a small number of people means real estate is in short supply for ordinary citizens. To realize a reasonable price flattening, corruption must be controlled. One method can be the open auction of houses confiscated from corrupt officials.

15. Urbanization

China’s economy needs a new growth engine. Exports are weak. During the third quarter of 2012, net exports contributed minus 5.5 percent to GDP, and the recovery of European and American demand still needs time. Investment is already high. The investment rate is up to 50 percent in China, indicating the end of the government-led investment era. Consumption is difficult to boost. The reform of income distribution patterns is hard to push forward.

In this context, the hope is that urbanization is the engine of growth for the next decade. There is great potential, since the current urbanization rate is slightly higher than 50 percent. However, for urbanization to make substantive progress, we must start housing, education, and health care reforms.

16. Kill the National Development and Reform Commission (NDRC)

The essence of a market economy is the pursuit of maximum profits, and effective competition and innovation follow suit. The role of government is mainly as guardian of the economy, maintaining rules for fair competition. The government cannot be both referee and player, and it shouldn’t interfere in micro-economic activity.

Currently, the National Development and Reform Commission’s main responsibilities have been reduced to “examinations and approvals,” like its predecessor, the State Planning Commission. This is incompatible with the concept of building a socialist market economy. For reform breakthroughs over the next ten years, it would be feasible to dismiss the NDRC and set up an institution dedicated to the design and review of structural reform.

17. Judicial Independence

Wu Jinglian, the economist, says there are good market economies and bad market economies, but a good market economy can only function under the rule of law. Without the rule of law, sooner or later, the economy will fall into a quagmire of crony capitalism.

Due to current excessive government involvement in the economy, coupled with a judicial system that is not independent, law enforcement is selective and flexible. As a result, people don’t trust the legal system, and repeatedly resort to petitioning officials or mass incidents. To strengthen the legal system, we need to establish constitutional review as a starting point. At the same time, we must make the court system independent in financial and personnel matters, which is the foundation of judicial independence.

18. Downsize and Decentralize

Currently, the government is too big. It has too much power and control of resources—an arrangement that will eventually strangle the vitality of the market economy. Reform essentially comes down to the government downsizing, decentralizing, and giving up profits.

Recently, the State Council announced cancellations and adjustments for projects requiring administrative approval. The new policy said the government would withdraw its involvement in matters that a citizen or organization can handle independently, or for matters that can be regulated by market mechanisms, and from matters do not require pre-approval when they can be managed afterward or indirectly. If these principles can be followed, the next decade will mark another golden era.