Hidden barriers to China's hugely ambitious reforms
The 3rd Plenary Session of the Communist Party last weekend has proposed massive reforms to transform China over the next few decades. But these reforms could actually make things worse
Last weekend the Chinese leadership held a meeting grandly called the ‘Third Plenary Session of the 18th Communist Party Central Committee’. According to the hype, the meeting is supposed to introduce reform policies that will define China’s social and economic development over the next decade and beyond. They are supposed to be unprecedented.
China, like every other country, badly needs reform. Their main task is to rebalance the economy by making a transition from an investment-driven growth model to a more sustainable, environment-friendly, socially stabilising one. The odds are that few of the reforms unveiled will ever be implemented and those that are may make things worse.
The rumour is that the plan will be based on a government think-tank proposal with memorable moniker of 383. The first three concerns three concepts: improve market mechanism, change the role of government and transform corporate structure. The eight represents eight major reform areas: urbanisation, tax and fiscal reform, reforming land ownership, financial reform, state asset management reform, dismantle state monopoly, further open-door policy, and innovation system reform. The final three concern reform thresholds. These include increase competition, deepen social welfare system and deepen land reform.
If you look at each of these reforms you can already see a major problem. Each of these reforms will be challenged by some very powerful entrenched interests. So the probabilities are that any reform enacted will be only partial. But a partial reform may be worse than no reform at all, because the success of one reform is often dependent on other reforms.
For example, one of the reforms being discussed is dismantling of the hukou system. This system restricts access to public services such as schools or hospitals outside a person’s official residence. There are approximately 260 million migrants in China, all living far from their official residences. The lack of the appropriate resident designation restricts migrants from buying homes, seeing doctors and sending their children to a local school.
As you might suspect the hukou system is a major source of resentment and arguably economically inefficient. China’s main engine of growth, exports, is slowing as competition from lower wage countries increases. To grow China must increase domestic demand. One way is to accelerate urbanisation. But the hukou system is a major obstacle.
The local governments are a powerful obstacle to the reform of the system. Their main objection is cost. If the hukou system is dismantled, they will become liable to pay for a sharp increase in the demand for services such as hospitals and schools. But local governments in China are broke. They have spent the last five years borrowing money to help stimulate the economy. No one knows the total amount of the debts, but burdening them with additional costs would not help.
Another potential reform would help with these costs. Tax and fiscal reform would renegotiate the division of revenues and responsibilities between the central and local governments. Presently local government expenses far exceed revenues. Since promotion is based on economic growth local governments waste what money they have on schemes to promote industrial growth rather than public services.
One way to provide more revenue would be to implement an annual tax on the market value of real property. It would provide a stable source of revenues for local governments, helping to bridge the gap between their receipts and outlays.
Presently, local governments make money by confiscating land from farmers and selling it to developers at highly inflated prices. This leads to speculators constructing see-through buildings and ghost cities where no one lives. Since they have few other sources of revenue, local governments have a powerful incentive to keep this Ponzi scheme going.
The real estate bubble forms a large part of China’s growth. If the building and speculation were to stop, it could lead to real problems. Without a real estate tax, the carrying costs of property are negligible. Like gold it is an attractive asset as long as it continues to appreciate with low costs. A real estate tax could increase those costs and lower the value of inflated houses. The assumption in China, like the US during our housing bubble, is that real property always appreciates. There could be a rapid exit if it no longer does. A property tax might just tip the scales.
A tax and fiscal reform would be easier with land reform. Right now, land in China is owned by various state entities. Instead of outright ownership, it is leased on a long term basis. If farmers and other were allowed to actually own land then they could get mortgages or sell the property. But if they were allowed to do that, then the property would no longer be available to local governments who can’t pay their bills without a property tax. As long as they can’t pay their bills they can’t provide more services to migrants.
So, in order for one reform to be successful, all of them must work. But, powerful vested interests will do everything possible to block them. Land reform is up against developers and local governments who are still profiting from the real estate bubble. A decrease in the value of real estate will incense wealthy and powerful investors. The loss of the hukou system angers the present urbanites who would see more competition for their present services. It also would result in the loss of a powerful control over internal migration.
Financial reform and state asset management reform are also intertwined. The main financial reform would allow banks to compete for deposits by allowing competitive interest rates. They are already allowed to compete on interest rates for loans. But, allowing competitive interest rates would rob the huge state owned banks of guaranteed profits. These profits are necessary to pay off bad loans often made to inefficient state-owned industries (SOEs).
The state asset management reform is an attempt to force the SOEs to become more efficient and wean them off of cheap capital provided by the state owned banks. But, allowing more freedom of capital flows may just channel more money to safer SOEs who have an implicit government guarantee. There is also a huge shadow banking system that is highly leveraged. Allowing the banks to compete with this system may starve it of capital increasing the risk of collapse. Much of the shadow banking system provides funds for developers and local governments who would be hurt by land reform.
Arrayed against financial reform and state owned industry reform are the local governments who rely on the SOEs for patronage and to provide jobs for social stability. The banks themselves are powerful entities often with semi independent local branches, who would really not like to see their advantages removed.
All of this would be made worse by the Chinese habit of gradual reform. A half measure in one area could result in unintended consequences especially if it was not supported by another reform in a different area. The distortions of the present system are so vast that any slight wobbles could easily grow into a crisis.
Any builder is familiar with need for one part of the structure to support another. The legal and regulatory infrastructure works in the same way: one reform supports others. Once in existence laws attract investment. Whole economies are built around specific legal assumptions. Changing the rules, even one rule, can have an enormous impact. Changing the rules is not only difficult, but dangerous. So, what may be unprecedented about the reforms coming out of the Third Plenary Session may be what no one planned.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)
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