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China's reform challenges
Thursday, 17 May 2012 01:01

With political instability in Beijing, and a change of national leadership coming up, the Chinese government is trying to maintain stability.  This means that there is little prospect of economic or political reform in the near future.

This is a great pity.  Because as the World Bank argues in its "China 2030" report, it is urgent for China to implement a new development strategy.  Even though this will not be easy, it is essential for China to become a modern, harmonious, and creative high-income society.

China's economic performance these past three decades has been spectacular.  Annual GDP growth rate of 10%.  Over 500 million people lifted out of poverty.  China is now the world's largest exporter and manufacturer, and its second largest economy.  2 of China's banks are among the world's top 10, and 61 Chinese enterprises are on the Global Fortune 500 list.

Before we examine the World Bank's proposals for future policy reforms, let's have a look at the key features of China's reforms which have driven this impressive performance:

(i) Pragmatic and effective market-oriented reforms.  Reforms were introduced in a gradual, experimental way --"crossing the river by feeling the stones".  The economy was thus allowed to "grow out of the plan" until the administered material planning system gradually withered away.

(ii) Balancing growth with social and macroeconomic stability.  This was absolutely necessary given the need to employ an additional 9 million entrants into the labor force each year, while also absorbing workers affected by the reform of state-owned enterprises and occasional external shocks.

(iii) Interregional competition.  China built on its strong local governments at various levels by allowing them to compete in attracting investment, developing infrastructure, and improving the local business environment.

(iv) Domestic market integration.  A single national market was achieved by removing barriers to the movement of goods, labor and capital, and by major infrastructure investments connecting regions, and the interior to the coast.

(v) Steady integration with the global economy.  Thanks to the establishment of special economic zones, and membership of the World Trade Organisation.

Despite these impressive achievements, the initial forces supporting growth are gradually fading.  China has benefited from the latecomer's advantage by following a development path adopted by other countries like Japan, Korea, Taiwan and Singapore.  This makes the role of government relatively straightforward -- providing roads, railways, energy, and other infrastructure to complement private investment; allowing open trade and investment policies that encourage technological catchup; and implementing industrial policies when market and coordination failures inhibit the development of internationally competitive industries consistent with the country's comparative advantage. 

But as a country develops, direct government intervention may actually retard growth, not help it.  The policy emphasis needs to shift even more to private sector development, ensuring that markets are mature enough to allocate resources efficiently and that firms are strong and innovative enough to compete internationally.  In this regard, China also has a long reform agenda if it wants to avoid the "middle income trap" and go on to becoming a high income country.  This reform agenda includes:

(a) Strengthening the foundation for a market-based economy.  Key here will be lifting the heavy hand of government from state-owned enterprises and the banking sector, internationalizing the financial sector, and fully freeing the movement of Chinese citizens within the country (by phasing out the hukou city registration system).  The government's continued dominance in key sectors of the economy, while earlier an advantage, is in the future likely to act as a constraint on productivity improvements, innovation and creativity.  And the close links between the government, big banks, and state enterprises have created vested interests that inhibit reforms and contribute to continued ad hoc state interventions in the economy.  Overall, there remains a lack of clarity in distinguishing the individual roles of government, state enterprises and the private sector.

(b) Accelerate the pace of innovation and create an open innovation system.  This means greater participation in global research and development networks, increasing the quality of R&D,  and building a few world class research universities with strong links to industry.  The reality is that government and state enterprises conduct the bulk of research and development -- and part of this effort still seems divorced from the real needs of the economy.  The natural inclination may be to protect domestic research efforts and innovative companies.  But that would prevent Chinese researchers from interacting with external research efforts, cut them off from ideas, and lower opportunities to adopt foreign technologies.

(c) Seize the opportunity to "go green".  This involves encouraging new investments in a range of low-pollution, energy- and resource-efficient industries to not only improve the level of well-being and sustain rapid growth, but also address China's manifold environmental challenges.  China's current development pattern has placed considerable stress on the environment -- land, air and water -- and has imposed increased pressure on the availability of natural resources.  The costs of environmental degradation and resource depletion in China approached 10 per cent of GDP over the past decade -- air pollution accounted for 6.5%, water pollution 2.1%, and soil degradation 1.1%.  20 of the world's most polluted cities are in China.  More than half of China's water is polluted, over 300 million people use contaminated water supplies, a third of China's waterways are below the government's own safety standards; and about one-fifth of China's farmland has been contaminated with heavy metals.

(d) Expand opportunities and promote social security.  This will be critical in reversing the rising inequality, helping households manage employment-, health-, and age-related risks, and increasing labor mobility.  China's high inequality can in part be attributed to unequal access to quality public services, particularly those that hep accumulate human capital and increase public participation in the development process.  One such factor is the hukou system.  While the hukou system no longer restricts movement of labor from rural to urban areas, rural migrants without urban hukous are still denied access to social entitlements that urban resdients receive, like health care, education and housing.  One of the key constraints to hukou reform is that local governments have neither the resources nor the incentives to extend public services to migrants and their families.

(e) Strengthen the fiscal system by mobilizing additional revenues and ensuring local governments have adequate financing to meet heavy and rising expenditure responsibilities, especially on the large social and environmental agenda.  Four of the ten Asian cities most vulnerable to rising sea levels are in China. 

(f) Seek mutually beneficial relations with the rest of the world.  China has benefited greatly through integration with the world economy, and needs to do so more in the future.  Thus, China should increasingly play a central role in engaging with its partners in multilateral settings to shape the global governance agenda and address pressing global economic issues such as climate change, global financial stability, and a more effective international aid structure that serves the cause of development in poor nations less fortunate than China.

The fact that China is the second-largest economy in the world and yet ninety-third in terms of per capita income has created a huge gulf between the world's expectations about China's ability to shoulder important roles and responsibilities in global governance and China's perceptions of its own capabilities to do so.  The process of China's participation in global governance will inevitably be gradual as the international community and China make constant adjustments to accomodate each other.

There may very little new in the World Bank's recommendations, and many of these have been made by others, very often in the past.  Perhaps the most interesting part of the report is its discussion of the need to overcome opposition to reform.  The report identifies three kinds of opposition.

First, the most resistant group is likely to be vested interests, such as those enterprises that enjoy partial or full monoploy (or monopsony) in key markets as well as firms, groups, institutions, and individuals who obtain special privileges and benefits or enjoy preferential treatment from the current power structure and institutional setting.  In other words, the Communist Party is no longer a key driver of reform, but an important break on the reform process.

Second, another group that may oppose the reform agenda are those who are likely to be hurt from reforms in the short-term, even though they will gain in the long term.  This could include workers in loss-making enterprises, energy- and pollution-intensive  industries, and unregulated financial institutions who think the reforms will hurt their economic interests.

Third, there are opinion makers who equate today's problems as outcomes of earlier reforms rather than of distortions that remain.  Some for example attribute the deterioration in the natural environment (air, water, land) to the market mechanisms rather than to ineffective implementation of existing laws, rules, and regulations, or inappropriate price and incentive structures.

Although the World Bank does not draw the parallel, overall China seems to be looking more and more like Japan.  That is, a country that launched its development with great leadership, but got bogged down by vested interests when it need to switch its development path to a more domestic demand- and innovation driven- economy.

But China's situtaion may be even more problematic for several reasons.  China's reform process may be getting bogged down at an earlier phase in its development path than Japan.  China is now undergoing dramatic population ageing, and in contrast to Japan will become old before it becomes rich.  The world economy on which China has depended for its economic development will likely remain much more dangerous phase for a number of years.  Further financial crises cannot be ruled out, and with its growing integration into the world economy, China is now more exposed to the risks of crises. 

In part because of its non-democratic and corrupt regime, China is also more exposed to the risk of social and political unrest.  Indeed, China is currently bristling with political, social and economic tensions.  And the public's trust in the judicial system is very low, and social frustration has been building.  And China is also vulnerable to the dangers of natural disasters, some induced by climate change, like rise in sea levels, earthquakes, floods, droughts, tsunamis and pandemic, which are likely to be magnified by increasing urbanization.

Emerging economies, especially China, have been the bright spot in the world economy for a number of years now.  But as the future looks more and more disquieting, any major disruption emanating from the emerging world will not only hit them hard, but also the whole world economy.


World Bank.  "China 2030: Building a Modern, Harmonious, and. Creative High-Income Society".

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