A year after China’s Communist Party vowed to give markets a decisive role in allocating resources, state intervention in the economy remains pervasive.
Chinese leaders, even as they celebrate “market-oriented reform,” continue to steer credit to favored borrowers, limit the ability of workers to move easily to pursue job opportunities and safeguard the privileged role of state-owned enterprises.
Though full implementation of the 330 reforms that Chinese President Xi Jinping promises isn’t due until 2020, the emerging picture underscores the complexity of the planned overhaul and the significant state role that is likely to endure in the world’s second-largest economy.
“They don’t have in mind laissez-faire capitalism,” said William Overholt, president of the Fung Global Institute in Hong Kong. “They have in mind a lot of big state enterprises that get various forms of support from the state. They have in mind reforming them, not abolishing them.”
After more than three decades of 10 percent average annual growth, China’s leaders are attempting the next step in building a “socialist market economy.” The transformation will involve revamping interest rates, energy costs, land rights -- just about every ingredient in the capitalist cookbook.
Making the task trickier is a deceleration that has China growing at its slowest pace since 1990. In response, Chinese officials at a Dec. 9 meeting may lower their growth target for next year to 7 percent, according to Goldman Sachs Group Inc. Forecasters at the nonprofit Conference Board anticipate an even sharper drop to about 4 percent growth by 2019.
The investment-heavy formula that more than doubled China’s output since 2005 has lost its punch. Over the past decade, the real rate of return on capital has fallen by half, according to research by Bai Chong-en, an economics professor at Tsinghua University. “China in recent years shows sharply diminishing returns” on its investments, concluded David Dollar, a senior fellow at the Brookings Institution, in a 2013 study.
China's President Xi Jinping delivers an opening speech of the APEC CEO Summit as part of the Asia-Pacific Economic Cooperation (APEC) Summit at the China National Convention Center in Beijing, Sunday, Nov. 9, 2014.
Xi’s embrace of market forces is aimed at reviving China’s prosperity engine, thus making the future safe for its one-party system.
“These reforms are meant to strengthen and maintain the current political setup,” said Louis Kuijs, chief China economist at Royal Bank of Scotland in Hong Kong. “The reforms are not an objective by themselves.”
Since the 1978 start of what it calls “reform and opening,” China has taken a gradual approach to abandoning the command economy. Today, the country remains a hybrid: Goods producers operating in global markets face fierce competition, while at home the state determines the price or availability of credit, land and energy.
At last year’s third plenum, the party’s Central Committee pledged to let resources respond to market forces and to limit the government’s role to maintaining stability and providing public services.
“The underlying issue is how to strike a balance between the role of the government and that of the market and let the market play the decisive role in allocating resources,” the Central Committee said.
The market emphasis comes as Chinese leaders replace the old export-led growth model with a greater reliance upon domestic consumption. That evolution -- though promising a better life for the emerging middle class -- is outpacing the government’s levers of control.
“You can’t use administrative measures to decide what to produce,” says Karlis Smits, senior economist with the World Bank in Beijing. “From the top, it becomes too complex to get efficient outcomes.”
Unwinding decades of central planning is proving politically and economically fraught. Moving too quickly to erase distortions caused by earlier state intervention -- say by removing all interest rate controls -- risks financial turmoil. Implementing reforms in the proper sequence also is vital, since many -- such as interest rate liberalization and the opening of the capital account -- are interrelated.
The first steps already have meant volatility. China’s state-owned airlines were caught off guard earlier this year when, in a step toward allowing the market to set the currency’s value, authorities doubled the yuan’s daily trading range.
The decision put the Chinese currency on course for its first annual loss against the dollar since 2009. Chinese airlines, which book revenue in yuan while buying aircraft and fuel with dollars, saw earnings evaporate.
China Southern Airlines Co. (1055), the nation’s largest carrier, suffered a 1.1 billion yuan ($179 million) net foreign exchange loss in the first half of the year as the currency sank 2.4 percent in dollar terms. A year earlier, the airline had posted a 1.52 billion yuan gain.
In a Nov. 9 speech, Xi acknowledged risks but insisted the economic redesign would be implemented. “An arrow shot cannot be turned back,” he said. “We will advance reform with firm resolve.”
Some worry that the initiative may stall amid opposition. The U.S.-China Economic and Security Review Commission, a congressional advisory body, concluded in its annual report that Xi made “little to no progress” this year.
“You shouldn’t be too hopeful about prospects for reform,” says David Hoffman, who heads the Conference Board’s China office. “There’s a lot of resistance there and also a lot of risk.”
Progress has been mixed in the financial sector. In September, when the People’s Bank of China wanted to pump more money into the economy, it gave 500 billion yuan to five hand-picked banks rather than lower interest rates and let the market decide which institutions received additional credit. The central bank, which isn’t independent of the Communist Party or Chinese government, injected an additional 269.5 billion yuan in October.
“That’s taken reform backwards. Providing credit to targeted banks -- that’s the opposite of letting markets play a more decisive role,” said Dollar, a former U.S. Treasury Department official based in Beijing.
Last month, the PBOC surprised investors by cutting interest rates for the first time in more than two years in response to signs of weakening growth. Central bank officials had been reluctant to cut, believing it would send the wrong signal about the need to wean the economy from its debt addiction and to avoid further subsidizing loss-making state-owned enterprises, according to economists such as Lu Ting, Bank of America Corp.’s head of greater China economics in Hong Kong.
Chinese leaders also plan to free migrant laborers to move more easily from the farm to the opportunity-rich cities. In July, the State Council announced changes in the household registration, or hukou, system that has anchored Chinese citizens to specific locales since the 1950s.
More than 1 million Chinese every month move to the cities. The vast majority are unable to transfer their registration to their new place of residence, depriving them of health care and preventing their children from attending city schools.
“I have made so many contributions, doing my work and paying tax, to Beijing,” said Peter Kou, 32, a sales consultant who migrated to China’s capital from his native Henan Province a decade ago. “But I can’t enjoy the benefits that a Beijing local has. That’s so unfair.”
Under the new rules, restrictions will be lifted entirely for the smallest towns and loosened for cities of up to 1 million residents.
The government intends to maintain “strict control over the population of megacities,” meaning migrants will continue to be discouraged from pursuing the plentiful job opportunities in the 14 largest cities, including Beijing, Shanghai and Shenzhen.
The cost of leaving perhaps 200 million people without full rights in 2020 will be measured in human capital. Migrants’ children, unable to attend better city schools, are unlikely to develop the skills needed for China to become a more innovative economy. Yet officials fear faster action is impossible before local governments have the ability to raise revenue for needed services -- another policy change in the pipeline.
To be certain, China has made progress on the third plenum agenda. In March, regulators approved a trial of five private banks. Five months later, the rubberstamp legislature agreed to a new budget law enabling local governments to raise money through direct bond sales.
Most interest rates, except for the benchmark deposit rate, have been liberalized. And last month, regulators opened a link between the Shanghai and Hong Kong stock exchanges, edging toward an opening of the capital account.
“There has been a fair amount of progress,” said Yao Yang, director of Peking University’s China Center for Economic Research. “By 2020, China probably will be a market economy, except it will still have a special presence of big” state-owned enterprises.
That’s a big exception. Though previous reform episodes shrank the state-owned sector, it still accounts for roughly 30 percent of China’s gross domestic product and more than 42 percent of industrial output, according to the World Bank.
Xi wants to make China’s state-owned enterprises more competitive and preserve a dominant role for public ownership. State businesses are especially prominent in strategic industries such as defense, electricity and oil.
The 100,000-plus enterprises, however, stand at the center of China’s wasteful system of finance and investment. They enjoy easy access to almost unlimited funds even as more profitable private companies sometimes go begging.
Xi’s program falls short of halting that profligacy. The 4.5 percent return on assets for state-owned industries is less than half that of private companies, suggesting the money China pours into its state firms could be better invested elsewhere, according to a study earlier this year by Andrew Batson, director of China research at GaveKal Dragonomics in Beijing.
“It’s probably the No. 1 reform issue they face,” said Frederic Neumann, co-head of Asian economic research at HSBC Corp. in Hong Kong. “It’s probably where the most capital is being wasted.”
Change won’t come quickly. Last month, a group of foreign investors visited China to examine several state-owned companies. Anne Stevenson-Yang, co-founder of J Capital Research, a Beijing advisory firm, who accompanied them, explained to the group’s Chinese hosts that the investors had come in response to China’s promised reforms.
The reaction of the state-owned companies’ bosses? “They laughed,” she said.