How a Great Power Falls Apart
Decline Is Invisible From the Inside
In early November, as Beijing braced for the Communist Party’s Third Plenum, the high-level conference that would decide major policies for the next decade, President Xi Jinping appeared to deliberately raise expectations for major economic reforms. He spoke of a “comprehensive” reform plan and invoked Deng Xiaoping, the man who changed history by overhauling China’s economy and politics at an earlier Third Plenum, in 1978.
Yet no sooner had the plenum closed and the party released its initial communiqué than observers dismissed the meeting as a bust. Markets slumped. Hong Kong’s Hang Seng Index dropped 1.9 percent, to its lowest level in ten weeks. The Shanghai Composite lost 1.8 percent. Many commentators argued that China’s leaders, faced with their first big test, were disinclined -- or else too timid -- to undertake the sweeping economic reforms that Xi had promised.
But then the verdict abruptly shifted with the release of a follow-up 60-point decision document, which presented a sweeping economic reform agenda that included new commitments to financial liberalization, the repair of China’s social safety net, new protections for property rights, and greater reliance on market forces. Across Asia, the markets shot upward.
Several factors explain this quick swing from pessimism to exuberance, not least of which is a volatile combination of high expectations for China as the world’s second-largest economy and deep cynicism about the Chinese leadership’s intentions and political will to overcome vested interests that oppose reform. Many look to Beijing to change its investment-led growth model to one based on consumption and innovation. And many will continue, therefore, to see what they want to see in the plenum’s reform agenda -- both its promises and shortcomings.
But it is vital to assess the plenum’s commitment to reform against the realities of China’s political economy and the Chinese government’s own goals. And, on that score, the plenum has reinvigorated a reform process that will, in time, make the Chinese economy more resilient, dynamic, and sustainable.
A month removed, it is possible to be more reflective about the plenum, what it did, and what it failed to achieve.
The meeting’s principal conceptual contribution was to replace the word “basic” with “decisive” in the 60-point “Decision on Major Issues Concerning Comprehensively Deepening Reforms” to describe the market’s role in allocating resources. With that change, it is now clear that the Chinese government is committed to pursuing and executing market-based reforms, much as we predicted in Foreign Affairs last spring. From Beijing’s perspective, this is an intellectual breakthrough because it means that Chinese leaders are prepared to allow the market to have a greater role in parts of the economy that have, until now, been mostly reserved for the state. One example is the allocation of capital, which has been concentrated in government-backed banks or else in informal lending channels. The plenum committed to boost the formal role of private capital.
Still, although this breakthrough is substantial, it would be a mistake to think that it is conclusive: to make the market decisive, the state must also retreat. That is why the question of the role of the state will define much of the reform challenge ahead. China’s premier, Li Keqiang, has declared war on powerful “vested interests” that oppose market reforms. But the biggest vested interest in the Chinese economy is, in fact, the state itself.
So Beijing must change the state’s relationship not only to the economy but also to Chinese society and individual citizens. Simply put, the state must transition from an “administrative” state to a “regulatory” one -- in other words, it must become more of an umpire among contending interests than an active participant in an economy that referees itself.
None of that will be easy to do. Even after 35 years of economic reforms, ideologues remain. They instinctively distrust market forces and still prefer the government to manipulate and control the market. The plenum’s outcome suggests that the state must surrender such roles if many of the reforms are to take hold.
Take prices -- a fundamental market signal of the relationship between supply and demand. In China, three important prices have been controlled by the state or have been subject to the frequent interventions of Chinese bureaucrats: the exchange rate (the price of the Chinese yuan relative to other currencies); the interest rate (in simplest terms, the price of money); and energy and resource prices (input prices).
To reduce an expensive subsidy to export industries and encourage domestic consumption, China’s currency was already appreciating before the plenum, and the eventual shift to a market-determined exchange rate seems almost certain over time. But the other two sets of prices -- interest rates and energy prices -- also appear poised to be further liberalized.
First, China has already liberalized lending interest rates, but it is likely to eventually liberalize deposit rates too. The Chinese central bank has outlined various steps, including testing the policies on an experimental basis in the newly established Shanghai Free Trade Zone and establishing deposit insurance, that should lead to market-based rates over the next several years.
Second, over the last decade or so, China has haphazardly liberalized the prices of some inputs but not others. In many cases, that has created complicated and distorted prices. For instance, although China imports crude oil at global market prices, the rate at the pump is controlled by the central government to protect consumers from inflation. This policy has led to regular hoarding of gasoline before anticipated price hikes and gripes from the oil industry about losses on their upstream investments. But during the recent plenum, China pledged to liberalize the price of commodities and scarce resources that have previously been subsidized, including oil, natural gas, and, over time, perhaps even water.
Subjecting these prices to market discipline will encourage more competition, allow banks to operate more like commercial ventures, and incentivize energy-intensive producers to become more efficient and invest based on a truer sense of costs. Market-based pricing will be a powerful tool for the government and companies to rationally and efficiently allocate resources and manage runaway resource consumption. To do so, however, the Chinese state must also be prepared to cede a long-standing pillar of its authority, reduce price controls, and perhaps tolerate a higher level of inflation.
Millions of Chinese once relied on an explicit social contract with Beijing. For most of its contemporary history, the state provided virtually all aspects of job security, social security, and retirement security, usually delegated through state-owned enterprises (SOEs) and other work units (danwei). That changed in the 1990s when SOEs, facing a “reform or die” moment, were forced to dramatically alter their functions. They became more commercially oriented and, in the process, shed many of their welfare obligations.
But since then, Beijing has largely failed to replace the old system with a new one of comparable quality and scope. Local governments, seduced by the lure of investment-led growth, spent liberally on infrastructure, housing, and other fixed assets rather than on welfare and retirement services. In some cases, local politicians shifted resources from social welfare to lucrative ventures such as real estate. One Politburo member, Chen Liangyu, was even indicted for pilfering some $4.8 billion from Shanghai’s social security funds to line the pockets of property developers.
The plenum unambiguously articulated the need to repair China’s social safety net, in part through fiscal transfers that will allow the central government to boost public spending on health care and pensions. It also encouraged the private sector to play a larger role in providing these services, particularly as an aging Chinese society demands more benefits. In an ironic twist, SOEs will likely be forced to partially resume their previous role as a source of social services funding. The dividends that they pay to Beijing will be raised two or three times to 30 percent by 2020, with the additional funds going to social welfare.
But to meet the public’s needs and rising expectations, the state cannot simply rearrange resources and rebuild the social contract. It must also deal with the questions of property rights and mobility. The plenum decision began to address these by giving citizens, especially rural Chinese, more property rights. Although the state nominally “owns” all land, Chinese citizens living in cities are allowed to buy and sell property, and they have a mortgage market to help them do so. But rural farmers have virtually no right to sell, transfer, or develop their own land. The plenum pledged, albeit without a timetable, to permit rural land to be sold, rented, or leased with “equal rights” and “equal prices” to state-owned land. Allowing farmers to use land as collateral should soon follow. And that, in turn, should incentivize rural Chinese to move into cities and take jobs in more productive sectors.
The logical next step would be to reduce, and eventually remove, controls on mobility -- the so-called hukou system that denies millions of Chinese equal access to social welfare benefits on grounds of “illegal” migration to the cities. The policy, enacted in a previous era to prevent a massive influx into cities, no longer makes much sense. China is now a majority urban country and the legions of migrants who intend to remain in the cities will not leave simply because the government denies them equal rights. There is a hint of change that the hukou policy may now be scrapped in townships and smaller cities -- but it will come neither quickly nor easily.
STATE OF BEING
Ultimately, China will need to reorder the state’s basic functions relative to the market, the social contract, and the citizen. But Beijing must also look to remake the state itself so that it is more capable of governance that will allow the market to work. That means the state must become more of an arbiter-like umpire than a pervasive and self-regulating participant in the economy.
Liberalizing prices is one step in the right direction because it will weaken bureaucracies whose current mandate permits them to use price controls to interfere with the market. Another step would be to ease market entry for private firms, which often face high administrative hurdles from local authorities. Already, the central government has taken modest steps with reforms that cut down on red tape and streamline project approvals at the local level. China has no dearth of rules and regulations, but there are few checks or balances on the state. Beijing could get back to basics by strengthening regulatory institutions and increasing enforcement capacity.
Yet surely many will wonder how the state can be remade if SOEs remain so dominant in the economy. The plenum’s decision revealed no intention to either downsize or privatize the most important state-owned firms, but such expectations were unrealistic in the first place. The fact is that large-scale privatization is off the table for now.
Still, Beijing could help to discipline SOEs by exposing them to robust competition. If the sectors that they now dominate were opened to private firms and foreign entrants, SOEs would become less sheltered entities. The plenum document alluded to this, but the test is likely to come in trade and investment negotiations. Foreign competitors will insist that Beijing open more sectors to fair and equal competition, and this would ultimately benefit Chinese firms too. If SOEs cannot compete and survive, then the state would need to be prepared to let some of them fail, much as the Chinese government ostensibly tolerated in the 1990s.
Competition is an essential ingredient of well-functioning markets that shapes the behavior of a firm, whether it is public or private. Norway’s Statoil is a state-owned firm that behaves like any private firm and has adopted global best practices. By contrast, the Chinese telecom giant Huawei is a nominally private firm that functions more like a state-backed national champion, often receiving state support in various guises. Even without privatization, then, Chinese SOEs could become more disciplined if they were exposed to greater domestic and foreign competition.
It is no small thing to restructure a $9 trillion economy, in which financial, labor, and industrial reforms are now inextricably interconnected. If reforms are to succeed, China needs not just to expand the market but also to refashion the state, even if a large state sector remains a fact of life. This is, ultimately, more of a political question than an economic one, and one that cannot be resolved overnight. So it is no surprise that Beijing gave itself until 2020 -- halfway through Xi’s second term, when he is expected to be joined by five new colleagues on the seven-member Standing Committee, a wholesale turnover -- to implement some of the toughest reforms. That will buy the Chinese leadership and its economy some breathing room as the country attempts such a massive rebalancing.
Many have bet long on Chinese growth over the last decade, believing that Beijing would continue to show a surprising capacity to adapt. The ambitious economic reform agenda that emerged from the Third Plenum suggests that their instinct was, on balance, right. Even amid a wave of bearish sentiment in recent years, it would be worthwhile to again bet long on reforms over the next decade.