The two roadblocks to real reform in China

China’s reform program has reached an impasse, with fundamental conflicts of interest and subtle resistance mechanisms blocking progress. Until these barriers are removed, there is little hope that China’s slowing economy – which grew by 7.4% in 2014, its lowest rate in nearly a quarter-century – can rely on reform to give it the push it needs.

Chinese leaders are well acquainted with how difficult it can be to implement drastic reforms. When Deng Xiaoping launched his radical program of “reform and opening up” in 1978, he faced fierce opposition – mostly from fervent ideologues and revolutionary diehards. Just as Deng’s status and forcefulness enabled him to face down his opponents and keep China’s economic modernization on course, President Xi Jinping’s determined leadership can overcome vested interests and implement the needed reforms.

Of course, reconciling the fundamental misalignment of interests in China will not be easy – not least because interest groups will not discuss, much less oppose, reforms in an open and transparent manner. Instead, they argue that the reforms are too risky or purge their substantive provisions. Only small concessions have been made to scaling back government intervention, affecting powers that are either irrelevant or never actually existed.

There are two types of conflicts of interest among the government bodies. First, China’s powerful bureaucracy is disinclined to cede its powers in the name of liberalization and a shift toward a more market-oriented economy.

For example, the Assets Supervision and Administration Commission of the State Council (SASAC) is the ministry-level government institution responsible for state-owned enterprises. Its task now includes eliminating the SOEs’ monopoly power, which is hampering market competition. But reducing the SOEs’ power would also mean a diminished role for SASAC – and, most likely, its eventual obsolescence. As a result, efforts to fight monopoly are lagging, and the next stage of reform – the transition to a “blended ownership system” – remains distant.

Similarly, the State Administration of Foreign Exchange (SAFE), the subsidiary of the People’s Bank of China that controls the foreign-exchange transactions of commercial banks and households, derives its power from controlling capital inflows and outflows. Recognizing that progress toward capital-account liberalization would imply its eventual demise, SAFE has made numerous excuses (to which the recent financial crises in the West have lent credence) for retaining tight control over foreign-exchange transactions. So, despite the government’s stated commitment to liberalize the capital account, the PBOC has yet to make observable progress.

The second major conflict of interest in China is between the central and local governments, which are supposed to be adjusting their revenue-sharing model. The problem lies in a mismatch between their respective shares of tax revenues and mandatory expenditures. With local governments forced to cover a large proportion of public spending with a disproportionately low share of revenues, local-government debt has swelled.

But the central government remains reluctant to make significant changes to the revenue-sharing model, wary not only of the effects on its coffers, but also of conferring more authority on local officials. Moreover, they doubt local governments’ ability to manage their budgets properly and to use the additional tax revenues efficiently.

The fundamental contradiction, as these examples show, is between the goals of the reform process and the incentives that underpin them. Nowhere is this clearer than in the “mixed ownership system” envisaged by the Third Plenary of the 18th Central Committee of the Communist Party of China. Encouraging the private sector to take stakes in SOEs in strategic areas like energy, power, and finance is supposed to increase competition, boost efficiency, and reduce pressure on the government to invest.

But why should private investors put their money in SOEs? As minority shareholders in firms whose managers are appointed by the Central Personnel Ministry, private actors cannot influence decision-making. Until the central government is willing to yield its control over SOE management, ownership reforms are likely to spark only tepid interest from the private sector.

If implemented fully, the current round of reforms would have a far-reaching impact on China’s political economy, because they shift the balance of power from officials to markets. This would enable China to continue its ascent toward high-income status, improving the wellbeing of millions of its citizens along the way.

But vested interests will not back down. Though they will not oppose reforms outright, they will continue to procrastinate and spread fear about economic instability and social tension to prevent changes that threaten to diminish their status and prerogatives. Unless and until China’s top leaders overcome such resistance, progress on reform will remain sluggish.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum. 

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Author: Keyu Jin, a professor of economics at the London School of Economics, is a World Economic Forum Young Global Leader and a member of the Richemont Group Advisory Board.

Image: Pedestrians walk under red lanterns at Pudong Financial Area in Shanghai. REUTERS/Aly Song