Douglas Paal

Vice President, Carnegie Endowment for Int'l Peace

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by Douglas Paal

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Douglas Paal is Vice President for Studies at the Carnegie Endowment for International Peace.
Nov 01, 2013

Beijing has announced that the Third Plenum of the 18th Party Congress will occur November 9-12.   It follows the First Plenum in November 2012, which named the top seven leaders on the Politburo Standing Committee, and the Second Plenum in March 2013, which named the heads of the key organs of government to serve these leaders for the next five years.  The Third Plenum therefore will follow recent custom and lay forth the planned initiatives of the new government of President Xi Jinping and Premier Li Keqiang after the first year of staff work and internal bargaining.

Douglas Paal

Douglas Paal

The State Council has announced grandly that the meeting will reveal decisions by the Center to “comprehensively deepen reform on certain important issues.”  Some of the early rhetoric and analysis surrounding the build-up to the Plenum suggested the possibility of deep and comprehensive economic, political, and social reform.

By now, however, it is clear that political reform will take a back seat to economic reform at this stage.  The recent detentions and arrests of political and human rights activists, coupled with internal Party “mass line” and “self-criticism” sessions, indicate that the new leadership is wary of risking economic and political reform simultaneously, if ever.  The lessons of Mikhail Gorbachev’s failed effort to combine political openness with economic change, with the resulting collapse of the Soviet Union, appear to loom large in Beijing’s thinking.

The Communist Party of China openly fears for its future, but has decided to strengthen internal discipline and sternly attack pervasive corruption as the path to salvation.  This is not a radical return to Maoism, though the rhetoric sometimes rhymes.  But it does signal that the Party is unready to contemplate a more liberal course or a fundamental change in the nature of its governance.

One category of political and social policy that many internal and external critics advocate to reform is the hukou, or household registration system.  Estimates range widely, but up to hundreds of millions of migrant workers from backward rural areas of China are living as informal workers in Chinese cities in a state of second-class citizenship.  They lack the right to register as residents, and hence are denied access to public schools and social safety nets.  Underprivileged, they must work harder, save more, and are the most vulnerable to the economic winds of change.  Premier Li Keqiang’s repeated desire to expand urbanization, which may well be featured at the Third Plenum, could conceivably provide new homes for the migrants and farmers who would like sell their land to urbanize themselves.

Despite the manifest injustice of their condition, these migrant workers are likely to fall victim again to the high cost of changing the status quo.  Putting them on city roles could massively increase fiscal outlays for already strapped local governments to provide education and social services, with increased downside risk in case of a contracting economic environment.  Moreover, the hukou system is run by the Public Security authorities, whose leadership has changed little with the new Party Congress lineup and therefore is inclined to be conservative.

An important gauge of the Third Plenum’s prospects for reform can be found in the people filling the responsible posts in the Party and government, and this portends limited reforms in the financial sector.  Xi Jinping and Li Keqiang jockeyed their way to the top amid considerable political bargaining with the people they succeeded.  The mixed result was a Politburo Standing Committee with five of the seven leaders unable to serve beyond their current five year terms due to age limits. One or two lean toward greater reform; others do not.   So, in a sense, Xi and Li must pick and choose their policy agenda in the context of a mixed bag of administrators who range along a spectrum of preferences and vested interests from status quo to rapid reform.

Consensus is still the preferred means to do business, even if it got a bad name in the latter years of previous leader Hu Jintao, when it often amounted to indecision.  Implicit is that if Xi and Li have a serious reform agenda, it will probably have to await comprehensive implementation after the next leadership shuffle at the 19th Party Congress in 2017, when they will have a clean slate to fill with their own people at the top.

If this analysis is correct, the prospect for a reform agenda is greatest for the financial sector, where known reformers are more prominently placed.  Freeing up interest rates, deepening financial markets, regulating the informal banking sector, and introducing competition, would all make sense as partial but important steps toward long term capital account convertibility and banking efficiency.  This may offer openings for foreign financial firms to participate more deeply in the Chinese economy,, but details remain to be seen.

It is also plain that prices need to be less regulated to capture costs better and to price in the environmental impact.  So energy, electricity, and water use need to be better measured and allowed to have their scarcity reflected in the prices billed.  There may be gradual openings for foreign firms in these areas as well.

Fiscal reforms are overdue to set a large number of municipalities and provinces on a sounder footing.  The authorities are just completing a nationwide audit of their debt, and early reports suggest a figure of RMB 14 trillion in outstanding local debt.  The leadership has already determined that a national GDP growth target of 7-7.5% is necessary to maintain the revenues needed to service the debt.  But new revenues and reduced unfunded mandates are likely on the horizon for the Third Plenum.

Many observers have speculated that State Owned Enterprises (SOE’s) will be targeted for reform, much as when former Premier Zhu Rongji painfully but successfully closed large numbers of money losing SOE’s in the late 1990s.

Overt SOE reform seems unlikely for two important reasons.  The first is that they are making money today, unlike in the 1990s and contributing to a small but important extent to the fiscal health of the system.  The second is ideological, because Party conservatives believe that a “socialist” state must own at least some of the “means of production.”  Despite the oligopolistic character of many of the SOE’s and the distasteful fact that the “princeling” children of top leaders are disproportionately benefiting from them, the vested interests behind the SOE’s appear too strong to attack frontally at this time.

One possible outcome is an effort by the financial sector reformers in the current leadership to seek to use indirect means to erode the dominance of the SOE’s and other features of a state directed economy in favor of a more competitive environment.  If consensus can be reached on gradual liberalization of interest rates, it could force the SOE’s to improve efficiency and competitiveness.  And if policy encourages the rise of private sector competitors and the break -up of national SOE’s into regional ones, it can extract better returns needed for China ultimately to escape the middle income trap that has arrested many other countries’ development.

But of course the vested interests will recognize these back door challenges to their way of doing business for what they are and conduct a spirited opposition.  This may be one of the more interesting policy arenas to watch in the coming months.

Another is the newly announced Shanghai Free Trade Zone.  Pundits vary widely in their expectations for the impact of the Zone on foreign investment, given talk of “national treatment” and free capital movement.  Is the FTZ a rational way to pressurize domestic competitors to stimulate competition and efficiency, or is it a bone thrown to the Shanghai authorities for political reasons?  The rules for the Zone are being hashed out now, and the results may help gauge the strengths of the respective interest groups in the current leadership.  Foreign enterprises should watch this arena carefully to evaluate the potential opportunities.

Douglas Paal is Vice President for Studies at the Carnegie Endowment for International Peace.