With the conclusion of the politically delicate trial of Bo Xilai, the disgraced former Communist Party chief of Chongqing, China’s new leadership can focus on their real business – launching another round of economic reforms to sustain high growth for another decade. Perhaps not by pure coincidence, on August 27, the day after the closing of the Bo trial, the Chinese Communist Party’s Politburo announced that the third plenum of the 18th Central Committee will be held in November.
The agenda of the plenum is the formulation and endorsement of a package of economic reforms that are designed to address the mounting challenges facing the world’s second-largest economy. In the post-Mao period, this third plenum is comparable, in terms of its historical significance, to the other two plena – the third plenum of the 11th Central Committee in December 1978 that launched China’s reform and the third plenum of the 14th Central Committee two decades ago that accelerated liberalization.
These similarities aside, however, there are crucial differences between now and then. The pressure for radical reform was far greater on the previous two occasions. In 1978, when Deng Xiaoping returned to power, the impoverished country was yearning for an economic revolution. In 1993, the political debacle of the Tiananmen crackdown and the collapse of the Soviet Union forced Deng and his colleagues to realize that, without more radical economic reforms, the Communist Party would not survive for long.
Fast forward to 2013, the new leadership under Xi Jinping faces different and tougher challenges. Opposition to reforms today is not based on ideology, but comes from vested economic interests. In the last two decades, China’s investment-driven growth model has delivered rapid development, but also created interest groups dependent on this model, which can be summarized as channeling cheap capital into infrastructure and manufacturing investments as means of expanding physical capital. Because the Chinese government is in charge of this process, capital allocation is not based on market principles, but on political priorities. The result is the empowerment of local governments, state-owned enterprises, and central ministries.
To be fair, this state-led development model has done wonders in building China’s physical capital stock. But the financial and social costs have been unbearable. Excess capacity has destroyed profitability in most manufacturing industries. Poor investments threaten the health of the banking sector. Pollution has reached a crisis level.
The objective of the third plenum scheduled for November is to re-balance the economy and the development strategy. Unfortunately for the new leadership, the needed measures to accomplish this goal will almost certainly face strong resistance from entrenched interest groups that have been huge beneficiaries of the old growth model. It remains to be seen whether the new leadership can overcome their opposition.
To evaluate whether the third plenum can deliver a credible reform plan, we need to focus on four policy priorities. If the third plenum’s announcements include strong commitment and specific plans for carrying out these reforms, prospects for China’s sustained growth in the coming decade should be bright.
The top priority is financial sector liberalization. This will require the downsizing of China’s colossal state-owned banks, the introduction of real competition (the quickest and safest way is to give foreign and Hong Kong banks greater freedom and access), and the abolition of most interest rate controls (the recent announcement of liberalizing the lending rate is a small, but positive, step). These changes will help direct capital into more productive sectors.
A complete overhaul of the fiscal system is the second priority. The current fiscal system, established in 1994, gives too much revenue to Beijing and too little to local governments. As a result, local governments have to rely on land transfers to generate income. A new fiscal system should broaden the tax base and rebalance revenue sharing between the center and the provinces. However, there should be tough strings attached. Local governments must re-orient public spending to social services.
The third pillar of reform is the downsizing of state-owned enterprises. These firms currently enjoy monopolistic protection and privileged access to cheap capital. Breaking up these firms to encourage competition is one approach. Privatizing some of them will send a strong signal to the market. Permitting private and foreign firms to enter markets previously dominated or monopolized by these firms will help increase efficiency and dynamism of the Chinese economy.
The last critical component is social reform, specifically the abolition of the hukou (household registration) system. This relic of the Maoist era restricts labor market movement, exacts a heavy implicit regressive tax on China’s most disadvantaged group (rural migrants who are excluded from government-paid social services in the cities), and limits social mobility. Announcing a firm timetable for its abolition can reassure hundreds of millions of rural migrants that they and their children have a bright future as full citizens of the Chinese nation.
Taken together, these are bold and decisive measures. If Mr. Xi and his colleagues can push them through the third plenum, they will prove, once again, no one should bet against China. If they fail, the future of the Communist Party will be in grave doubt.
Minxin Pei is the Tom and Margot Pritzker ’72 Professor of Government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Fund of the United States