RED ZONE: China’s economic reforms

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Xi Jinping. Photo Credit: Getty Images/Sasha Mordovets

2014 will be a critical year in China’s attempt to clear the so-called middle income trap — a bad patch in economic development when newly industrializing economies reach but can not progress beyond that stage. It typically occurs when per capita income reaches $10,000-12,000 a year. Soar above that, and a country goes on to become a high-income or developed economy. Otherwise, it just gets stuck.

China’s annual per capita income is now above $6,000. The economy will likely have to clear the middle-income trap within the term of Xi Jinping’s leadership. Most developing nations do not make it. Of 101 countries that were middle-income in 1960, only 13 had become high-income countries 40 years later, according to a study by the World Bank.

The main reason that the failures fail is not that they do not move up the production value chain, developing their own technologies and becoming more innovative in place of being merely imitative, all the hallmarks of a middle-income country. It is because they do not put in the necessary structural reforms to strengthen the rule of law, governance and accountability.

Those are all needed to foster a good environment for business. Without it, a developing nation cannot overcome the inevitable law of large numbers. It is a far greater task to grow a $6 trillion economy by 10% in a year than to grow a $350 billion one by a similar amount. That latter number, as it happens, is roughly the size China’s economy was in 1981 in nominal terms. Thirty years of double-digit annual growth turned it into a $6 trillion one.

The low-cost manufactured exports and fixed asset investment that drove that rapid growth cannot be sustained at their previous pace. The supply of workers and capital available to be switched from low-productivity agriculture to higher-productivity manufacturing is running dry. And, in China’s case, unfavorable demographic trends are coming into play.

Xi and prime minister Li Keqiang understand that the economy needs to change for the next phase of its development, and that the state capitalism that served the country well for the past 30 years will not do so for the next 30, and not even the next 10. The Party’s behind-closed-doors Third Plenum, held in November, was an exercise in making the Party’s next level down of leadership sign off on that understanding and its implication — that structural reform is needed to promote a market-based economy, redefine the role of government, lessen the power of state-owned enterprises (SOE) and develop the private sector.

Xi got the broad if not unanimous support of the Party’s senior leaders. He had to couch his objectives in the more socially conscious language of harmony and inclusion, and accept a post-meeting communiqué that said reform would give markets a “decisive” role in the economy but also “unceasingly increase the energy, control, and influence of the state economy.” A lot of the detail on how that near-impossible balance will be achieved is yet to be thrashed out. 2014 is the year when that hashing-out starts in earnest.

It is the politics of those details that make 2014 such a critical year. The changes that China needs to rebalance its economy — its proxy language for structural reform — go the hub of the nexus of government, Party and state. There are clear implications for the Party in adopting market reforms that will eventually challenge its monopoly on power. Xi has to get off on the right foot if he is not to risk a backlash from Party hard-liners.

Precedent is against the Party retaining monopoly rule. No country, as noted, has successfully cleared the middle-income trap and remained a one-party state. Examples abound close to home: Japan, South Korea, Hong Kong, Taiwan and Singapore, to take five from the World Bank’s baker’s dozen. Even the closest approximation any democracy outside a city-state has had to one-party government, the Liberal Democratic Party that oversaw Japan’s post-war economic miracle for 38 uninterrupted years in office, was eventually put into opposition at the ballot box.

It would be asking a lot of Chinese exceptionalism for the country to defy that weight of history. For the Party to retain a leading role — even if leading is redefined in rich China not to mean monopoly — it will need to find a way either for its existing elite to prosper in China’s reformed economy or to co-opt the new elite the new economy throws up — just as the old elites absorbed the wealth-creation of the infrastructure investment driven economy of the past 30 years.

Reining in the power and privileges of the SOEs provides a challenge to Xi and Li in this respect. SOEs, like the People’s Liberation Army, are a wellspring of power, money and influence for the princelings. The descendants of Mao’s original revolutionary leaders form an elite collective dynasty of some 400 families who hold extensive sway over the Party, military and the economy. This has left China with a politically entrenched public sector of state-owned enterprises that dominate the economy, particularly in banking, energy, telecommunications and transport. Yet loosening the SOE grip on such key sectors of industry and finance to provide more room for private entrepreneurs is an essential component of the reform program.

Breaking the vested interests will be hard. Where they are not corrupt, they are systemic — and in some cases the’re both. The princelings, though, are neither a monolithic block nor are all opposed to reform; Xi himself is one of their number. But modernizing the governance of the PLA to make China’s military internationally competitive is an easier sell for the reformers — and creates more winners among the incumbents — than modernizing state-owned enterprises and banks to the same end.

By most accounts, Xi has moved early to consolidate his power. 2014 will be the year when he has to start to deploy it with very particular purpose, notably to resolve the inevitable factional infighting between the inevitable winners and losers from reform. His plan seems to be first to expand financial-markets reform to bring market-pricing to capital, then to let markets take over from government the leading role in pricing land, energy and water.

The intention is to promote more efficient allocations of those resources than the present system of subsidies, then let that work its transformative power on the broader economy while giving time for the old elites to adapt to the new economic realities. At the same time, the president is using an anti-corruption campaign and strictures against official extravagance to back up a message of both the necessity and inevitably of reform.

Like a pole vaulter facing a difficult jump, Xi has firmly grasped the pole of structural reform and taken the first steps down the runway. 2014 is the year he must start to accelerate, albeit in a measured way, if China’s economy is to generate the momentum to propel it into the ranks of rich countries. If he fails, China could languish for decades as a middle-income country like South Africa or Brazil. That is not what most Chinese see as an acceptable future.