Source: Financial Times

Markets are fixated on whether the falling growth rate of China’s economy finally bottoms out this quarter but when the next generation of China’s senior leaders takes centre stage next month, this will be a trivial matter compared with three key policy choices they will face over the coming years. These are recalibrating the respective roles of the state and the private sector; reducing Beijing’s reliance on the banking and finance system in favour of the government’s own budget; and allowing the pace and pattern of urbanisation to be shaped more by market forces than centralised directives.

For the public, the overriding concerns are widespread corruption and increasing disparities. For the economic growth process to be enduring, it cannot continue to foment the kind of social unrest that now requires more to be spent on internal security than on the military. There is no simple solution for these concerns, but acting on the three choices will go far in addressing the root causes.

Beijing has succeeded in making the right choices in these three areas before. China became the world’s second-largest economy because its leaders allowed the private sector to play a greater role. It skilfully used its financial institutions to secure the resources to rebuild its basic infrastructure when its fiscal position was too weak to play this role. And improving connectivity and labour mobility across regions allowed China to benefit from the economies of scale that came with urbanisation.

Yet as successful as these initiatives have been, their impact has faded in recent years largely because of the emergence of vested interests which are now milking the system. The choices facing the incoming leadership are tough, not so much because of their analytical complexities, but because of the political capital required to tackle them.

Perhaps the most sensitive issue concerns the role of the state. A decade ago it was ideology that made scaling back the state’s dominance difficult. Now, with so many state entities having benefited from their privileged position, it is the potential for self-gain that is holding needed reforms hostage. The fate of these state-owned enterprises has become so interwoven with the interests of well-connected Communist party officials and state-controlled banks that many reformers have given up on the possibility that these unholy relationships can be broken. But the outlines of what needs to be done are known, including creating intermediary agents to separate ownership and operating responsibilities for state enterprises, and promoting more competition by opening up activities restricted to the state to private sector entry.

The financial sector has been the glue binding together various vested interests. China has relied on its banks to fund state-mandated initiatives, including many that should have been supported through fiscal channels. While critics have complained that this was achieved through financial repression, this strategy did make possible a massive investment-led growth process. But the weaknesses of this approach are now becoming more apparent. Funding biases have limited the opportunities for the private sector to drive innovation while the budget has been inadequate in meeting the escalating demand for social services at local levels, thus contributing to the sense of widening disparities.

Reducing the excessive dependence on the banking system requires overcoming the vested interests of the party which finds it easier to deal with a handful of state banks than two dozen provincial level budgets – even though a revitalised fiscal system would offer more transparency and accountability.

Managing the growth of cities including establishing more reliable sources of revenue is another important challenge. Many in China see rapid urbanisation as a mixed blessing. On the plus side it spawns more economic activity but this comes with emotionally tinged perceptions about increased congestion, environmental degradation and deteriorating services. Thus the debate has been about curtailing the pace of urbanisation and altering its pattern by promoting secondary cities while restricting growth in the larger ones. China’s mega-cities are generally perceived to be too large, but the problem lies more with flawed urban management practices than absolute size limits.

This year the proportion of China’s population living in urban areas reached 50 per cent, but given its enormous population relative to arable land, the urbanisation rate is still too low. Excessive numbers of Chinese are still working in rural areas for low returns. Their movement to more productive urban-based activities is the easiest option to secure the productivity increases needed to keep the economy growing at about 8 per cent over the coming decade.

The greatest barrier to China’s urbanisation process is its unique “hukou” system which makes it difficult for the country’s 250m migrant workers to establish legal residency and access services in the major cities. Liberalising the residency system would go far in ameliorating social tensions and stimulating expansion in services which is the key to unlocking China’s longer-term growth potential. But here too, strong vested interests are holding back reforms. Municipal leaders are reluctant to lift hukou restrictions because of unwarranted fears about reduced job opportunities for established residents and budgetary pressures for additional programmes.

With each generational change in the leadership, there is a burst of wishful thinking that major reforms may now materialise. The more cautious realise that China’s collective leadership system reduces the likelihood of game-changing shifts, and history tells us that progress is more likely to come from initiatives that are piloted locally and then adopted nationwide. This pragmatic approach has worked well in the past but for these three policy choices, vested interests create an imposing gridlock. Just one or two strong signals of policy direction coming from the new leadership can pave the way forward.

This article was originally published in the Financial Times.