Source: Financial Times

The let-down that China watchers felt when the much anticipated summary communique came out of the third plenum of the Communist party was soon overridden by the ambitious agenda laid out in the subsequent “decision” document. Despite the vagueness of the communique, the “decision” provided a comprehensive reform programme that, if acted upon, will absorb the energies of this generation of senior leaders and beyond. Ironically, rigorous implementation of these reforms will alter market incentives so that annual gross domestic product growth in the coming years could rise to 8-plus per cent even as the recent Central Economic Work Conference debated whether to lower the official target to 7 per cent to reinforce that quality now matters more than quantity.

There has been no shortage of commentary summarising the 16 sections and 60 key points in the “decision”, making it is easy to get lost in the plethora of specific measures, not to mention the broad objectives that have yet to be made actionable. Yet underpinning the discussions were two central goals: revamp the policies that had driven up debt levels and strengthen drivers of productivity so that growth will be more sustainable. If implemented, the third plenum package provides the basis for realising these two goals.

To make something so comprehensive into something comprehensible, think of the third plenum agenda as having: one core principle – that the market should be decisive; two policy instruments of revamped fiscal and financial systems; and three cross-cutting themes – the elimination of the urban-rural divide, the development of competition between the state and non-state sectors, and the clarification of the economic and political relationship between Beijing and local governments. All of this is to be implemented by two new co-ordinating groups, one dealing with economic issues and the other with security.

By stating that markets would be decisive in determining prices and allocating resources, this plenum has resolved a longstanding ideological issue in China but its operational significance remains to be seen. While product prices are now largely liberalised, continued state intervention combined with lack of competitive forces and weak institutions means that the key input prices of capital, land and labour will remain distorted for some time. Nevertheless, the push toward more market-based influences is now set.

Regarding policy instruments, China’s intended financial reforms are already under way. What is new in the third plenum statement is recognition that China’s debt problems can only be resolved through a major reform of the intergovernmental fiscal system. The to- be-developed reforms need to address two structural weaknesses. One is that the localities are responsible for providing most public services but most revenues flow to Beijing. The second is that the budget as a share of the Chinese economy is unusually low compared with other countries. As a consequence local authorities have increasingly relied on bank borrowings and land development to fund their expenditures rather than the budget. This has led to excessive credit for speculative property development and the reckless accumulation of debt.

The growth-enhancing part of the third plenum comes partly from narrowing the rural-urban divide. The tendency in the past to treat rural and urban areas as separate economic entities has created inefficiencies and exacerbated inequalities. That the ratio of urban to rural incomes is more than three – the highest of any major economy – illustrates the potential for securing productivity gains from a better-managed urbanisation process and moderating spatially-driven income differences. Thus the package of reforms dealing with land markets, access to social services and liberalised labour migration has the potential of ratcheting up productivity-driven growth and promoting equity.

The other part of the productivity agenda comes from fostering greater competition between the state and the private sector. The leadership has signalled its openness to continued private sector expansion, easing earlier uncertainties that have retarded private investment. The emergence of new private banks, which will be more willing to fund small and medium enterprises, will be another spur to private investment. At the same time, public investment in areas of genuine need, particularly social infrastructure, is being given an official nudge and, by drawing on the liquidity that already exists, should result in higher economic activity without the need for excessive monetary expansion.

The third cross-cutting theme is inherently more complex to address but also potentially more far-reaching in its impact. China’s achievements have been attained through a uniquely decentralised system of governance through which Beijing sets the performance targets for localities and uses the appointment of their key officials – party secretaries, governors and mayors – to shape incentives and establish accountability. This has worked well in supporting economic liberalisation by motivating the localities to respond to growth objectives, but it has discouraged political liberalisation by creating a preoccupation with the preservation of political stability as measured by containing social unrest.

Unsurprisingly, it is in this area of governance that uncertainty about the way forward is greatest. But the new leadership has clearly recognised that China needs to develop a more diverse set of economic and social criteria on which to assess officials’ performance. And there is also a nascent understanding that balancing these priorities is best achieved through a governance system which does better in perceiving popular needs and rewarding officials for being accountable to them. For these reasons, the creation of the co-ordinating groups dealing with economic and security issues, likely presided over by the top leadership, provides a logical closure to the thinking underpinning the third plenum proposals.

This article was originally published by the Financial Times.