By the Blouin News Business staff

A look ahead to China’s pivotal third plenum

by in Asia-Pacific.

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Liu He. Photo Credit: China News Service

Liu He is arguable the most important person in the global economy right now. The 62-year-old deputy head of China’s National Development and Reform Commission, the country’s top economic policy agency, and an influential hidden hand behind China’s economy since at least 2008, is drafting the report on economic reform that President Xi Jinping will present to the Party’s third plenum next month.

That meeting, a gathering of the most senior leaders in the country, is being talked of by state media in the same breath as the third plena of 1978 and 1993. At the former, Deng Xiaoping launched the opening-up of China’s economy to the world; at the latter Zhu Rongji kicked off the dirigiste socialist market economy. A high level of expectation is being set that Xi will usher in a similarly massive transformation of the world’s second-largest economy.

There is broad consensus among China’s highest levels of leadership — and has been for some years — that the high-growth investment and export model that has propelled China’s economy for three decades has run its course. The well of cheap labor, transferred from farm to factory, is running low. China’s demographics, too, are working against growth. The value of foreign-developed technologies is diminishing as they age.

Most of all, the economy needs to move up the value chain, developing native technologies, and get productivity gains from innovation and the efficient use of capital. A new model based on domestic consumption is necessary for the next, slower phase of growth if China is to avoid the ‘middle-income trap.’ This snares fast-industrializing developing nations, preventing them from moving on to becoming developed economies because without structural change, growth slows to the point where there isn’t the momentum to make the leap to clear the trap.

Neighbors Japan and South Korea managed to avoid that fate. So it would be a regional embarrassment for China not to. Yet it is not loss of face that most worries China’s top leaders, but the potential loss of the Party’s claim to a monopoly on political power. It dare not falter in delivering ever-rising living standards to its people.

What Liu — a pragmatic, publicity-shy economist with a master’s degree from Harvard who carries the rank of minister and is highly regarded among fellow policymakers inside and outside China for his sharp analytical mind — will not lay out for his boss to present is a detailed blueprint and timetable for economic reform. Plena don’t do that. They set overall direction and highlight what has received political sign-off at the highest levels. That last is critical. When it comes to economic reform there are many vested interests to square off at many levels in the bureaucracy, the military and state-owned enterprises. All three sets are are now powerful economic actors in their own right with the weight to be roadblocks to change.

When China’s technocrats get to implementing the policies and priorities that Liu and Xi have laid out, they will likely be working on six broad fronts, all interconnected:

  • Giving the private sector more scope to erode the economic dominance of state-owned enterprise. That will involve breaking up monopolies in certain industries, diversifying ownership, lowering entry barriers to private firms, and providing better access to finance for small and medium-sized firms, which in turn will mean bringing parts of the shadow banking system into the light;
  • Speeding up financial-markets reform, including interest-rate liberalization, and a broadening of the range of retail savings and investment products;
  • Further internationalization of the currency, which both moves the yuan towards greater convertibility and forces a restructuring of the export sector that can no longer rely on the subsidy of an undervalued currency;
  • Further reductions of market-distorting subsidies on industrial inputs such as power and other raw materials;
  • Allowing more foreign investment into sectors of the economy that have generally been protected (such as energy, finance and telecoms) in order to improve their innovation, skills and international competitiveness;
  • Weaning local governments from their dependence for revenue on land sales. This would also rein in the corruption-plagued, market-distorting investment they encourage by imposing the discipline of capital markets on local governments. Developing a municipal bond market would tie in directly with other financial-market reforms;
  • Relaxing or eliminating the system of household registrations known as hukou as a way to support the urbanization that the president sees as critical to promoting domestic consumption.

This web of reforms will take time to have effect. There will be no ‘big-bang’ reform imposed from the top down as Zhu tried with the state-owned enterprises in 1993. But by dint of incremental but interconnected change across a number of fronts, Xi will hope to alter the economic environment so that the vested interests which would be potential losers from reform will be forced to adapt, but will both have the time to do so and the chance to profit from doing so.

What Liu won’t draft for Xi is any roadmap to political reform, though it is hard to think of any nation that has successfully avoided the middle-income trap without changes to its institutional arrangements, and none that has done so and remained a one-party state. But China will keep the focus of its reform strictly economic.

Liu was instrumental in the publication last year of a World Bank report on China’s development, titled “China 203o: Building a Modern Harmonious and Creative High-Income Society.” That couched a lot of China’s needed reforms in terms of reducing income inequality, universal social services, greater environmental protection and more energy efficiency — all laudable aims for a Communist Party. The report’s subtext, though, was that China needs structural reform to promote a market-based economy, redefine the role of government, lessen the power of state enterprises and develop the private sector.

Those are policies the top leadership knows China has to pursue. What Liu has to craft for Xi to deliver at November’s plenum is an argument to convince his fellow elites that it is necessary and inevitable that the way China has run its economy for 30 years — 30 years that from inside China look immensely successful and which have made many members of its elite powerful and wealthy — has to change. It is quality of growth that matters from now on, not quantity. And matters most of all to the political strength that the leaders gathered to hear Liu lay out the future hope (we presume) to pass on to their successors.