This explains why China is taking so long to reform its economic system

This 1988 photo provided by China’s Xinhua News Agency shows Communist Party Leader Xi Jinping, right, then secretary of the Ningde Prefecture Committee, doing farm work. Photo: Xinhua/AP

When China’s new leaders, President Xi Jinping and Premier Li Keqiang, came into power in November 2013, they denounced the previous leadership’s formula for producing growth. They were right to do so — this formula relied on export of cheap goods and government investment for growth, and benefited state-owned enterprises at the cost of private companies and consumers. The new leadership declared that it was going to let the market play a decisive role in the economy, but now they are turning back to old measures to stimulate growth.

During the global financial crisis, under the previous leadership, China borrowed money and spent it on infrastructure. It relied heavily on the public sector (state-owned enterprises, state banks, ministries and local governments) to build up infrastructure without really supervising how these entities were spending money. The result was redundant or unsafe infrastructure projects, corruption, huge debts, and limited job creation or benefit to private companies.

More recently, the new leadership tried to stop this. It focused instead on building more market friendly institutions through top-down reforms, for instance by removing government red tape on businesses, inviting private businesses to invest in state-owned enterprises and experimenting with financial liberalization. Beijing hopes that those top-down market reforms will stimulate dynamism at the bottom – more innovation and productivity in businesses and more private consumption. It also instituted an anti-corruption campaign to weaken those that liked the old system just fine, although many observers regard this campaign also as a political campaign by Xi to remove his opponents.

But now that economic growth has slowed and the stock market has started to tumble, China is turning again to its traditional remedies.

Harking back to old “people’s movement” measures used by the previous government during the financial crisis, under which people were obliged to buy goods to keep the economy going, Chinese financial regulators have pressed listed companies and their employees to buy shares in their own companies to buoy the stock market. State-owned enterprises and state banks were forbidden to sell the shares they control. The state-owned Assets Supervision and Administration Commission has ordered its provincial bureaus to report daily which local SOEs bought stocks, and how much.

The government has vowed many times to reduce reliance of the national economy on export, but in view of slowing growth, it allowed the currency yuan or renminbi to devalue again on Aug. 11 in a move to boost exports. Beijing has tried to close down finance companies that local governments created to borrow money outside budgetary restraints, as they built up dangerous levels of debt. However the government allowed them to borrow again in May this year. The government has also approved a new wave of infrastructure, real estate and heavy industrial projects since late 2014, dubbed “Stimulus 2.0” by Chinese businesses, reminiscent of the deficit spending on poor quality construction projects that the previous government undertook during the financial crisis.

None of these measures are working well, and so they are damaging the Chinese government’s reputation for competence. So why are Chinese policymakers repeating the mistakes of the past, trying to solve structural problems in the economy through pseudo-Keynesian stimuluses?

The answer lies in vested interests, institutions and cultures. Both top-down reform and bottom-up dynamism are harder to generate than the reformers hoped.

First, it’s tough to overcome vested interests — here, state-owned enterprises and government units that do not wish to give up power and money. In the past few weeks, official news outlets have published a series of unusual editorials criticizing the “unimaginably” fierce opposition to Xi’s reforms. Among Xi’s opponents are a number of party elders who have urged Xi to shift focus from anti-corruption measures to reinvigorating the economy.

Vested interests retain a lot of influence, in part because market oriented reforms have been half-hearted. Either the leadership still believes in the value of the public sector to the national economy, or it judges that timing is immature for privatizing state-owned enterprises. Key reform policy papers in late 2013 and early 2014 announced that public ownership was still to serve as the main body of the economy, and state owned enterprises were to be strengthened.

The Anti-Monopoly Law, passed in 2007 to prevent monopolistic practices and protect fair market competition, has so far been used mainly as a weapon against foreign companies. Financial reform, in particular, interest rate reform and banking reform, is slow, allowing the financial system to still protect state banks and their major clients — state-owned enterprises. Piecemeal tax and social insurance reforms still fall short of helping the poor and the middle class.

When they weren’t overseen by the central government, local governments went out of control, pursuing their own self-interest mainly through infrastructural or industrial projects financed by renting out land, thereby boosting local GDP growth as their political achievement and at the same time accumulating personal wealth. Now they blame Xi’s anti-graft campaign for discouraging them from starting big projects.

When Premier Li Keqiang ordered financial regulators to boost share prices on July 4, the regulators did not take action until after two more days of steep market losses and an edict from Xi. The old lack of oversight and the new heavy-handedness are both symptoms of the same problem. There are no systematic, regular decision-making and monitoring institutions.

Political and business cultures remain largely in the old days. In the political world, government officials cared mostly about creating short-term GDP growth and pleasing their bosses, in order to boost their political careers. Under the New Normal, however, they have no idea how to earn political credits beyond demonstrating loyalty to Xi.

In the business world, it takes time to build a culture of innovation, business reliability and entrepreneurship. And given SOE dominance, private companies are cautious about the government’s push for mixed ownership companies and public-private partnerships, fearing that they are just another trap to eat up private money.

Old habits die hard. Long-standing illnesses are even harder to cure. Vested interests are still trying to maintain their privileges and the old systems they have benefited from. China’s leadership hasn’t yet set up proper decision-making and market institutions, which are needed for creating political and market incentives for a new model of growth.


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