China’s Reform Moment: The Communist Party can’t afford to cling to a broken status quo

June 27, 2013, 12:09 p.m. ET

China’s Reform Moment

The Communist Party can’t afford to cling to a broken status quo.

The recent credit crunch in China has highlighted the need for financial reform. But lurking behind this drama is a bigger story: All of China’s economy is nearing a growth and reform watershed. The question is whether Beijing’s new leaders are willing to give up some political control to maintain the growth they need to retain political legitimacy.

The problem is that China’s old economic model is running out of steam. Growth slowed to 7.7% last year, a 13-year low, and then to 7.3% for the first three months of this year. HSBC‘s HSBA.LN +0.72% latest survey of manufacturing sentiment found the most pessimistic outlook in nine months, with companies expecting more rapid economic deterioration. Indicators such as slack domestic shipping and electricity consumption point to greater weakness than the official GDP data suggest.This is happening because Beijing’s old methods of supporting the economy are breaking down. The prime issue—and one implicated in that financial crunch—is credit expansion. Beijing juiced the economy for several years after the global financial crisis by opening a gusher of new credit.

Fitch Ratings estimates that total social financing, which measures both on- and off-balance-sheet debts, now stands at 198% of GDP, up from 125% before that credit stimulus. But the returns on that additional credit have fallen precipitously. Comparing the rapid rate of credit creation to the slowing rate of GDP growth, it appears each $1 of new credit now yields only 17 U.S. cents in GDP growth, according to Bloomberg, compared to 83 cents of growth per credit dollar in 2007.

In other respects, too, the current system is no longer capable of delivering previous levels of growth. Local governments are running out of worthwhile public-works projects to build. The large, state-owned firms Beijing fostered for the sake of guaranteeing employment are struggling to deliver the productivity gains China needs now.

As the benefits of the old system dwindle, the costs become more onerous. The financial repression Beijing has used to suppress interest rates paid to depositors so that banks could make cheap loans to manufacturers now depresses the consumer spending China hopes to encourage. The diversion of resources toward manufacturers has stunted the service industries that should be driving higher domestic consumption.

Although leaders in Beijing often say they will tolerate a slower growth rate if that growth is “better”—meaning tilted toward domestic consumption instead of investment and exports—this doesn’t appear to be happening. Household consumption as a percentage of GDP is declining, one sign that even as growth slows fewer of the benefits of development are being distributed to Chinese citizens.

The way out is for Beijing to undertake a new round of bold, market-oriented reforms. Privatization of state enterprises should be on the agenda, as well as ending the monopolies many of them enjoy. Leaders could lift restrictions on foreign investment in Internet companies that inhibit technology-driven industries by deterring foreign participation. The full liberalization of interest rates on loans and deposits would boost household incomes while forcing companies to increase efficiency in line with a higher cost of capital. There are plenty of other possibilities, as Beijing’s leaders well know.

The obstacle will be politics. A freer economy by definition requires less political control, which means less control over the levers of economic power by the Communist Party. Market-driven interest rates mean less politically directed credit. Fewer state enterprises mean fewer patronage jobs for local commissars to pass out to friends and family. A freer economy also means tolerating private wealth not controlled by the political class.

Perhaps this explains the reluctance already in evidence in Beijing. The National Development and Reform Commission recently released a blueprint for reforms. It included some useful elements, such as a proposal to reduce the number of investments requiring Beijing’s approval. But it ignored privatization and state monopolies. Most of the measures, including reforms to the railways ministry, aim to make government investment smarter rather than reduce its scope and size. None of this goes nearly far enough.

Yet the political risks of inaction are greater than those of reform. China will need rapid growth for many years to absorb its tens of millions of still unproductive rural workers, to finance the retirement of an aging population, and above all to satisfy the ambitions of its urban middle class.

New President Xi Jinping speaks often of an amorphous “China dream,” but the Chinese people already have dreams of their own. An unelected ruling class that can’t deliver jobs and rising incomes will eventually find itself dealing with unrest far broader than the chatter on microblogs. As Deng Xiaoping understood at an earlier watershed moment, the only real choice is reform.