China’s leaders must put reform pledges to the test; Economic protection means that Beijing forestalls innovation, writes Henry Paulson

March 24, 2014 5:40 pm

China’s leaders must put reform pledges to the test

By Henry Paulson

Economic protection means that Beijing forestalls innovation, writes Henry Paulson

Since President Xi Jinping took power 18 months ago, Beijing has adopted sweeping commitments to economic reform. These pledges include giving the market the “decisive” role in allocating resources, eliminating regulatory barriers that have stifled the private sector and enhancing China’s social safety net.

These commitments are welcome. Yet market participants and business leaders reserve judgment, waiting for them to be implemented.

The reforms, however, cannot be judged by unrealistic expectations or free-market fundamentals. Mr Xi has no plans to remake China’s economy in the image of a Group of Seven country. Nor is it realistic to think Beijing will simply privatise its 113 central state-owned enterprises.

The real test of “reform” is not whether it will advance but how. Will Mr Xi’s reforms embrace meaningful competition?

Competition is the lifeblood of a market-driven economy. Exposing China’s economy to the discipline of competition will have positive and enduring effects. The market can play the “decisive” role Beijing intends only if the leadership abandons anti-competitive policies.

Three tests will be crucial. First, do China’s leaders open most sectors, including energy, finance and high tech, to private companies, thus allowing them to compete with SOEs? Second, do they roll back policies, such as subsidies, that have shielded SOEs from market discipline, and force them to compete on a level playing field? Third, do they open the economy to foreign competitors, which would expose Chinese groups to best-in-class competitive practices?

The recent annual meeting of the National People’s Congress offered a glimpse at answers to some of these questions. For the first time since November, when the Communist party adopted a comprehensive plan for reform, the NPC afforded leaders the opportunity to double down on their pledges – and begin to make them real.

Here is the bad news: economic reform remains a monumental challenge. China’s leaders are struggling to turn a gigantic ship in a new direction. That was hard enough in the 1990s, when China last undertook serious reforms. Then its nominal gross domestic product was $1tn. Today it is $9tn – and the pace, scope and sequencing of reforms is complex and contentious.

But here is the good news: the NPC has made clear there will be no turning back economic reforms. And Mr Xi’s anti-corruption campaign is sending a strong message to vested interests that oppose change.

China’s leaders are taking steps to encourage competition. Still, reforms must advance further and faster. Take, for example, the first of the three tests. Many industries remain closed to competition. They are dominated by large SOEs, function as oligopolies and allow little scope for private operators.

The big state banks have dominated capital allocation, with capital directed disproportionately towards public players. But the model may be changing. Mr Xi has made a commitment to establishing wholly private banks, partly to boost lending to businesses and reduce the scope of the shadow market.

Xi Jinping’s anti-corruption campaign is sending a strong message to vested interests that oppose change

In the long run reform must extend beyond financial services. Whole parts of the economy remain protected. By keeping them closed, Beijing forestalls entrepreneurship and innovation, and the 10m-12m jobs China hopes to create this year.

The second test will probably prove tougher. Withdrawing subsidies would expose some SOEs’ inefficiencies, resulting in job cuts and potentially fuelling unrest.

Beijing can take steps to remove unfair advantages and wean SOEs off easy credit and cheap energy. One solution is to deepen interest-rate reform, building on the recent announcement of an ambitious two-year timetable for establishing deposit insurance and liberalising deposit rates.

Likewise on subsidies, Beijing has announced moves to expand resource taxes and force industrial consolidation. Rationalising energy prices also would help China shift to a less energy-intensive growth model.

Ultimately, Beijing needs to open its market to foreign competition. In many sectors, such as financial services, foreign companies are global leaders. Many in China favour domestic reforms yet wish to exclude foreign competition. But the country would benefit from the practices introduced by foreign companies.

In principle, Beijing has made a commitment to take this step by agreeing in bilateral investment treaty talks with the US and Europe to adopt a “negative list” that presumes sectors are open to foreign competition unless specifically excluded.

That suggests Beijing understands the need for competition. But Washington and Brussels should move expeditiously to conclude these treaties with China – putting to the test its leaders’ commitment that competition, not reform for its own sake, is something they are prepared to adopt and champion.

The writer is chairman of The Paulson Institute and a former US Treasury secretary