Is China serious about economic reform?

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China’s annual legislative meeting, the National People’s Congress, is underway in Beijing, and the titans of the Communist Party are making all sorts of grand pronouncements on the future direction of Chinese economic reform. We’ve gotten a look at not just China’s plans for the economy for 2011, but over the medium term as well in its 12th five-year plan. In the short run, the government said its main, immediate task is fighting inflation, which was a well-above-target 4.9% in January. But it’s the long-term vision that is much more interesting. Beijing is signaling nothing less than a major shift in its economic priorities.

In the past, Beijing has been extremely focused, arguably overly focused, on keeping up its economic growth rate, no matter what the consequences. Now, government leaders are saying, the priority should be on growth that is healthier, sustainable and, most importantly, does a better job of translating big GDP gains into improved human welfare. Here’s how Zhang Ping, head of the National Development and Reform Commission, put it in a Sunday news briefing, according to The Wall Street Journal:

We need to reconfigure the line of thinking when it comes to growth…In the past five-year plan, it was absolutely necessary to prioritize maintaining growth…Now we want to put more emphasis on ensuring and improving people’s livelihood.

Beijing’s policy agenda is exactly what the economy needs. But are policymakers truly serious about following through on their reform pledges? Fulfilling them means a complete overhaul of the way in which in the Chinese economy operates. And I think it’s fair to question if Beijing is willing to make the sacrifices necessary to turn their economic vision into reality.

First, some of the highlights. China has decided to lower its growth target from 7.5% a year to 7%, an indication that they’re becoming more concerned about quality of growth instead of just big headline numbers. To boost worker welfare, Beijing wants to see income keep pace with gains in the overall economy. The growth of the average worker’s income has generally lagged behind GDP growth and productivity gains over the past five years. In other words, the workers of China aren’t benefiting as much as they should from the country’s economic progress. On top of that, the government plans to increase social welfare spending, in areas like healthcare. The end goal is to stimulate domestic demand so private consumption plays a larger role in the economy.

Such reforms are absolutely crucial for China’s economic future. The gap in income between the rich and poor is yawning in China, and that’s a source of both economic and political instability. We forget amid all of the talk of China’s rising superpower status that some 200 million Chinese still live on less than $1.25 a day, according to the World Bank. Some 900 million of China’s people reside in the rural hinterland, where they have much more meager economic prospects than those lucky enough to live in Shanghai, Beijing, Guangzhou or a handful of other wealthy metropolises. Beijing’s leaders are acutely aware that such a divide poses political risks to Communist Party rule, of the sort now unfolding in the Middle East. Improving the welfare – and thus the spending power – of more and more Chinese is also crucial for “rebalancing” the entire economy, away from its unstable dependence on debt-driven investment and exports, and towards greater private consumption. So the bottom line is: Beijing understands the problems facing the economy and has outlined a plan to fix them.

That’s the good news. Now we have to ask: Is any of this actually going to happen? The fact is we’ve been hearing much of this stuff out of the Chinese government – increasing domestic demand, closing the income gap, rural development, more social welfare – for some time, but progress has been slow at best. Take the role of domestic demand in the economy, for example. Retail sales on consumer goods – which I’m using here as a rough approximation of private consumption – increased 14.8% in real terms in 2010, according to government data. That looks pretty impression until you discover investment in fixed assets rose 19.5%. So there’s no sign of serious “rebalancing” here. Granted, government policy can’t redirect economies on a dime. But Beijing could be doing more to boost the importance of domestic spending in the economy. For example, Beijing could be investing even more in a social safety net and public services to free-up disposable income among consumers and encourage them to spend. HSBC economist Qu Hongbin had this to say in a March 6 report:

To ramp up spending on education, health care and other social welfare, spending on these areas will be accelerated to increase by over 14%yoy this year, outstripping the planned 11.9% growth rate for 2011′s total fiscal spending. Though a step in the right direction, the scale of this shift in fiscal spend from construction to social welfare likely remains too modest for effective rebalancing of China’s growth engine to consumption in the near term. More still needs to be done…The task of rebalancing China’s growth engine from one of construction to one of consumption is more than just a 2011 story. It’s one that will take, and last, at least through 2015 and beyond.

Secondly, some of Beijing’s stated reform goals conflict, and it is not clear which reforms will win out over others. For example, boosting wages runs counter to the goal of controlling inflation. Even more importantly, certain of Beijing ‘s promised reforms will also demand sacrifices elsewhere, sacrifices I’m not certain China is willing to accept. Raising the income and welfare of the nation’s workforce also has a downside – to China’s international competitiveness. The fact that China has been generally able to keep labor costs in check has been a big help to both exporters and state companies. Higher labor costs could hurt China’s ability to compete with India, Indonesia and other emerging-market rivals.

China has so far shown little willingness to follow through on other promised measures that would undercut the nation’s export machine, most notably currency reform. Policymakers have repeatedly talked of the need to increase the flexibility of the exchange rate and the use of the yuan internationally. A stronger yuan would also help fight inflation and speed the rebalancing of the economy (by making imports cheaper). Though there has been a bit of progress, the fact is the Chinese currency today is being valued through the same methods used in 2005. In other words, Beijing has not been willing to move on currency reform to help achieve its other policy goals in order to protect exports. Will better worker welfare get forgotten in the quest for global market share as well? We can’t rule that out.

And don’t expect Beijing to make any sacrifices to growth to fulfill its reform goals either. The government’s decision to lower its growth target has received way too much attention, in my opinion, since those “targets” have meant zilch in the recent past. As BofA-Merrill Lynch points out, average GDP growth was 11.2% during the previous five-year plan (2006-2010), significantly above the 7.5% growth “target.” In 2011, the government is already targeting above-target 8% growth. In fact, every time the growth rate seems to dip anywhere close to the “target,” officials freak out and furiously do whatever they can to pump growth back up. In recent years, that’s meant a potentially destabilizing credit expansion. Here’s Merrill economist Ting Lu in a March 7 report:

Actually, there are some concerns about growth as the government remains cautious over economic outlook and believes the global recovery is not solid yet. We believe that…the Chinese government has no intention to greatly slow growth. We believe the 8% growth target (in 2011) is conservative because the government may wish to aim low and achieve high… Advancing social welfare to build a harmonious society is surely the focus, though Beijing still clearly believes growth and job creations are the best ways to improve social welfare.

My personal view is that Beijing is dead serious about its main reform goals. But my question is whether or not they’re willing to make the hard choices to get there, at least in the near term. Does Beijing want export competitiveness or more rapid income improvement? Will Beijing accept lower growth in the process of shifting from an investment to a demand-driven economy? Can Beijing fight inflation and control its currency? Beijing’s policy experts want to have their cake and eat it, too – and then have a bit of apple pie afterwards. Maybe they can navigate through their competing policy priorities and interests. Rapid growth solves a lot of problems. But unfortunately, economics often demands trade-offs; you give on one front to achieve another. Until Beijing shows greater willingness to do that, their reform promises might remain just promises.

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