To reboot China’s economy, Beijing must have the confidence to let go

Fear of losing control is holding Beijing back from much-needed economic reforms, yet their success would shore up the central government’s credibility
Reforms must address local governments’ dependence on property development, the private sector environment and consumption

Yukon Huang

Published: 5:30am, 7 Nov 2023

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China is mired in an economic slowdown that threatens its impressive achievements over the past four decades. Officials, struggling to counter the bad news, are arguing that the worst may be over, as reflected in some economic indicators.

Even so, there is no doubt China’s economic woes are grounded in deep structural problems that are not being adequately addressed because the solutions would weaken the government’s control over the economy.

Yet such reforms could secure the social and economic benefits needed to strengthen the credibility of the authorities.

Views on China’s economy have fluctuated between extremes over the past year. Reversal of the country’s draconian Covid-19 policies last winter led to a burst of enthusiasm that “revenge consumption” would spark an economic revival.

But the optimism proved short-lived given the drumbeat of disappointing second-quarter economic outcomes and recent manufacturing indicators. Major financial institutions have cut their China growth forecasts and markets are looking for bolder actions that would signal a clear commitment to reforms.

Addressing three festering issues would dramatically improve growth prospects: the interrelated financing problems affecting the property market and local governments, the discouraging operating environment for the private sector, and the lower-than-expected household consumption.

The government’s actions so far have been too little, too late, largely because the systemic solutions are seen as contrary to socialist ideology.

The growth slowdown is mainly due to the collapse in property development given unsustainable financing methods and reduced demand for housing as urbanisation moderates.

Because of mounting debt problems, local governments are unable to step up infrastructure investments to counter the slump. These issues are being addressed separately but they are linked.

Local governments lack the revenue base to fund services and relied on land sales and property development to generate financing. This fed into a multi-decade dependency on property development to drive growth, characterised by the risky financing arrangements of real estate giants such as Evergrande and Country Garden.

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This predicament emanates from a structurally misaligned fiscal system that not only failed to generate adequate revenue but also does not match the revenue needed with the expenditure responsibilities of local governments.

The central government gets most of the fiscal revenue, but local governments are burdened with the bulk of the expenditure responsibilities.

The solution lies in a long overdue fiscal reform since the last one undertaken in 1994 is no longer suitable. But such a reform is politically sensitive as it would channel relatively more revenue to the local authorities and reduce Beijing’s power to control the provinces.

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If the property market cannot drive growth in the coming years, then more is needed from the private sector. The leadership is trying to assure the business community of fair market access and financial support.

The problem comes from the increasing pressure being put on private companies to adhere to the leadership’s priorities, including the regulatory clampdowns on China’s digital giants several years ago and on other companies, such as the recent investigation of Foxconn, Apple’s principal manufacturer in China.

But despite repeated exhortations and the recent 31-point plan, private companies and equity markets are not convinced there has been a real change in attitude.

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To counter such sentiments, a much bolder gesture is needed. One option would be to retract the requirement that private businesses must have a Communist Party cell as part of their governance structures, since their presence creates undue suspicion and blurs political and commercial objectives.

Given the sharp decline in returns on investment, attention has focused on increasing consumption to prop up demand. Suggestions that major fiscal stimulus or subsidies are needed to encourage households to spend more are undermined by China’s high debt levels. But there is a stroke-of-the-pen solution that would be more financially sustainable.

That would be to drop China’s restrictive “hukou” policies, which govern the household registration system. China is unique among major economies in restricting access to social services and employment opportunities for millions of its citizens who have relocated from rural areas to large urban centres.

Modest liberalisation efforts have been under way for years, but the focus has been on smaller and medium-sized cities, leaving the restrictions largely intact in China’s mega-cities such as Shanghai, Beijing and Guangzhou.

While residency reforms are usually cast as a social issue, the economic implications are also significant. Households lacking residency rights save much more of their incomes than other households. Merely giving them full residency rights would significantly boost China’s consumption rates for years.

But the leadership has been reluctant to do so, since regulating the location of the population is a prerogative of the centralised system that is not easily abandoned.

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The factors that shaped China’s remarkable growth – rapid urbanisation driven by export-oriented industrial expansion and massive property development – are no longer viable, but the potential for robust growth still exists.

The reforms, however, that would make this possible have not been undertaken because of the state’s desire to preserve its control over key resources (financial and labour) and private sector activities.

But history can repeat itself. Among the famous sayings linked to Deng Xiaoping when he launched China’s reform process more than four decades ago is: “It doesn’t matter if a cat is black or white, as long as it catches mice.” Deng had the foresight to realise that achieving more rapid growth through pragmatic policies that might hit at the boundaries of socialist ideology would strengthen, rather than undermine, party legitimacy.

The coming Third Plenum, held every five years to outline the government’s longer-term economic objectives, provides a timely opportunity to signal such a change.

Yukon Huang is a senior fellow at the Carnegie Endowment for International Peace and author of “Cracking the China Conundrum: Why Conventional Economic Wisdom is Wrong”.