It's the economy - China's 'decade-long leadership change'

11 Mar 2013

The University of Sydney Business School

By Hans Hendrischke

The recent transition to a new leadership group shows how much the Chinese Communist Party depends on continuity and process over personality.

Following China's Party Congress in November 2012, China's National People's Congress (NPC) is now convening in Beijing to complete the 'once-in-a-decade leadership change'. The Congress will appoint a new group of state leaders, including a new president and a new head of government. But there will hardly be any new faces. All of the new top leaders have been in office for the last five years. This is a rejuvenation rather than a change of leadership.

Like the 18th Party Congress of the Chinese Communist Party (CCP) at the end of last year, this first session of the 12th NPC will demonstrate the commitment of the new leadership to economic continuity and gradual structural reform. It will disappoint those who are hoping for dramatic personnel and political changes. If the new leadership had a political platform, the two most important slogans would be 'economic continuity' and 'process over personalities'.

The real news emerging from the leadership change is the prioritising of the economy. Political reforms, in spite of all the headlines, come second and are geared towards enabling economic reforms. The economic agenda of the new leadership comprises nation-building policies, welfare and public finance and interlinked enterprise and government reforms. This long-term agenda gives the new leadership less room for policy initiatives than an incoming government under a two-party electoral system would normally have.

The nation building policies of the new leaders are bound by the current 12th Five-Year Plan (2011-15) as the new government comes in exactly at mid-point of the planning cycle. Nation building includes infrastructure and strategic industry policies, including long-term planning of energy and environmental policies. The new government's performance will be judged by how well the aims of the current Five-Year-Plan are achieved and extended into the future. Planning is constantly adjusted. Over the past year, planning documents leading up to 2020 have been released for areas such as research and development, environment, energy, transport and infrastructure, including on-going approvals of major investment projects. The current NPC session is expected to announce details of administrative restructuring and adjustment of responsibilities for bodies such as the National Development and Resarch Centre.

Second on the economic agenda is the structural shift towards increasing domestic consumption and the related reform of public finance. The aim of doubling the 2010 GDP per person by 2020 looks achievable, considering that China's 2012 GDP per person has already grown by about 30 per cent since 2010. Reducing economic inequality through increased welfare spending, better health services, extension of social services to the countryside, improvement of education and higher labour standards are all plans dating back to China's socialist era, but now serve the purpose of stabilising China's market economy. Implementation of these welfare measures will require reform of public finance to overcome the deep-seated institutional flaws of China's market economy.

Public finance is one of the burning issues of China's governance. While the central government relies on VAT, local governments are responsible for 80 per cent of government expenditure, but only about half of their budget revenue is allocated through formal government channels. The other half has to come from extra-budgetary revenue raised through entrepreneurial activities, such as local real estate development and income derived from local enterprises. In China's nested government hierarchy these local funding sources are out of central government control and vary widely according to local circumstances. Faced with this informal local economic autonomy, the central government struggles to implement national level social and welfare policies uniformly down to county and township level.

However, the central government is split in its attitude towards underfunded local budgets. Looming deficits provide a powerful incentive for local governments to develop private enterprise activity in their jurisdiction. This is one of the reasons why China's small and medium enterprise (SME) sector now accounts for approximately two-thirds of GDP. The drawback of this flourishing SME sector is that the collusion between local governments and private enterprises breeds real estate speculation and corruption, which in turn incite civil unrest.

Reform of public finance will have to fund local government budgets without disabling incentives for local economic growth. Without changes to local fiscal incentives, no degree of legal reforms will be able to contain the corruption and civil disturbances that afflict local governments. Nor will the central government be able to control how central welfare funds are spent at local level. The new leaders have announced reforms in local taxation, but how successful they will be remains to be seen.

The third economic challenge to the new leadership is the triangular relationship between the private SME sector, the state-owned enterprise (SOE) sector and the finance sector. It is fashionable to present the last 10 years since 2002 as a lost decade without any major reform. The proponents of this view overlook the spectacular growth of the private enterprise sector across China's eastern and more-developed inland provinces. This unique transformation was never fully publicised for political reasons. The SME sector was able to grow in a shadow economy parallel to the state-owned sector until it can now no longer be overlooked by the SOE and formal finance sectors.

The new leadership's policies in support of the state-owned sector have to be seen against this background. The central government is now under economic pressure to formalise a framework for cooperation as well as competition between the private and the state-owned sector. That includes reducing state monopolies, expanding market access for the private sector and a new top-down privatisation of state-owned assets with detailed yet to be announced. This will force the hitherto state-controlled finance sector and the huge central banks to service the private enterprise sector. At the same time, restructuring of China's large enterprise groups in nine major industries is going on with the aim of placing Chinese industry groups in a position to better compete with multi-national corporations.

In China's institutional and legal environment seemingly technocratic reforms often require political determination to take on established interest groups and powerful constituencies. Local tax and budget reform will not work without cooperation by local, provincial government organisations. Opening up new markets to China's private shadow economy and concentrating economic power of enterprise groups requires cooperation of central bureaucracies and central elites. Without substantial improvement of property rights, legal supervision and formal procedures stretching down to the local level these reforms will carry substantial economic and social risks.

These are the imminent political reforms on which the new leadership has fixed its gaze. Failure to succeed will endanger long-term economic growth and social stability. Success will depend on public confidence that the leadership is committed to the transition from person based politics to stable procedures and a rule-based system. This will be one of the yardsticks to measure whether the new leadership is reformist or not. If successful, this underlying agenda of the new leadership will unfold gradually and most likely without spectacular headlines.

However, one policy before the new leaders that has the potential to attract global attention is China's outbound direct investment which bodes well for China's economic globalisation as China's foreign economic relations have always proceeded at a much faster pace than domestic reforms. Accumulated Chinese direct investment into Australia since 2007 has passed the US$50 billion mark at the end of last year, ahead of the United States and Canada as Australia's closest competitors. The target of a further 15 per cent growth of outbound direct investment in 2013 unveiled at the National People's Congress in Beijing has important implications for Australia. Details of this development will be analysed in the forthcoming report by the University of Sydney/KPMG team.

An earlier version of this article was published by Asian Currents.