- June 27, 2017 Reform
China’s Other, More Important Trilemma
Chinese market reforms are not simply about relying on prices, rather than state fiat, to allocate resources, capital, and labor. On a more fundamental level, reforms are about setting predictable rules that can guide the formation of market prices.
Fair and credible rules are the necessary condition of a well-functioning and vibrant market economy. If rules are often flouted or arbitrarily changed, especially changes that mostly just benefit the state, that in turn will make people cautious about making major investment decisions. In this scenario, it doesn’t matter that firms are “free to set prices” in the marketplace since those prices are themselves more or less meaningless.
China has yet to mature into a truly rules-based economy, since its economic, legal, and governance institutions are still relatively underdeveloped. But a larger question mark hanging over its economic future is whether Beijing can actually make substantial progress toward instituting a rules-based environment in the near term. Doing so will require true governance reforms, and these are much more challenging than simply liberalizing prices.
A key reason why governance reforms are so difficult is the existence of a “trilemma” that is, in fact, of Beijing’s own creation. This is not the trilemma analysts usually associate with China’s choices on currency policy or capital account liberalization. Instead, it is a reform trilemma born out of the Chinese state’s simultaneous pursuit of three contradictory objectives: state control, a large state sector, and market reforms.
This contradiction sits at the heart of the very question of whether and how China can reform and has been especially glaring since the promulgation of the ambitious sixty points reform program unveiled at the Communist Party’s Third Plenum in November 2013. Its existence goes a long way toward explaining the mismatch between the potential of Xi Jinping’s economic reforms and the reality of less than stellar outcomes. Much of the analysis in this space, which is part of the ReformPedia product, revolves around this fundamental framework and how reforms may be assessed based on the untangling or deepening of this trilemma.
To begin, the current reform trilemma implies that only two of the Chinese government’s three objectives are actually attainable at the same time. To put this more simply, analyzing China’s ongoing economic reforms is essentially about determining which of these three objectives is being prioritized and which instead is being marginalized or perhaps abandoned altogether.
Objective 1: State Control
This goal has two dimensions: macroeconomic management/intervention and the control over individual state-owned enterprises (SOEs). It is the latter—the ability to control individual SOEs—that matters most to the trilemma. If the Chinese government is merely interested in maintaining authority on managing the macro economy, then there is no trilemma. In all developed countries, the central government has the authority to regulate and manage the macro economy, while at the same time maintaining a rules-based economy. The existence of China’s massive SOE sector complicates the situation, however, especially since Beijing seems to want to keep many failing SOEs in business. If the state were, in fact, willing to give up control over SOEs, then Beijing could actually own a large amount of state assets while maintaining macro management and a rules-based economy. The simplest way to achieve this would be to let the state own minority non-voting shares in all major Chinese firms. In this instance, the state would become a passive investor, and it would always earn returns that are basically equal to the average return across the broader economy. There would also be no reason for the state to arbitrarily change policies to favor certain firms since it would not have any particular interest in a specific firm and would surely prefer that all firms do well to earn its average returns.
The problem at the moment then is that Beijing appears to want instead of this to strengthen the Chinese Communist Party’s (CCP) control over individual SOEs. That seems clear if one looks at the bulk of SOE-related policies adopted or invigorated over the last five years. In SOEs where CCP control has not been firmly established, those state companies are not allowed to accept private investment. And that is in spite of the fact that history has demonstrated that state control and interference in SOE operations usually impair an SOE’s bottom line.
Although SOEs in commercially competitive sectors, such as retail, are allowed to be majority owned by private investors, these are few in number. The majority of SOEs are, in fact, in industries that are considered to be strategically important to the state, which is why SOEs need to be dominant in the first place. The list of strategically important sectors has been whittled down over the years, but new sectors are being added to the list nonetheless. As important, Beijing has invested heavily to accelerate SOE entry into emerging sectors—for example, Beijing in 2016 established two funds totaling ¥550 billion ($80 billion) to deploy into emerging sectors. With additional borrowing available from state banks, the amount of capital flowing to these sectors could end up being multiples of these funds.
Objective 2: Maintaining Significant State Assets
If we accept that state control of individual SOEs is the default condition for the Chinese Communist state, then that surely conflicts with the goal of maintaining a large state sector. It is rather straightforward why this is the case: SOEs in China have historically enjoyed favorable policies and preferential treatment, but many of them continue to underperform and wither, thus requiring additional government support and subsidies. Without government life-support, the majority of SOEs would already have failed.
It is true that some advanced economies in the Organization for Economic Cooperation and Development (OECD) also have sizeable SOE sectors. But none is as large as China’s: the total assets of China’s non-financial SOEs are ¥137 trillion ($20 trillion). To maintain such a large SOE sector, government subsidies alone are not enough, Beijing needs to constantly change the rules to protect SOEs from competition.
Objective 3: Creating a Rules-Based Economy
Finally, since the very survival of SOEs relies on the constant change or bending of the rules in their favor, maintaining the SOE sector at its current size is incompatible with the intent to create a rules-based system. And that is not all: the constant change of rules to bolster SOEs directly violates free market principles and the spirit of the Third Plenum reforms, thereby jeopardizing the credibility of new pro-market policies.
In short, Beijing needs to make a choice between sticking to its own rules and allowing the SOEs to sink or swim on their own or, failing this, to constantly dole out support to state firms. And this choice is made more complicated by the fact that Beijing’s equity in SOEs is not purely economic, but also political, which makes the state ever more willing to change rules in their favor.
The bottom line is that market reforms need to proceed in tandem with strengthening checks on the state’s authority. This is not as impossible as it may seem today. A quick detour into China’s recent economic history shows a history, at times, of empowering the private sector, which, over a longer horizon, makes the violation of rules more costly for the state. Some notable examples include giving farmers long-term leases over their land, the official recognition and protection of private property rights, and allowing businessman to join the Communist Party through the so-called Three Represents policy of former President Jiang Zemin.
The current Chinese government has also vowed to treat firms equally, irrespective of ownership. But not enough toward this goal has been done in reality. In addition, as China’s growth is slowing down, the competition between different types of firms will intensify. More than ever, Beijing needs to demonstrate a genuine effort to treat all market players fairly and equally, without consideration of their ownership. In particular, it should stop bailing out failing SOEs, or change rules of the game to benefit SOEs.
The solutions to China’s reform trilemma may very likely lie outside the realm of economic reform—in other words, it is, at its core, a political problem. Those interested in China’s economic reform are advised, then, to closely watch political and legal developments as well.
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