China's Economic Reform Proposals Have Strategic Implications for Multinationals
The environment for doing business in China could become more efficient and transparent under the reduced direct intervention from the central government
China's Economic Reform Proposals Have Strategic Implications for Multinationals
Need to Know . . .
- Rebalancing and structural reform will be China's most fundamental challenges during the coming decade. The preferential treatment enjoyed by foreign businesses in the past in exchange for China's top-line growth target will no longer be aligned with the country's macro policy priorities. The pendulum may swing in the other direction and foreign companies could be under more scrutiny
- Success for foreign companies will increasingly depend on being able to articulate a clear and compelling local value proposition and creating more sophisticated levels of engagement with different levels of government and local firms
- China's need for modernization in multiple sectors will open new opportunities for foreign companies; however, these companies will need to have sufficient patience, persistence, and strong stomachs for operating with considerable ambiguity in governmental guidelines and policies
The 18th Central Committee of the Communist Party of China held its Third Plenum in Beijing in November and the meeting received enormous attention from within and outside China. One reason for the interest is that Third Plenums have gained political importance as a platform for new leaders to launch transformational reforms. Another is the developing consensus that China’s economy is at a critical inflection point requiring major structural changes in its growth model; however, little progress has been made over the past several years.
Despite being comprehensive and ambitious, the reform agenda, which is described in the communiqué released at the close of the meeting and the follow-up statement (“The Decision on Major Issues Concerning Comprehensively Deepening Reforms”), received mixed reactions. It is criticized for being vague, lacking details and strict deadlines, and not being overwhelmingly innovative, especially regarding economic matters. In addition, the absence of genuine discussion of political reform is a major disappointment for some.
What is encouraging is that China’s new leaders have demonstrated a stronger will to ensure the successful implementation of the reform proposals. A powerful group established after the meeting and headed by President Xi is expected to be able to circumvent vested interest groups and make and follow through with tough decisions.
Significant economic proposals concern the financial system, fiscal and tax policy, state-owned enterprises (SOEs), urbanization, and inward/outward foreign investment. The proposals provide insight on the potential impacts on foreign businesses operating in China over the coming decade.
The agenda does not introduce major breakthroughs on financial reform, but rather calls for continued implementation of existing reforms, including
- interest rate liberalization;
- capital account convertibility;
- exchange rate liberalization;
- developing the bond market to increase the proportion of direct financing in the economy; and
- establishing a deposit insurance scheme.
To help ease financing difficulties faced by private small and medium-sized enterprises, the agenda proposes to allow private capital in the establishment of non-government-controlled financial institutions as well as promote the share issuance registration system, which will let firms offer shares publicly without having to apply for regulatory approval. One much-anticipated reform notably absent from the agenda, however, is one that would allow more Chinese individuals to invest in foreign stock markets under the qualified domestic individual investor program.
Fiscal and Tax Reform
Under the current fiscal system, which was put in place in 1994, local governments are requested to return a large share of their tax revenue to the central government and thus do not have enough financial resources for local needs. They are still responsible for paying social welfare and establishing and maintaining local infrastructure facilities.
As a result, local governments have relied heavily on land sales as a primary revenue source, which is widely believed to be a major driver behind China’s property bubble.
- more transparent budgets
- redefined responsibilities and revenue distribution between central and local governments;
- the introduction of more stable revenue sources for local governments—the central government will accelerate the property tax legislation process
An experimental property tax reform was introduced in Shanghai and Chongqing but has not generated significant revenue; it has not been expanded into other major cities.and resource tax reform, and will implement the switch from an environmental protection fee to an environmental protection tax; and
- allowing local governments to issue municipal bonds or use private capital to finance infrastructure investment projects.
The widely expected privatization of state-owned enterprises is not mentioned in the reform agenda. Instead, the statement emphasizes adhering to the principle of the public ownership system and strengthening the control and influence of the public sector in the economy.
Meanwhile, it adopts a pro-market rhetoric, promising to
- let the market play a “decisive” role in resource allocation;
- improve market-determined pricing mechanisms (especially for water, oil, natural gas, electricity, transportation, and communication); and
- ensure equal rights, rules, and opportunities for private firms.
The seemingly contradictory statements likely reflect the government’s incremental approach to SOE reforms in order to gain broad-based political support, in part because of resistance from SOEs, a powerful vested interest with strong incentives to maintain the status quo.
One of the agenda’s more encouraging proposals stipulates that SOEs will transfer more of their profits to the public finance account, with the funds being allocated to China’s social pension and welfare system. The payout ratio will reach 30% by 2020, representing a significant change from the current level, estimated to be 5-15%.
Urbanization is widely considered the key engine for China’s economic growth over the coming decade. To efficiently accelerate this process, the agenda brings forward aggressive reform initiatives for rural lands and the household registration system.
Current law stipulates that rural lands fall under collective ownership managed by local party officials, and rural residents have rights of use but are prohibited from making commercial transactions. Although the agenda doesn’t explicitly intend to alter the underlying ownership, it advocates granting rural residents more property rights by allowing both homestead land and certain agricultural land to be mortgaged, guaranteed, or transferred to third parties. In addition, the agenda proposes letting rural residents hold shares of collective-owned assets, receive yields, and withdraw with compensation, and encourages the development of rural property markets.
These measures will
- help stimulate domestic consumption by providing more income sources and funding support for rural residents who want to migrate to cities;
- partly alleviate labor supply shortages in the industrial and service sectors; and
- restrain rampant corruption whereby local officials confiscate land from farmers for sale in inflated real estate markets.
Regarding household registration reform, the agenda promises to
- fully liberalize residence restrictions in small cities and towns;
- relax residence restrictions in medium-sized cities;
- determine reasonable conditions for residence in big cities; and
- strictly control the population size of megacities.
The seemingly cautious approach might reflect worries about various potential risks associated with a huge influx of migrants into cities, such as limited job opportunities and insufficient financial resources to provide infrastructure and social benefits.
Inward/Outward Foreign Investment
The agenda calls for greater openness for both inward and outward foreign investments. For foreign investors, it promises to relax investment restrictions by establishing a negative list approach for foreign investment approval, opening all areas of the economy not explicitly prohibited. This could be a significant improvement over the current positive list approach, which indicates only the industries in which foreign investors are allowed to invest. The success of this policy change will largely be determined by whether the scope of prohibited areas is significantly reduced.
Another section specifies that China will open up finance, education, culture, and healthcare services and relax restrictions on foreign investment in child and senior care, architectural design, accounting and auditing, logistics, and e-commerce. Wider market access to the general manufacturing sector, including the steel, chemicals, and automotive industries, is also allowed.
The agenda identifies the Shanghai Free Trade Zone, which was officially launched in September 2013, as a “major measure” to experiment with related reforms that may be expanded to the rest of the country. It says that more free trade parks (ports) will be established and China will open more border areas to foreign investors.
For domestic investors, the agenda calls for establishing the principal position of private companies and individual investors in overseas investment. In the past, Chinese companies had to obtain government approval to invest overseas, a process that often took several months. This posed significant challenges for domestic firms, especially small and medium-sized firms with limited resources to deal with bureaucracy. The agenda states that the government will reduce direct intervention, overhaul the complicated application requirements, and simplify the approval process.
In the future, firms may need to only register their overseas investments with relevant authorities, not seek approval, unless the project affects national security, compromises environmental safety, exploits strategic resources, or disrupts other key public interests. The agenda specifically encourages overseas investment in infrastructure projects and labor supply contracts, and allows domestic firms to develop innovative ways to engage in greenfield projects, mergers and acquisitions, securities investments, and joint ventures.
Mixed Reactions and Business Implications
Despite being comprehensive and ambitious, the reform agenda was criticized by some observers for being vague and not overwhelmingly innovative. The plenary sessions are designed to make mission statements—which, by their nature, tend to lack execution details—but some of the initiatives included in this plenum, especially for economic matters, were already proposed by the previous leadership. This time, however, the leaders have demonstrated a stronger will to ensure successful implementation.
Immediately after the meeting, a new central committee headed by President Xi was set up to be responsible for the general planning and implementation of economic reforms. The establishment of such a powerful group follows a familiar format for the Communist Party for issues deemed too sensitive or complex to be coordinated purely at a governmental level.
The full impact of the economic reform agenda on businesses will become clearer when more details are released. Several factors present both opportunities and challenges for foreign companies operating in China.
First, after more than three decades of double-digit economic expansion, China is at the end of its high-growth era. Rebalancing and structural reform will be its most fundamental challenge over the coming decade, and senior leaders have signaled more tolerance for slower economic growth in the short run in order to achieve more sustainable growth in the long run. As a result, foreign companies that continue to rely mainly on riding the wave of overall economic growth to achieve corporate growth will likely not do well. The preferential treatment enjoyed by foreign businesses in the past in exchange for China’s top-line growth target will no longer be aligned with the country’s macro policy priorities, either. The pendulum may swing in the other direction and foreign companies could be under more scrutiny thanks to increased consumer awareness and cynicism as well as intensified competition from China’s domestic companies.
Second, the environment for doing business in China could become more efficient and transparent under the reduced direct intervention from the central government. As the central and local governments redefine responsibilities and revenue distribution, local governments will very likely be given more authority over local economic issues. Therefore, success for foreign companies will increasingly depend on being able to articulate a clear and compelling local value proposition and creating more sophisticated levels of engagement with different levels of government and local firms.
Third, China’s need for modernization in sectors such as healthcare, banking, finance, education, and environmental protection will open many new opportunities for foreign companies with particular expertise or knowledge that can help inform the process. Chinese leaders, however, have a tradition of policymaking through experimentation, as described by the Chinese proverb regarding “crossing the river by feeling the stones.” It is especially the case for China’s new leaders, who need to determine how to achieve meaningful reform progress against a background of a large, diverse population with disparate needs across different geographies, a set of entrenched and powerful vested interests, and a giant economy that is still underdeveloped in many critical functions. More than ever, foreign companies will need to have sufficient patience, persistence, and strong stomachs for operating with considerable ambiguity in governmental guidelines and policies.