The re­forms China re­ally needs

Business Standard - - OPINION - SHANG-JIN WEI

This year marks a decade since the global fi­nan­cial cri­sis erupted. For the United States, 2018 is very dif­fer­ent from 2008. The econ­omy has gone from the brink of col­lapse to the brink of over­heat­ing, thanks to a mas­sive tax cut en­acted when growth was al­ready ro­bust.

Yet, for China, 2018 feels sim­i­lar to 2008 in an im­por­tant way: Neg­a­tive shocks orig­i­nat­ing in the US pose a sig­nif­i­cant threat to its eco­nomic growth. In 2008, the shock was a de­cline in de­mand for its ex­ports, ow­ing to the col­lapse of Lehman Broth­ers and the en­su­ing global fi­nan­cial cri­sis. To­day, it is the trade war ini­ti­ated by US Pres­i­dent Donald Trump’s ad­min­is­tra­tion.

The risks China faces are not en­tirely out­side its con­trol. The sit­u­a­tion could be made worse if the coun­try re­peats the pol­icy re­sponses of 2008 — namely, re­ly­ing ex­clu­sively on mas­sive fiscal and mon­e­tary stim­u­lus to prop up de­mand.

While the au­thor­i­ties’ re­sponse a decade ago did avert a sharp re­ces­sion, it also paved the way for many other prob­lems, in­clud­ing soar­ing debt lev­els for lo­cal gov­ern­ments and state-owned en­ter­prises (SOEs), the ex­pan­sion of shadow bank­ing, the re-emer­gence of ex­cess ca­pac­ity in sev­eral sec­tors, and a de­cline in the rel­a­tive strength of pri­vate firms. The Trump ad­min­is­tra­tion has in­voked some of th­ese con­se­quences as jus­ti­fi­ca­tions for its trade war.

In th­ese cir­cum­stances,

China might be tempted to dou­ble down on stim­u­lat­ing ag­gre­gate de­mand with short­term mea­sures like chan­nel­ing more in­fra­struc­ture in­vest­ment through lo­cal gov­ern­ments and fur­ther credit eas­ing for SOEs. But that ap­proach would risk creat­ing an­other decade’s worth of prob­lems. A bet­ter strat­egy would be to fo­cus on struc­tural re­forms.

For starters, pri­vate firms need to know that they are com­pet­ing with SOEs on a level play­ing field in terms of reg­u­la­tion and law en­force­ment, ac­cess to bank loans and other re­sources, and op­por­tu­ni­ties to se­cure govern­ment con­tracts. Non-sta­te­owned firms have been the most im­por­tant source of growth in the last four decades, so it is en­cour­ag­ing that Peo­ple’s Bank of China Gov­er­nor Yi Gang em­pha­sised this prin­ci­ple of “com­pet­i­tive neu­tral­ity” in a re­cent speech. So far, this term has not been re­peated by higher-level lead­er­ship. But the govern­ment should for­mally adopt it as a guid­ing norm for eco­nomic gov­er­nance.

Sim­i­larly, when it comes to for­eign trade and in­vest­ment, China should adopt a prin­ci­ple of “govern­ment neu­tral­ity” to reg­u­late co­op­er­a­tion and con­trac­tual ne­go­ti­a­tions, in­clud­ing tech­nol­ogy trans­fer, be­tween for­eign and do­mes­tic firms. More broadly, it should con­tinue to re­duce bar­ri­ers to trade and in­vest­ment by for­eign firms in China, in­clud­ing by fol­low­ing through on the an­nounced re­lax­ation of re­stric­tions on for­eign fi­nan­cial firms op­er­at­ing in the coun­try. Such mea­sures would raise Chi­nese house­holds’ real in­come by en­hanc­ing their pur­chas­ing power, while strength­en­ing the com­pet­i­tive­ness of the coun­try's cor­po­rate sec­tor by putting pressure on less ef­fi­cient do­mes­tic firms. China's own ex­pe­ri­ence fol­low­ing its ac­ces­sion to the World Trade Or­gan­i­sa­tion sug­gests that greater open­ness ul­ti­mately brings more pros­per­ity to its house­holds.

Es­tab­lish­ing greater labour-mar­ket flex­i­bil­ity is the third struc­tural re­form China needs. Since the mid-1990s, the com­bined manda­tory con­tri­bu­tion rate for pub­lic pen­sions, med­i­cal care, and other ben­e­fits has of­fi­cially been very high — about 50 per cent over the wage bill, which is higher than the me­dian con­tri­bu­tion rate in OECD coun­tries. Yet weak en­force­ment long meant that do­mes­tic firms largely ignored those costs. Then, in 2008, the au­thor­i­ties be­gan to en­force the con­tri­bu­tion rate vig­or­ously, which squeezed firms. Add to that a re­quire­ment that firms must of­fer a longterm con­tract to any in­di­vid­ual af­ter two con­sec­u­tive short-term con­tracts and pay a hefty sev­er­ance pack­age if they need to down­size the work­force. As a re­sult, the econ­omy’s abil­ity to han­dle neg­a­tive shocks and ad­just the com­po­si­tion of em­ploy­ment has been se­verely di­min­ished.

Given China’s pro­duc­tiv­ity lev­els and stage of de­vel­op­ment, a com­bined manda­tory con­tri­bu­tion rate of about 3540 per cent for all gov­ern­ment­pro­vided ben­e­fits would be more ap­pro­pri­ate. The adop­tion of that rate, to­gether with other mea­sures to en­hance labour-mar­ket flex­i­bil­ity, could boost China’s eco­nomic re­silience con­sid­er­ably.

A fi­nal re­form that would go a long way to­ward for­ti­fy­ing China’s econ­omy would be a tem­po­rary re­duc­tion of the cor­po­rate-in­come and value-added tax rates. A tem­po­rary cut would put far less pressure on the pub­lic bud­get than a per­ma­nent one, while si­mul­ta­ne­ously pro­vid­ing more in­cen­tive for firms to in­vest. In this sense, such a cut would amount to both sup­ply-side re­form and ag­gre­gate de­mand man­age­ment.

China’s lead­ers are aware of the need for most of th­ese re­forms; in­deed, they have made sup­ply-side re­form their official pol­icy mantra. But, so far, they have been fo­cus­ing on re­duc­ing ex­cess ca­pac­ity and delever­ag­ing, rather than on mea­sures that will boost pri­vate en­trepreneurs’ con­fi­dence, re­duce the econ­omy’s vul­ner­a­bil­ity to shocks, and but­tress growth. Given that two of th­ese re­forms — com­pet­i­tive neu­tral­ity and greater open­ness to both do­mes­tic pri­vate-sec­tor firms and in­ter­na­tional firms — would also help to as­suage the US, the mo­ment to act could not be bet­ter.

China should con­tinue re­duc­ing bar­ri­ers to trade and in­vest­ment by for­eign firms. This would make its own cor­po­rate sec­tor more com­pet­i­tive by putting pressure on less ef­fi­cient do­mes­tic firms

The writer is Pro­fes­sor of Chi­nese Busi­ness and Econ­omy and Pro­fes­sor of Fi­nance and Economics at Columbia Univer­sity. ©Project Syn­di­cate, 2018

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