Three Post-Mortems On China's Third Plenum
China's Third Plenum has come and now truly gone, following the second, 20000 word "decision" which followed the spares initial communique, which contains much more promises and pledges about the future with a 2020 event horizon, so it is a fair bet that nothing of what was resolved will be implemented in a world that will be a vastly different from the one today, but one has to digest current news regardless. So for the sake of those who analyze such things as promises out of a centrally-planned communist nation, here are three takes on the third plenum, courtesy of SocGen, Bank of America and Goldman Sachs.
The complete reform decision from the 3rd Plenum of the 18th Central Committee of China's Communist Party was made public three days after the meeting concluded, which was four days earlier than the last Plenum. Although the communiqué released right away was vague, the decision set new courses and proposed fairly specific changes for a number of big reform areas. The following are a number of points on economic reform that are encouragingly concrete.
- State-owned enterprises (SOEs) will pay 30% of their dividend to the Social Security Fund by 2020, up from 10-20% at the moment. This ratio may not impress everyone, but it is laudable that the leaders are willing to set this target explicitly.
- All investors will be allowed to enter any industry other than those on the “negative list”, which is the new mechanism being tested in the Shanghai free trade zone (FTZ). The eventual nation-wide adoption aimed by policymakers is probably the reason why the first experiment started off cautiously. The decision does also highlight the significance of the Shanghai FTZ, which in our view will lead the path of China's service sector liberalisation.
- The list of factor prices to be liberalised is specified and extended to include transportation and telecommunication, besides water, oil, natural gas and electricity.
- Rural land for non-agriculture uses that is collectively owned by farmers will be allowed to enter the land market at same prices and with same rights as state-owned land. The language is boldly specific. This revolutionary change would undermine local governments' monopoly over land markets and boost farmers' income, thus providing them with the start-up capital to settle in the city.
- Private investors can set up banks. Again, this is an example of being encouragingly specific. Other languages on financial market liberalisation - interest rates, the yuan and the capital account - are mostly the same as stated before. However, this segment of reform has been most clearly laid out planned so far, which actually does not need further clarification from the Plenum.
- Appraisal of local governments' performance will focus more on aspects other than GDP, such as pollution, excess capacity and debt.
- Fiscal spending will decouple from fiscal revenue or GDP, and fiscal deficit will be assessed over economic cycles.
In addition, the one-child policy will be relaxed. This is a very positive signal that the new leadership is actually walking the reform walk.
The Plenum did not provide any time frame other than “achieving major breakthroughs in all major reform areas by 2020”. It will still be unrealistic to expect everything to happen in 2014, but this is definitely a good start.
From Bank of America:
The dust has not settled yet
We believe markets were disappointed by the brief communique of 3rd Plenum of the 18th CPC (Communist Party of China) Central Committee released on 12 Nov, but then were greatly rejuvenated by the more detailed 20000-character “Decision” released three days later. The communique could be considered dull, crammed with clichés calling on strengthening the party ruling and upholding state-owned sector’s control of the Chinese economy. The “Decision”, however, uses more plain langue to convey forceful messages on pushing for reforms including ending the labor camp, easing the one-child policy and vertically integrating the judiciary system.
It’s a great plenum, but it may not be a watershed
We believe the current leadership did a great job in delivering such a comprehensive collection of reform plans. Given all the social, economic and political constraints, this “Decision” is perhaps the best reform package we can get at the moment if we take into account the fact that these new leaders only took office in just one year. In this regard, Chinese new leaders’ efforts, strength and political skills should be highly praised and appreciated, in our view. However, some of the messages in the “Decision” may conflict with each other, some reform goals are still too vague, some reforms might be just intermediate steps towards a truly appropriate system for China, and some reforms might not be effectively carried out. It’s great to see many reform ideas passed in this party plenum, but dust has not settled yet. In our view, regarding historical importance, this 3rd Plenum could be ahead of many other plenums (including some 3rd plenums) post the Cultural Revolution, but might still be behind the 3rd Plenum of the 11th CPC Central Committee in 1978 and the 3rd Plenum of the 14th Central Committee in 1993.
Many breakthroughs, but not a big surprise
Some people called the “Decision” a big surprise; we disagree. Most of those reforms included in the “Decision” were well expected by us (see our preview of the 3rd Plenum here, especially the table on page 6) and have been circulated in various media for a while. That being said, the long list of reforms in the “Decision”, though well discussed by scholars and covered in media, could arouse enthusiasm among people who have been craving for reforms for many years but were disappointed time and again. On market impact, we expect markets will remain bullish for a few more days, but that the enthusiasm will taper rather quickly as people refocus on the difficulty in implementing these reforms and the limitation of the reform proposals of the “Decision”.
A brief summary of reforms delivered by the 3rd Plenum
In our view, the new party leadership under Mr. Xi Jinping did three things:
Picking the low-hanging fruits to boost confidence, centralizing control of the state by taking away power from local governments and ministries to flex their muscles, and upholding the role of markets to achieve efficiency and fairness.
- Picking the low-hanging fruits includes nationalizing basic pension and ending the much disliked one-child policy and labor camp.
- Centralization includes setting up the new State Security Committee (SSC) and the team for comprehensively deepening reform, vertically integrating courts, procuratorate and party disciplinary units, pushing forward the reform of letting counties report to provinces directly by cutting the prefectural level governments, and integrating the Food and Drug Administration.
Upholding the role of markets includes raising the role of market from “foundational” to “determining”, promising to protect private property rights, giving farmers’ better rights in trading their non-farming lands, further cutting procedures for examination and approval, shifting to a registration-based stock issuance system and allowing doctors to practice outside hospitals (in their own clinics).
The limit of centralization
A more centralized control under Mr. Xi’s standing committee could help deliver some economic and social reforms. However, there is no free lunch. Political centralization could be the best choice at the moment given all the social and political constraints, but trusting political centralization is once-and-for-all solution disciplining government officials (or “putting power in a cage” in the CPC leadership’s own words) and fostering fair competition may be naïve. For such a vast country with 1.3bn population and huge regional diversities, the benefits of centralization could be uncertain in some aspects.
- A vertically integrated system would still be bothered by information asymmetry between different layers. So even if upper level officials are clean and honest, it would still be hard for them to guarantee their juniors are equally honest.
- We believe China’s current top leaders are good and reform-minded, but centralizing power to a small team at the central level will naturally bring about the issue of power handover: what if those successors are less reform minded and less honest?
- Emphasizing vertical integration and top-down disciplinary measures could lead to a lack of bottom up check and balance by the people and media. And centralization might be indirectly dependent on the state owned sector.
Those low-hanging fruits
Picking the low-hanging fruits includes nationalizing basic pension and ending the much disliked one-child policy and labor camp. For some reasons including the global financial crisis which consumed too much time of the previous government, a number of relatively easy reforms were left to the new leaders.
Ending the one-child policy
Since November 2012 we have been predicting that the Chinese government would significantly ease its one-child policy at end-2013 or early 2014, and we updated the call in early August that China may significantly relax its outdated one-child policy soon by allowing families to have two kids if at least one parent is a singleton. In the past few months, predicting the end of the one-child-policy has been increasingly become a consensus call and many investors have already taken positions on that. However, investors were quite disappointed last week as the communique of China’s ruling Communist Party’s 3rd Plenum did not mention anything related to population policy or family planning, not to mention an outright on ending the one-child policy. But as expected, the “Decision” released on 15 Nov pretty put an end to the one-child policy by allowing families to have two kids if at least one parent is a singleton.
The impact: Around 9.5mn incremental babies
If the Chinese government really carries out the reform of the one-child policy soon by allowing families to have two kids if at least one parent is a singleton, what’s the impact? People might be still disappointed that the government does not permit all families to have two children without any restrictions. But we think the difference is quite small. This is because the one-child policy now is only strictly enforced in urban areas and some developed rural areas where most couples at their child-bearing age have at least one singleton (note China’s one-child policy started from late 1970s).
According to the 2005 population survey, singletons account for 29.3% of Chinese aged 30 or under (the generation affected by the one-child policy). The ratio should be significantly higher in urban areas. Assuming 60% of the people of child-bearing age in urban areas are singletons, on top of the 36% families which are already allowed to have two children, 48% urban families at child-bearing age can benefit from the coming reform. Using census data, there are 79mn women of child-bearing age (23 to 42) this year. 48% of 79mn is 38mn. Assuming 25% of them choose to have a second child, about 9.5mn babies could be born as a result of this reform to one-child policy.
Replacing Re-education through labor (Laojiao)
As part of China’s penal and correction system, Laojiao is used to detain persons for minor crimes without any court trial. Due to the lack of court orders and transparency, the Laojiao system could be misused by local officials and has become a source of disaffection among the people. China’s top policymakers mentioned in the beginning of 2013 that they will reform the Laojiao system in the next couple of years. We expect that this point could be briefly mentioned again at the 3rd Plenum, though it might be much more uncertain regarding the timeline for replacing Laojiao with a more transparent correction system for petty crimes.
Social security tax and social security system reform
China’s central government merely set guidelines on the nation’s social security system. Most of the current social security schemes are managed at the local level. In practice, it makes it difficult for people to transfer their contribution to the security schemes from one province to another when they relocate. By contrast, in the US and many other large countries, pension systems are managed at the national level while medical insurance systems are administered by both central and local governments. Besides, the current pension system in China is designed in 1997 as the hybrid of a defined benefit (or pay-as-you-go) system and a fullyfunded individual account system. However, the system has not functioned smoothly. Individual accounts broadly became “empty” as the administration used the individual account contributions to help pay the pensions of current retirees, with large-scale SOE restructuring in 1998 forcing many workers out of jobs and to start receiving immediate pensions at relatively young ages.
Given China’s aging population and mounting concerns over the current pension and medical insurance system, the social security system reform could become one of the focuses in the coming 3rd Plenum, in our view. The reform should centralize the administration of the social security system to facilitate labor mobility and urbanization. The current pension system should also be restructured to better prepare for the aging population, provide more incentives for individual contributions, and ensure the fairness and sustainability of the insurance system.
A more centralized party ruling
Many Chinese people recognize the key risk the country faces is the development gap between the existing rigid legal/government system and the newly economically empowered middle class which, increasingly equipped with access to internet, mobile phones and social media, has been seeking for more accountability on part of the government. We know very well that reform in this regard faces the biggest barriers and few achievements will likely be made in the near to medium term. Still, we expect some progress could be made in the legal areas as top leaders in Beijing try to rein in corruptions and take lessons from the misbehaviors of the former Chongqing CPC chief Mr. Bo Xilai who had an unchecked control of everything in Chongqing including local judiciary, prosecution and police. On the other hand, local protectionism significantly weakened some government functions, such as examining safety of food and drug and protecting IP rights. A weak central government also prevented the previous leadership from carrying out some reforms which were supported by a majority of people and should be faced with little resistance.
Centralization includes setting up the new SSC and the team for comprehensively deepening reform, vertically integrating courts, procuratorate and party disciplinary units, pushing forward the reform of letting counties report to provinces directly by cutting the prefectural level governments, and integrating the Food and Drug Administration.
A new team for deepening reform and a new SSC
According to the communique and the “Decision”, the CPC central committee will set up a team responsible for comprehensively deepening reforms and vows to reach decisive achievement in reforming important sectors by 2020. It’s still uncertain whether President Xi Jinping or Premier Li Keqiang will lead the team, but Han Zheng, the current party chief of Shanghai, will most likely be the first deputy director of the team.
The 3rd Plenum also decided to establish “State Security Committee”, which should be the counterparty of the White House National Security Council (NSC) in the US. Similar to the NSC, China’s SSC will most likely be chaired by Xi Jinping, CPC chief and President of China. Key members will likely include Premier Li Keqiang, the chairman of the CPC Central Military Committee, the Minister of Foreign Affairs, the Minister of State Security, the Minister of Public Security and a bunch of other senior officials related to foreign affairs.
Legal reforms towards a more centralized judiciary
The hierarchy of China’s court system dovetails with the administration. In line with national, provincial, prefectural and county governments, there are sittings of the “Supreme People’s Court” in Beijing, "high people's courts" in provincial capitals, autonomous regions, and special municipalities, "intermediate people's courts" at the level of prefectures, and "basic people's courts" at the level of counties and municipal districts. The shortcoming of this system is that, since local CPC chiefs have absolute control of personnel and funding for the regions’ courts (in additional to policing and prosecution), local CPC chiefs’ power cannot be effectively checked and balanced. This absolute power in turn easily leads to corruption and collusion by senior officials. Under this system, justice could be sacrificed, and people’s disaffection could be accumulated.
The Third Plenum set out an ambitious agenda.
The full report of the Third Plenum of the 18th Party Congress was released late Friday. In contrast to the high-level summary released earlier (see China: The Third Plenum sets the tone for continued market reforms, emphasizing fiscal and rural reforms, and a more open economy, November 11, 2013), the full report is much more substantive and unveils a bold economic reform agenda. The broad agenda encompasses price liberalization measures (energy and resources, and financial market), opening up the market to private and foreign competition, SOE reforms, fiscal reforms, and improving urbanization process through land and hukou reforms. We believe these measures point to a stronger focus on market discipline and medium-term sustainability by the new leadership. .
A number of key messages can be distilled from the report:
1. Pro-market stance: development of the market mechanisms, more opening up of the markets to competition, curbing the power of SOEs (although the state is to remain dominant) and government interventions, and continued financial reforms.
2. Social Fairness: greater focus on farmers’ property/land rights and even access to public services by rural and urban residents, public policies to protect vulnerable
3. Growth sustainability: significant emphasis on fiscal reforms to increase transparency and re-align central and local spending responsibilities; calls for mechanisms to monitor and manage debt and financial risks, and emphasis on environmental protection.
4. Top-down decision making: centralized strategy to be led by a reform committee at the top. The principle of “top-level design” of reforms was emphasized, to complement the decentralized “touch the stone to cross the river” model that encourages experiments but often leaves the direction of changes unclear.
The current reform agenda bears some similarity in its scope and depth as the landmark economic plan 20 years ago, when the market was just beginning to open up amid initial reforms. There are similar focuses on difficult areas this time: the scope of the market, SOE, and fiscal reforms. Again, the opening up to international markets is used as an important impetus to push forward domestic reforms (Exhibit 1).
Key reforms and interpretation
The reform agenda is broad. The commitment to market/SOE/rural reforms is stronger than our earlier expectation, that to fiscal reforms somewhat softer, and financial reforms generally in line (see Asia Economics Analyst: 13/37 - What to expect out of China’s 3rd plenary session in November, October 10, 2013). There are also a number of new emphases including in particular changes to the population policy and environmental protection.
As discussed earlier, these reform measures could improve China’s medium-term development path from three key dimensions: reducing supply-side growth bottlenecks, aiding domestic rebalancing, and institutional changes to ensure fiscal, financial and resource sustainability. The reforms from the Third Plenum report and their links to growth are mapped out in Exhibit 2 (we leave out population policy given the limited growth impact, in our view).
The Third Plenum’s emphasis on the role of market mechanisms and competition is stronger than earlier expected. The market is to play a “decisive” role in allocating resources. Price liberalization covers a broad set of sectors including utility, water, transportation, and communication. The government can set the price only for public goods, but should refrain from allocating resources directly. Government procurement of social services will also be broadened. More scope for private sector development through price deregulation and equal market access outside of a negative list (unspecified) is called for, and share cross-shareholding between public and private enterprises is emphasized. Despite the firm language that the state sector will remain dominant, there is also a call for better SOE management through corporate governance, transparency, and higher dividend payout ratio to the budget. The emphasis on market principle and fair competition was greater than we had expected.
Rural reforms emphasize an acceleration of land related and hukou reforms. Instead of targeted agricultural support, the current framework incorporates rural reforms in the national urbanization process, emphasizing the fairness aspect of rural and urban residents (property rights, access to public services). The decision attributes the same land rights in rural areas as in urban ones, which is a significant step forward from the previous dual-structure system for the urban and rural lands. In addition, it requires the establishment of a unified market of the urban-rural construction land, and calls for setting up intermediaries for rural construction land transactions (somewhat sooner than we expected). Land policy reforms aim to prevent wasteful use of land, and reduce local government’s monopsony in rural land acquisition. Hukou reform also received strong endorsement, as we expected.
Fiscal system to improve but the wording is somewhat softer than expected. Emphasis on transparency, shifting of some local spending responsibility to central is in line with our expectation. The budget will focus on the structure of spending rather than on the yearly target, and a multi-year fiscal system is to be established. The process to realign central and local is likely to take more negotiation however (indicated in the document as a “gradual process), somewhat softer than we expected. Municipal bonds will be introduced to support the urbanization related projects. Property tax related legislation will accelerate, though there is no firm commitment of the timing.
Financial/external reforms in line with expectation. No major surprises on the opening up to international markets and financial reforms with the expected pledge that financial /interest rate/exchange rate/capital account reform/FTZ will continue. Although the absence of details on financial reforms may be disappointing at first sight, however, given the steady progress of financial reforms, this is also a less controversial area and perhaps does not require explicit further endorsement to proceed.
Environmental protection/population policy: surprise areas. A comprehensive property right registration system over natural resources will be established, and local officials will be evaluated with environmental protection benchmarks. There is also explicit loosening of the existing one-child policy framework, which we believe has possible implication for the urban population to the tune of several million additional newborns each year.
* * *
Implementation of such sweeping changes is the key. One uncertainty is how reforms towards decentralization and a market-oriented system will be carried out in a centralized policy and political environment, and how the risks during the process of liberalization will be monitored and managed. There are also remaining questions on the role of State Capital Investment companies, the pace of property tax introduction, and the strategy to rein in local government debt and reduce moral hazard. On the other hand, the newly set up reform committee could raise market expectations for reform carry-through. Early indications of the reform steps could be given at the Central Economic Working Conference in early December
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