China in Transition

Proposals for Supply-side Structural Reform

Chi Hung KWAN
Consulting Fellow, RIETI

Policies to stimulate productivity growth

Since around 2011, the Chinese economy has shifted to a new stage known as "the new normal," after a high-growth period that had lasted for about 30 years. The shift was triggered by a decline in China's potential growth rate associated with changes on the supply side, such as the transition from a labor surplus to a labor shortage. In response, the government has set out its policy of supply-side structural reform. Specifically, at the Central Economic Work Conference held in December 2015, the following five tasks known as the "three cuts, one reduction, one strengthening" were announced: 1) cut excess production capacity, 2) cut down excess stocks, 3) cut excessive debt, 4) reduce costs, and 5) strengthen weak areas. However, many of these policies are merely stopgap measures based on administrative orders that remain within the scope of "supply-side management." In order to sustain medium- to high-speed growth, the growth engine must be shifted from the expansion of inputs such as labor and capital to productivity improvement. In order to achieve this, in addition to innovation, reallocation of resources (labor, capital and land, etc.), which typically takes the forms of industrial upgrading and ownership reform, needs to be promoted via market-oriented institutional reform (see Figure).

Figure: How to Raise Productivity
Figure: How to Raise Productivity
(Source) Created by the author

1. Promotion of innovation
To promote innovation, first, intellectual property rights protection should be strengthened. The intellectual property system that protects patents and copyrights will promote innovation by balancing the exclusive right of intellectual property with its availability. In China, however, although the development of related laws has been progressing, these laws are not necessarily fully enforced, as symbolized by the widespread availability of pirated copies and counterfeit items. This has hampered investment of foreign companies in China and, in turn, their technological transfers.

Also, the framework to support venture companies from a financial perspective should be strengthened. The venture capital industry, which supports innovation companies and high-tech companies in China, lacks both capital and experience. Although there is a startup board (ChiNext) in the Shenzhen Stock Exchange, the role it can play as a channel for venture capitalists to exit their investments is limited. Many of China's leading high-tech firms, including Tencent, Alibaba, and Baidu, are listed on boards overseas. In the future, their return to domestic exchanges should be urged through the easing of regulations.

The tight control on information flows should also be eased. Not only conventional media, but also the Internet is subject to strict censorship. This hinders innovation.

2. Industrial upgrading
In order to achieve industrial upgrading, the focus must be on the fostering of new industries rather than protection of old industries. As a way to create an environment in which new industries can be fostered, regulations that impede new entry and competition should be abolished as soon as possible. At the same time, production factors such as labor, capital, and land should not be fixed in ailing industries through import restrictions and subsidies. Rather, government policies should be implemented to facilitate their reallocation to new industries. In addition to reforming the household registration system which hinders the mobility of labor and disposing of zombie companies, speeding up agricultural land reform is needed to make room for large-scale farming and urbanization.

Also, in order to avoid the industrial hollowing out that may result from the relocation of industries overseas, China should open up more widely to the world by promoting inward foreign direct investment. The entry of foreign companies not only will help transfer technology and management resources, but also create jobs and stimulate competition.

Furthermore, when Chinese companies seek to access overseas markets, export from the headquarters should be prioritized over local production. The government should create an environment for free trade by entering into free trade agreements (FTAs) and other means so that Chinese companies can access overseas markets through exports, while producing domestically. Further trade liberalization will apply external pressure on China in a similar manner to its admission to the World Trade Organization (WTO) in 2001, and become a driving force for domestic economic structural reform.

3. Ownership reform
When pursuing ownership reform, state-owned enterprises (SOEs) must be privatized. There are many inefficient SOEs in China. Many of the problems with SOEs such as inefficiency are the result of inadequate corporate governance. Even in a developed capitalist economy, managers can infringe on the owners when ownership and management are separated. This problem is particularly serious in China where ownership of SOEs is ambiguous. It is impossible to establish corporate governance unless SOEs are privatized (See Note).

It is also necessary to end discrimination against private enterprises which are the leading force of the market economy. Until now, private enterprises have faced discrimination in many areas including market entry and financing. To realize their potential, creating an equitable and fair market environment is the top priority.

Furthermore, to promote investment, the protection of private property must be strengthened. If such protection is not adequate, capital flight may occur, with private enterprises sending their profits overseas instead of reinvesting at home. In recent years, the stagnation in private investment, coupled with a widening capital account deficit, suggests that capital flight may have already been taking place.

The need to further market-oriented reform

Supply-side structural reform is not a new concept for China, and has formed the core of the reform and opening-up policies implemented since the end of the 1970s in its pursuit of a market economy. It is no exaggeration to say that the high growth over a period of almost 40 years was brought about by supply-side structural reform. However, China's transition from a planned economy to a market economy is still only halfway through. The economic reform package of the Xi Jinping administration, announced as the "Decision of the Central Committee of the Communist Party of China on Some Major Issues Concerning Comprehensively Deepening the Reform" and adopted at the Third Plenary Session of the 18th Central Committee of the Communist Party of China in November 2013, emphasized that "the market will play a decisive role in resource allocation." This is the very direction of supply-side structural reform to which China should aim beyond the supply-side management centering on the "three cuts, one reduction, and one strengthening."

The original text in Japanese was posted on November 30, 2017.

  1. ^ The Chinese government has allowed the privatization of small to medium-sized SOEs, but it has been reluctant to privatize large-sized SOEs. In the “Guideline to Deepen SOE Reform,” announced in September 2015, this stance did not change, and the following was highlighted: Aim for bigger, stronger, and better SOEs, and unceasingly improve the vitality, control, influence, and risk handling capabilities of the state-owned economy. Instead of privatization, the government is promoting mixed-ownership reform, in which private capital is introduced to SOEs, on the premise that the government remains the largest shareholder. As long as the government stays in control, however, business management of SOEs is unlikely to change drastically.

December 14, 2017