China’s Gradual Reform Dilemma

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China’s Gradual Reform Dilemma

Numerous efforts to rebalance the Chinese economy, including Xi Jinping’s, have failed. Why?

China’s Gradual Reform Dilemma

In this March 1, 2019, photo, people look at a display with photos of Chinese President Xi Jinping at an exhibition commemorating the 40th anniversary of China’s Reform and Opening Up Movement at the National Museum in Beijing.

Credit: AP Photo/Mark Schiefelbein

Xi Jinping announced at the Chinese Communist Party’s 20th National Congress that China would “deepen reform and opening persistently.” In March, Premier Li Keqiang told reporters, “Economic opening will not change, just like the Yangtze and Yellow Rivers will not backflow.” Despite the constant question over whether the era of economic reform has come to an end, in the mind of Chinese leaders, the commitment to economic reform will never change; instead, they are changing the focus of reform. The “primary contradiction” has switched from low productivity and economic backwardness to unbalanced development. 

As Michael Pettis has summarized, the core of China’s economic imbalance is excessive investment, which forces up the saving rate and suppresses domestic consumption. In 2011, then-Premier Wen Jiabao claimed that Chinese economic development was “unbalanced, uncoordinated, and unsustainable.” Ten years later, Xi Jinping identified the same problems, despite his various pledges to bring high-quality and sustainable growth to China. Numerous efforts to rebalance the Chinese economy, from deepening reform in 2013 to the deleveraging campaign to property tax, have failed to achieve their goals. 

The reason behind these successive failures is the incremental nature of China’s reform. Many scholars believe that gradualism is the trademark of China’s success, especially in comparison to the collapse of the Soviet Union. Indeed, China’s gradual reform resulted in a stable transition from the Maoist system to a market economy and one of the most notable economic miracles in world history. However, gradualism led to path dependency, which stalled further reforms. 

At the political level, the key to initiating and sustaining Deng Xiaoping’s economic reform was creating and expanding a pro-reform winning coalition. During the Maoist era, the military-industrial complex (MIC), which included the People’s Liberation Army (PLA) and heavy industrial ministries, dominated the Chinese economy and supported an autarkic economy. Thus, Deng’s first task was to overcome the MIC’s opposition. Deng attracted support from provincial leaders and agriculture and light industry officials by promising decentralization, marketization, and economic opening. 

Following his return to power, Deng summoned provincial leaders who shared reform interests with him to Beijing, most notably Zhao Ziyang from Sichuan and Wan Li from Anhui. Deng entrusted them with economic management roles within the central government to wrestle power away from Hua Guofeng and other hardliners. As the reform continued and the economy grew, Deng successfully expanded his winning coalition to inland provinces and heavy industries. The vested interest groups of the Maoist system decided to take advantage of the expanding foreign direct investments and business alliances with coastal provinces, as Susan Shirk explained in her book, “The Political Logic of Economic Reform in China.”

Yuen Yuen Ang illustrated China’s gradual reform path in her book “How China Escaped the Poverty Trap.” Ang argues that the conventional wisdom of setting up liberal democratic institutions first and then building up the market faces problems in emerging markets. In contrast, China reformed gradually and improved institutions along the way. China adopted “second-best” institutions to jump-start economic development. These weak institutions solved local problems largely through improvisation. Instead of establishing liberal market rules, local Chinese governments utilized Leninist and Confucian traditions, such as local-led investment attraction campaigns and the mobilization of investment through relational connections. As economic development continued, the pressure to improve the market forced the government to perfect institutions. Local governments began to give up the obsession with investment attraction and established investment management agencies to facilitate “high-quality” investments.

The key to China’s gradual reform has been adaptive informal institutions, which existed within China’s formal political system. Adaptive informal institutions are bridges between formal rules and practical realities. Local officials selectively bend laws and regulations to allow the development of the Chinese private sector. The emergence of Township and Village Enterprises (TVEs) during the 1980s fits into this narrative. Despite its commitment to economic reform, China still held ideological taboos against private enterprises. Until the late 1980s, China followed Deng Liqun’s “eight-man rule”: hiring less than eight people is socialist and employing eight people or more is capitalist exploitation. To reconcile this ideological taboo with the reality of a flourishing rural market economy, local governments allowed private entrepreneurs to “wear red hats” and register their businesses as collectively owned TVEs. Once the informal and formal gaps were closed in the 1990s and taboos against the private sector were lifted, many entrepreneurs decoupled their businesses from the local government and formally registered them as private businesses.

For a long time, the Chinese government continued to push forward reforms and improve economic institutions incrementally. For example, local governments strived to improve the business environment under intense competition to attract investments. Such efforts included budgetary reform to reduce arbitrary and predatory fine collections and improve contract law enforcement. However, unlike the prediction from many scholars, market development did not pressure the Chinese government to resolve the fundamental problems of the Chinese economy.

The problem behind these failures is the path-dependent nature of China’s economic reform. While development created pressure for further institutional improvement, it also created vested interest groups. These interest groups benefited from exploiting the current development model and opposed any attempt to rebalance the economy. The adaptive informal institutions also left local governments the power to bend the rules to pursue rent-seeking opportunities. For example, China’s weak market institutions created a profit-sharing logic between local political and economic elites within a local jurisdiction; the more prosperous the local economy, the more local elites will profit. 

In addition, Ang argues that the foundation of China’s fast economic growth is access to money, which in practice means business elites bribing local officials for business opportunities. Thus, Chinese local governments doubled down on the investment-led pro-growth policies and sustained the opaque bidding process because the distribution of investment projects created opportunities for local officials to collect bribes and reward loyal business cronies. Local officials reject any rebalancing effort to protect the profit-sharing system. The anti-corruption campaign only led to passivity on the part of local officials.  

Entrenched vested interests also make creating and expanding a pro-reform winning coalition nearly impossible. Local officials, vital members of Deng’s original winning coalition, became the biggest vested interest group under the profit-sharing scheme. The potential candidates for a new winning coalition are private businesses and households, since they will be the biggest beneficiaries of the abolition of financial repression. However, the CCP leadership is unwilling to create this coalition because empowering these forces might lead to political instability. The Chinese government prefers to co-opt private businesses rather than empower them. 

In addition, as the reform process becomes increasingly zero-sum and cut-throat, vested interest groups will resist rather than embrace the changes because the benefit of reform will not reach them. For example, Chinese banks have rejected the rise of online finance platforms, such as Jack Ma’s Ant Finance, because these platforms snatched household saving deposits away and undermined the financial repression system; the banks get no benefits from the rise of these new platforms.

Another reason for path dependency is the extent and complexity of China’s economic problems. The Chinese economic system can be best described as “pulling one hair will move the entire body”; it is so intertwined that any change will lead to more problems. Gradual reform solves the most pressing surface-level problems while ignoring the root causes. As a result, addressing one challenge leads to more problems. Gradual reform becomes a game of whack-a-mole rather than incremental institutional improvement.

For example, China’s 1994 fiscal reform was necessary to strengthen its central fiscal spending power. However, the reform led to administrative and financial recentralization, which led to the squeezing of rural private businesses. In addition, Zhu Rongji, the engineer of this reform, made a deal with local officials to ease off local resistance, which allowed local governments to raise their own budgets by all means. This “deal with the devil” opened the gate for local governments to use land sales for revenues, which led to the real estate bubble, overinvestment in infrastructure, and the local profit-sharing scheme.

Facing a complex and intertwined situation, China needs a comprehensive reform addressing the root causes of its economic problems. However, the risk-averse nature of the Chinese government prevents such a reform from happening. The entire political structure, from Beijing to the localities, despises any reforms that might lead to instability. Rather than embracing rural credit unions and other private financial institutions and guiding their healthy development, then-General Secretary Jiang Zemin cracked them down under the concern of financial stability. Similarly, the concern for financial and social stability led Beijing to crack down on P2P lending and Ant Finance. Beijing feared the social stability consequences of the potential failure of private financial institutions, even though such institutions nurture economic rebalance. The 2021 Government Work Report incorporated financial security as China’s top national security concern and declared that “structural risk in the financial sector must be prevented at all costs.” 

In many ways, China’s gradual reform does not solve problems; it kicks them forward and hopes they disappear due to fast growth. In reality, the CCP is not so much kicking cans down the road as kicking snowballs downhill: shifting these problems forward only makes them accumulate until they are too big to move. The current situation poses a question for the CCP: should it continue with gradualism? Given Xi’s emphasis on continuity in his work report to the 20th Party Congress, a big bang reform is unlikely, and that means problems will continue to pile up.