China's Economic Reform

Why It Must Reform or Collapse

Chinese President Xi Jinping must reform China's economy.
Chinese President Xi Jinping applauds during the opening of the 3rd Session of the 12th National People's Congress at the Great Hall of the People on March 5, 2015 in Beijing, China. Photo by Lintao Zhang/Getty Images

China's economic reform is a long-term plan to shift from a command economy to a mixed economy. That means its recent slowdown in economic growth is intentional. It's not a sign of a collapse. It's consistent with a long-term plan Chinese President Xi Jinping released on November 16, 2013.

In December 2015, China's leaders hammered out details of the five-year plan it drafted in October. It will continue the reforms outlined in 2013.

Global leaders have become more interested in President Xi's plans now that China has become the world's largest economy. (Source: "China Crafts a Blueprint for Overhauls," The Wall Street Journal, October 26, 2015.)

If you understand this blueprint for economic reform, all the warnings about China's slowdown or collapse will be less alarming. That includes the 3 percent drop in the yuan to dollar exchange rate and the July drop in China's stock market in 2015. It also explains China's desire for the yuan to become a global reserve currency.

China's Economic Reform Plan

The reform plan moves China's economy away from government spending, state-run companies and low-cost exports. It moves it toward private investment, entrepreneurial innovation and domestic consumption. It needs to reduce overcapacity in factories, sell a stockpile of newly built and vacant homes, and lower business costs. As a result, China is willing to accept a slower rate of growth.

It will probably be between 6.5 percent and 7 percent.

To do this, President Xi outlined steps to make China's financial system more competitive. The government will lower taxes instead of increasing spending. It has also lowered interest rates to make borrowing easier. But the American Enterprise Institute says that the plan only saddled companies with more debt.

In fact, corporate debt is now 160 percent of GDP. Compared to that of the United States at 70 percent, this is very high. (Source: "China Reforms," The Wall Street Journal, December 22, 2015.)

China has gotten by with a large shadow banking system that substituted for small private banks. There's a lot of corruption as well. Reforms make it harder for the small businesses that rely on the current system. 

China's state-owned companies are the pillars of China's economic growth. But many are bloated, ineffective and unprofitable. They are in the steel, glassworks and other manufacturing industries. The reforms modernized them to attract private investors. But they created a glut of commodities.  The oversupply caused prices to plummet which consequently sabotaged the privatization efforts.

The government will loosen price controls on water, electricity and natural resources. Companies in these industries can consolidate and become larger. But they must become profitable. They will also be listed on China's stock market to hold them accountable. (Source: "China to Overhaul State Sector," The Wall Street Journal, September 14, 2015.)

In return, they will pay 30 percent of earnings as dividends to the government.

Proceeds will be used to fund social security programs by 2020. That allows the Chinese people to save less, spend more and boost demand. 

Banking reform will restore competitiveness. First, the government insured bank deposits in 2014. It then allowed banks to raise interest rates for consumer deposits. That gives savers more to spend and banks more to lend. More privately-held smaller banks have been created to spur innovative new companies and drive competition. (Source: "China's Economic Reforms," CNBC, November 17, 2013.)

That also helps them grow enough to launch an initial public offering. In the past, the government decided which companies could list stocks on the market. The reform will allow the companies to make their own decisions. (Source: "Fixes to Finance Stall Out in China," The Wall Street Journal, November 27, 2015.)

This greater risk is being carefully introduced. The government will allow some companies to default without bailing them out. That will create bank losses that the government will try to manage. (Source: "China Reports Broad Economic Slowdown," The Wall Street Journal, March 14, 2014.)

The People's Bank of China is taking steps to allow the yuan to replace the U.S. dollar as the world's reserve currency. As a first step toward international currency trading, the yuan is now traded in London and Singapore. That will open China to more foreign direct investment. (Source: "China Is All Bark, No Bite on Finances," The Wall Street Journal, January 6, 2014.)

These changes are needed but risky. Other countries, such as Norway, Argentina and Thailand, liberalized their financial sectors only to experience banking crises within a few years.

To make these risky reforms acceptable, President Xi also granted more personal liberties. Couples can have a second child if one spouse is an only child. That will reverse a declining labor force. Labor camps will be abolished. Those were punishments without judicial process for dissidents, prostitutes and the homeless.

Rural workers will keep their right to public services when they move to an urban area for work. Farmers can sell their land instead of the local government controlling its use. That will probably be opposed by the local authorities who depend on revenues from these collectives to pay their debts. The government may allow localities to set their own higher tax rates. This could upset the balance of power though between them. If successful, these measures will increase the labor supply for urban businesses. (Source: “Success of Chinese Leaders' Plan May Rest on Rural Regions,“ The New York Times, November 17, 2013.)