Could markets work under China’s socialist system?

The Third Plenary Session of the 20th Central Committee of the Chinese Communist Party (CCP) has just ended. Much attention was given to this meeting because several third plenums over the past 50 years have been crucial to the development of China’s market economy.

Having to rebuild a devastated China in 1978, the CCP leaders reached the consensus at the third plenum of the 11th Central Committee to reinvigorate the domestic economy and open it up to the world — this marked the start of China’s market reforms. The success of the rural economic reform further convinced the sceptics in the CCP leadership to enable bottom-up market reforms after 1984.

Nevertheless, the concept that the socialist economy must be a planned economy remained mainstream then, and the debate about “whether the market should be surnamed socialism or capitalism” remained. After three years of stagnation and energised by Deng Xiaoping’s Southern Tour, the 14th National Congress of the CCP in 1992 finally adopted the socialist market economy as the goal of China’s economic reforms. 

Subsequently, the third plenum of the 14th Central Committee further clarified that the socialist market economic system “must enable the market to play a fundamental role in resource allocation, regulated by the nation on a macro level”. Since then, China’s market reforms have taken a comprehensive top-down approach across all sectors.

However, the temporary measures in response to emergencies often created long-term impacts and path dependencies. When China’s economy fell into deflation from 1998 to 2002, the central government hastily ordered local governments to strictly ensure 8% annual economic growth. This marked the reintroduction of issuing annual orders to directly manage the economy, an approach abandoned since 1987. 

Local governments at all levels were since tasked to ensure economic growth. The government’s market interventions were no longer limited to the “macro level” as defined by the third plenum of the 14th Central Committee.

The 2008 global financial crisis further eroded the will to implement market reforms. State-owned enterprises (SOEs) were no longer limited to the important industries related to national security and economic lifeline but expanded to competitive industries and sectors from which they were required to exit. The pace of marketisation of the factors of production, which had lagged for many years, stagnated. Largely rhetoric, reforms were sluggish, and prospects were bleak.

Against this backdrop, the third plenum of the 18th Central Committee in 2013 proposed that the underlying issue of economic system reform is to strike a balance between the roles of the government and the market, so that the former could better fulfil its role with the latter playing the decisive role in resource allocation. 

This plenum, which appeared to refocus China’s reforms, was well received at home and abroad. Optimists viewed this decisive role of the market as more appropriate than the “fundamental role” in 1993. However, they overlooked the part on letting the government “better fulfil its role” and failed to notice the withdrawal of “macro-level regulation” as the means for the government’s market intervention. It was subsequently evident that the government’s market intervention became increasingly intensive at the micro level. Consequently, the market played a diminished rather than bigger role in resource allocation.

In recent years, China’s economic growth has stalled. Chinese enterprises lack vibrancy, and deflation has become a clear trend. As such, the third plenum of the 20th Central Committee this year was closely watched for clear directions for reforms. 

The plenum proposed to finish building a high-standard socialist market economy in all respects by 2035, which shows the market’s indispensable role. With 32 years of experience and lessons learnt since 1992 in exploring the socialist market economy, China plans to complete building this economic system in the next 11 years. Few at home or overseas, however, understand what a socialist market economy is. They question whether markets are compatible with China’s socialist system. Questions include at least the following three aspects.

First, how does the socialist market economy protect private property?

While market forces may be used to improve economic efficiency and vibrancy, the lack of contractual safeguards means that private property is unprotected, severely denting the incentive for production, investment and innovation. Consequently, the economy is unable to prosper amid the limited vibrancy in the market.

Property protection is particularly important in an innovative economy. The production of innovative products involves many partners and the protracted process means it takes time for the benefits to materialise. Compared with the simple market transaction of payment upon delivery, these innovative products are “property rights-intensive” and have stringent requirements to safeguard contract execution and property rights protection.

Since the Chinese government wields great power, it is duty-bound to protect private property. Yet, power may be abused, dampening the incentives for production and creation. As power is wielded by tens of thousands of officials at all levels, their respective interests constantly affect its exercise.  

China has intensified its anti-corruption efforts since 2013. In the past 11 years, over 200,000 cadres at or above the county or division level and 600,000 cadres at the township or section level were investigated, and over 3.7 million cadres disciplined by the party and the government. Evidently, it is very difficult for those exercising power to fairly and justly safeguard the property and legal rights of enterprises and individuals in the market.

Indeed, enterprises and individuals would feel helpless against such power. Will last year’s salaries and income be required to be returned this year? Will a legitimate business that is doing well today suddenly be stopped tomorrow? These problems often appear in daily life and affect the confidence and decision-making of investors and consumers.

The third plenum of the 20th Central Committee mentioned that the rule of law is important to underpin a Chinese-style modernisation, and China should improve the mechanisms for ensuring that all are equal before the law. Two necessary steps must be taken before this goal can be achieved.

First, those who exercise state power must be regulated and restricted so that they “do not do what is not mandated by the law”. Second, the ability of enterprises and individuals to fight for their legitimate rights and interests must be enhanced, the freedom to stand up for their rights be safeguarded, and effective channels be made available. 

The crux of the matter is, can the two necessary reforms of restricting the power of government officials and empowering rights protectors be realised in China’s socialist market economy? Is the current unitary organisational structure of governance compatible with a society based on the rule of law?

Second, what role should local governments play?

The debt problem of local governments in China, which has been exacerbated by the real estate market downturn and the sharp decline in land sales revenue, has in recent years become a hot topic. Local government debt has its unique historical background and is closely linked to the economic role of the local governments.

In the 1950s, Mao Zedong called the Soviet-style economic management “tiaotiao dictatorship” (条条专政), or a dictatorship under the rule of line ministries of the central government, and advocated proactive “tiao-kuai integration” (条块结合), or a combination of vertical control of the central ministries and lateral management of local governments. 

While the management of Chinese SOEs were sometimes delegated to provincial governments, there were also local product exchange centres operated outside the purview of the central planning agency.

Although these practices rendered China’s central planning unscientific, they cultivated a group of local cadres with the necessary economic management experience. Encouraged by the fiscal responsibility system introduced in the early 1980s, local governments vigorously supported township enterprises and developed local SOEs. This actively contributed to the bottom-up approach to market reforms.

In 1998, plagued by the economic downturn and deflation, the central government ordered and mobilised local governments to ensure 8% annual economic growth. From governments of provinces and cities, to districts, counties, townships and communities, all were tasked with developing the economy and attracting investment.

Initially, this was a tall order because local governments faced financial difficulties after the implementation of the tax-sharing system in 1994, coupled with the state-owned banks’ reluctance to lend amid banking reforms and bad debt recovery. Without funds, the local governments were helpless, until real estate became a new pillar industry. 

When local governments invested in projects and build infrastructure, they could either use the finance generated from land sales or use local government financing vehicles to raise debt, thus becoming the main contributor to ensuring economic growth. Local governments began to engage in projects for political mileage and image, and “to use money to resolve internal conflicts among the people”. Such irresponsible spending gradually accumulated huge local debts.

Local government debt was directly related to the sharp rise of real estate prices and the local government’s motivation to increase fiscal revenue from land sales. In addition, the incentive mechanism in land sales attracted significant resources to the real estate and infrastructure construction industries, which skewed economic development, aggravated income inequality, and reduced the proportion of residents’ income and consumption to GDP every year from 2000 to 2010. 

Local government behaviour also changed when faced with fiscal difficulties. Instead of extending a helping hand to enlarge the tax base, they took actions that killed the goose that laid the golden eggs.

The above discussion shows that the actions of local governments will have a profound impact on the entire country, and these actions are closely related to local finance and the tasks undertaken by local governments. The current way of solving local fiscal difficulties is to increase local tax sources and to match local governments’ fiscal resources with their administrative responsibilities. 

In other countries, property tax is the main tax source for local governments. However, levying property tax in China has faced many obstacles, and will unlikely be implemented amid the downturn in the property market.

Another reason for the expansion of local debt is the uncertainty of the local government’s administrative responsibilities, which continuously expands according to the whims of the higher-level governments. Besides ensuring economic growth, the customary practice of “the central government treats but the local governments foot the bill” makes the administrative authority of the local governments at all levels unclear and difficult to match with fiscal resources.

Does the role of local government necessarily include being responsible for local economic growth? What should subordinates do when they have no money to complete tasks assigned by superiors? In a system where leaders of lower-level governments are appointed by their superiors, how can the respective fiscal responsibilities of the higher and lower-level governments be clearly defined?

The third plenum of the 20th Central Committee has proposed to modernise the system of governance and governance capabilities by 2035. Clarifying the relationship between the central and local governments as well as the role of local governments is most vital to this.

Third, what are the rules for government intervention in the market?

The original idea of the government’s economic intervention was that it was indirect and realised through macro-regulations. Subsequently, however, indirect intervention was no longer advocated. With government intervention, some industries were concentrated on the supply side, others on the demand side, and some interference occured on both supply and demand. As a result, they formed simulated market activities and prevented market forces from functioning.

In industrial policy, the original thinking was that “the state regulates the market and the market guides the enterprises”. However, it later became direct state intervention in enterprise activities, with each state, province, city and county having their respective industrial policies.

For SOEs, the focus used to be on keeping only large and viable SOEs and allowing smaller and loss-making ones to be closed, merged or privatised, limiting SOEs to industries related to national security and economic lifeline, and withdrawing them from competitive sectors. However, various levels of local governments subsequently followed suit, also keeping their “large” SOEs, resulting in many SOEs directly competing with private enterprises in the perfectly competitive sectors.

Today, government intervention is ubiquitous. Ministers, tax officials and bank loan officers, from central ministries and commissions to township authorities and commercial entities, can have direct and crucial impacts on enterprises. Entrepreneurs are most concerned by this type of regulatory risk, and the enterprise operating environment rapidly deteriorates, especially when these interventions are compounded due to changes in political circumstances and national security requirements.

The third plenum of the 20th Central Committee hopes to “foster a fairer and more dynamic market environment, and make resource allocation as efficient and productive as possible”. To this end, rules must be formulated to reduce direct government intervention and where in the market the government could intervene.

It is believed that China’s reforms have entered deep waters and reformers must be ready to tackle tough issues. To achieve the 2035 goal, there is no avoiding the above three questions, which must be resolutely confronted. Only by taking practical action to address these tough issues can the market regain confidence and drive a healthy economic development.

This article was first published in Lianhe Zaobao as “三中全会与市场经济”.

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