The implications of accelerating Chinese economic reforms

The implications of accelerating Chinese economic reforms.

What I Learned This Week

March 8, 2018

The 19th Central Committee of the Communist Party of China (CPC) held its Third Plenary Session in late February. This is the first time we can ever recall that the Third Plenary session has been held near the beginning of the year, which underscores the sense of urgency about economic reforms.

According to the meeting minutes, one important document was approved: the “Decision to Deepen Reform of Party and State Institutions” [中共中央关于深化党和国家机构改革的决定]. Although details have not yet been released, most observers expect a major downsizing of government that will open up the budget to allow more room for tax cuts.

Several constitutional amendments were also proposed during the session, including a change to the governance system that was enacted by Deng Xiaoping in 1982, originally designed to prevent lifelong leadership. Although the proposed constitutional change, which may result in President Xi ruling indefinitely, sparked critical comments from Western media outlets, one major advantage went largely unreported: there will be a relatively long period—at least a decade or more—of political stability in China.

This is especially important as it will enable the government to carry out all the important reforms and achieve major targets before Xi hands the reins to his successors. Since 2013, Xi has embarked on a series of ambitious initiatives, such as One Belt-One Road (OBOR), “Made in China 2025”, military reform, reductions of excess industrial supply, and many other reforms. If Xi steps down in 2022, as current rules stipulate, then all these initiatives would be at risk of floundering, with no top-level sponsorship.

Considering the populist upheaval that has taken hold of Italy, the U.K., and the U.S. in just the last two years—with all three countries struggling to boost their economic fortunes in a low-growth world characterized by high debt levels and poor demographics—the rationale behind the proposed constitutional change appears to have more merit now than it may have had in prior decades.

Moreover, the proposed change does not necessarily guarantee lifelong leadership. Last week, the People’s Daily ran a lengthy commentary explaining that the change was an “important move” to strengthen the party’s leadership. The commentary added: “This amendment does not mean changing the retirement system for party and national leaders, and [it] does not mean a life-long term system for leading officials.”

China is not the only country that has moved in the direction of long-serving leaders. Consider the cases of Angela Merkel (now in her fourth term as Germany’s chancellor), Shinzo Abe of Japan, Russia’s Putin and Turkey’s Erdogan. It remains to be seen what impact the trend toward long-serving leaders will have, as there was a similar trend in major countries immediately before World War II. However, one thing is abundantly clear: global politics will become more confrontational than the past, which might necessitate stronger leaders than a system of short leadership terms can produce.

Consider the changes that have already occurred within China’s entrenched political and military elite over the past five years. An estimated 1.5 million officials were investigated and many punished, including two former Vice-Chairmen of the Central Military Commission (CMC), Guo Boxiong and Xu Caihou. This is hugely significant: the last time such high-ranking military officials were punished was 1971, when Lin Biao, then-Vice Chairman of the CMC, fled the country after a failed military coup against Chairman Mao Zedong.

Additionally, former National Security Czar, Zhou Yongkang, became the first member of the Standing Committee of the Central Political Bureau to be jailed since the end of the Cultural Revolution. Since year-end 2012, more than 150 officials above the provincial and ministerial-level have been investigated or jailed.

President Xi and the rest of the government have won broad popular support with their efforts to narrow China’s wealth gap, in addition to the anti-corruption campaign. According to data from Statistics Bureau, China’s Gini coefficient, a gauge that measures income inequality, fell from its 2008 peak of 0.491 to 0.467 in 2017. Usually, when economic growth is strong, the gap between rich and poor widens, since wealthier people are better-informed and have more capital to invest at the front-end of the economic cycle. Therefore, by ensuring that the gains from the current cycle are spread more evenly, China has set an excellent example for the rest of world. New property-tax regulations will be drafted and proposed at the next congress meeting, with the aim of cracking-down on property speculation, which should further narrow the wealth gap.

As Xi embarks on his second term, which began last fall, he can now focus on appointing his allies to the most important positions and push harder for more broad-based economic reforms, as we explained in our series entitled “China’s reforms will shake the world.” (See WILTWs December 5, 2013; February 27, 2014; and April 17, 2014.)

Xi’s economic reform agenda over the coming years will have two major near-term implications. One is that the government’s effort to enforce deleveraging and excess capacity reduction will continue. Premier Li Keqiang continues to push the “structural reform of supply” to the top of the government’s agenda in 2018. Xiao Jie, head of the Ministry of Finance (MOF), said this week: “Whoever raised the debt would be held responsible for it… The only legal way for local governments to borrow money is to issue local government bonds.” China managed to cut its government debt-to-GDP ratio from 36.7% in 2016 to 36.2% in 2017, according to Xiao.

The second major implication is that taxes are likely to be cut. During a speech earlier this week, Premier Li announced that the government will increase the nationwide personal income tax threshold this year, for the first time in seven years, sparking loud applause in his audience. Raising the income-tax threshold is tantamount to a tax cut for workers at the lower-end of the income scale.

Additionally, deductible educational and medical expenses will be allowed in the calculation of personal income taxes for the first time, according to Xiao Jie, head of the MOF. The value-added tax (VAT) system will also be further simplified and consolidated, in the direction of transitioning from the current three-tier VAT regime (17%, 11% and 6%) into a future two-tier regime (11% and 6%). Xiao estimated that the total tax cut for this year alone could reach 1.1 trillion yuan, equivalent to 1.3% of China’s 2017 GDP. By way of comparison, the U.S. tax cut amounts to $1.5 trillion for ten years, or $150 billion per year, which is about 0.8% of U.S. GDP.

According to Hua Sheng, a renowned professor at Wuhan University, a reduction in the VAT rate from 17% to 11% could boost corporate profits by 20%, which will have a positive impact on China’s real economy—especially the manufacturing sector.

Only time will tell if China’s present path will have positive results for its economy, population and standing in the world. Nevertheless, it is noteworthy that while Washington ratchets-up its rhetoric toward other countries as a solution to its long-simmering problems, Beijing is instead focusing more on internal solutions.