China's New Roadmap for Reform

Reforms aimed at introducing capitalistic market principles to the Chinese economy have been the driving force behind the country's development for the past 35 years. These changes-conceived in their broadest form by Communist Party leaders at their periodic plenary sessions and subsequently implemented at the policy level by Chinese government agencies-have been highly successful in transforming the country's economy. In the eight years prior to the first reforms, implemented after the 1978 plenary meetings, China's real per capita GDP growth averaged 3.9 percent. Since economic reform has taken root, the real per-capita GDP growth rate has more than doubled, averaging 8.7 percent between 1978 and 2012. Real income levels between 1978 and 2012, meanwhile, have grown 17-fold, from US$540 to US$9,300 per annum, in 2012 purchasing power parity U.S. dollars.

A key impact of the economic reforms-a second round of which was implemented after the 1993 plenary sessions-was to increase China's productivity. Growth in China's total factor productivity (TFP)-a measure of the economy's efficiency and productivity gains (rather than higher labor participation or increased capital investment) rose markedly after economic reform began. In 1971-80, China's TFP growth averaged 0.9 percent annually-only minimally higher than that of the U.S., a mature economy. Since the beginning of the reform era, China's average annual TFP growth has shot up to the 3-5 percent range, while U.S. TFP growth has hovered near 1 percent.

After more than 30 years of rapid growth, however, China's economy now faces serious challenges to its development prospects. First, economic growth is facing a secular downtrend as China approaches middle-income-level status. Second, as wages have increased with the economic boom, the labor force has become less competitive in the low-value sectors that helped drive its initial economic growth.

As the Third Plenary Session of the 18th Central Committee commenced on November 9, there was widespread acknowledgement by both outside observers and those within the Chinese government that the most recent economic reforms-those resulting from the 1993 Third Plenum-had become a spent force.IHS forecasts that China's GDP growth-currently at 7.8 percent-will average only 7.1 percent in the second part of the decade. Its export-oriented growth model has reached its limits and, to sustain growth, China will need to cultivate consumer demand and move up the value chain.

Recognizing this, the Committee emerged from its recent week-long meeting with economic policy directives that IHS believes will push China's economy forward, albeit incrementally, with a focus on drawing clearer boundaries of the state's involvement in the market, allowing private enterprise a more prominent role.

IHS has highlighted five areas of critical importance the Plenum emphasized for securing China's economic growth over the long term:

• Liberalizing the financial system
• Reining in monopoly power across a number of industry sectors
• Significantly opening the market to foreign investment and competition
• Improving labor mobility through reform of the hukou (resident passport) system
• Placing greater emphasis on environmental protection and ecological preservation

While the policy documents do not provide a clear reform path for each of these areas, they do touch on all of them, generally carving enough space for reform should the political resolve be sufficient.

In addition, IHS analyzed the likely impact the Third Plenum's directives will have on six industrial sectors:

• Energy
• Chemicals
• Automotive
• Healthcare
• Maritime
• Defense

A common theme for all of these sectors is the impact market reforms and greater competition will have on the monopolies that exist today.

Five areas of importance

Financial Markets

The Decision-as the document spelling out the policy directives is known-calls for specific measures to be taken to liberalize the economy's financial markets, including:

• Accelerating marketization of interest rates and currency exchange rates
• Enabling of cross-border financial flows, including investment and trading of foreign debt
• Encouraging the growth of small- and medium-sized private financial institutions

Of particular note is the move toward deposit interest rate liberalization, which would increase competition among the existing state-owned banks. IHS expects this will motivate financial institutions to more efficiently allocate capital and thus reduce the likelihood that less competitive state-owned enterprises (SOEs) will have priority access to credit. Additionally, competitive deposit rates will offer new options for savers and reduce the appeal of the exotic and poorly regulated financial vehicles that have sprung up in recent years and raised systemic financial sector risk.

Monopolies and Market Competition

Over the past decade, concern has increased that China's SOEs have grown too powerful, diminishing the role of private enterprise in the economy and in many ways distorting markets and creating inefficiencies. Somewhat troubling, The Decision reaffirms the critical role that SOEs play in the economy, while simultaneously using strong language to encourage a level playing field for private enterprises.

The Decision calls for "eliminating all entrenched barriers" to private investment and competition and for the protection of private property to ensure that all forms of ownership-state, collective or private-operate on a level playing field. Specifically, it stipulates that all market participants "can have equal access to production inputs, compete in an open, fair, and equal manner and are afforded the same level of legal protection."

While anticipating a continuing role for SOEs-likely a reflection of the difficulty of dismantling these entrenched interests at this time-The Decision calls for strengthening oversight of SOEs as well as requiring they take on new ownership under a system that will see an increasing number of them sell shares, as well as allow private enterprises to take part in their capital investment projects.

Foreign Investment

Foreign investment and competition is slated for deeper reform, with The Decisioncalling for the opening up to foreign companies of such areas as finance, education, medicine, elderly care, construction design, accounting and auditing and electric services.

Additionally, The Decision calls for accelerating reform in the Shanghai Free Trade Zone, as well as establishing additional zones in other areas throughout the country. Importantly, within these zones it calls for improving protection of foreign investment and legal rights and opening government procurement markets further.

IHS believes that these new measures will lead to further opening of China's markets to foreign companies and allow them to have a more level playing field relative to domestic players.

Labor Mobility

The Decision carves out extensive space for needed reform of the rural-urban dual system, including hukou-the program of household registration that effectively restricts migration of workers from rural to urban areas that is seen as an impediment to economic development. IHS believes that-while reform of hukou is necessary to grow the Chinese middle class and consumer spending-there is likely to be significant difficulty in pushing these reforms through on a broad scale over the near term. Concerns over the possible effects of an expedited urbanization policy-damage to rural economies, strains on city government services and increasing social unrest and crime-will lead to a go-slow approach in this area.

Environmental Protection

For the first time, a CCP Third Plenum document incorporates the phrase "ecological protection"-calling for the prohibition of development that fails to meet unspecified environmental standards. Similarly, the Decision calls for the establishment of an independent regulator with the authority to provide regulatory oversight, enforce environmental regulations and make environmental information public.

While inclusion of language pertaining to environmental protection is encouraging, it remains to be seen how closely government officials will be held accountable for upholding new standards-particularly as the country attempts to restore economic growth to earlier levels. The more likely scenario is that, as a greater proportion of the Chinese public approaches middle-income-level status and has a greater stake in quality-of-life issues, pressure will increase on the government to ensure that more stringent environmental standards are upheld.

Sector-specific implications

Energy

The Decision stipulates that all prices that can be arrived at through market competition should be determined by the market, with little government intervention. IHS believes that natural resource sectors-including gas, power and oil products-will see further price reforms, as competitive segments see a retreat of government price setting.

Structural market reforms in the gas and power sectors will accelerate. Of particular significance is a clear intention to unbundle natural monopoly assets from business segments that can be opened for competition. IHS expects the entrance of more non-state players into the non-natural-monopoly parts of the gas and power markets, creating a more level playing field and encouraging further investment to meet the country's surging energy demand.

Chemicals

IHS believes the next reform in China's chemical sector will include loosening of the current monopoly in the refining sector. Private and foreign companies, as well as SOEs, will challenge the National Oil Corporation's dominance in petrochemicals and enhance the overall competitiveness of the Chinese chemicals industry.

IHS expects an acceleration in the consolidation and rationalization of the excess, old and uncompetitive capacity in chemical sectors such as ammonia, methanol, PVC, carbide and coal coking.

Automotive

While the Third Plenum documents do not directly mention the automotive sector, the principles laid out in many of the proposed top-down reforms are likely to have an impact on the future development of the auto sector in China. Key implications for domestic and international players include:

• Non-state players could own stakes in state-owned automakers or parts suppliers
• Acceleration of free-trade zone development could allow automotive suppliers to build components for export, as well as import components without facing high tariffs
• Expansion of preferential trade zones along China's land borders will further encourage auto exports to neighboring countries

Healthcare

The Decision outlines a number of broad targets in the healthcare sector that follow the health reforms blueprint set down in 2009, including:

• Separating the provision of medicine from drug sales-to end hospitals' reliance on mark-ups applied to medicine sales to patients as a source of revenues
• Addressing doctors' remuneration, training and their ability to transfer between institutions
• Continuing emphasis on cost-containment efforts in the supply of medicines and both direct and indirect pressure on drug prices;
• Greater private-sector and non-profit involvement in the provision of medical services, including society-sourced funding, to make up for shortfalls in the public provision

Maritime

The Chinese maritime sector has seen great losses in recent years, with shipbuilding companies hit hard by the bursting of the order-book bubble. SOEs have been assured continued support-in exchange for which the government is requesting the industry to improve its efficiency, curb wastage and move into more technology-driven markets.

The recent reforms open up SOEs to partial exposure to market forces, which will encourage state-owned Chinese shipbuilders to compete more openly on the international market-with the likelihood that they will win more contracts in the lucrative energy sector.

Free-trade development is likely to increase around port cities, providing an alternative to the main marine trading hub of Hong Kong. As well, coastal areas are being earmarked for more development in an effort to increase their connectedness with international trade.

Defense

A key decision impacting the defense sector to come out of the Plenum was the establishment of a National Security Committee to coordinate responses for all security issues faced by China-including domestic, foreign, and both traditional and non-traditional threats. Having one entity that includes traditional security apparatuses such as the People's Liberation Army as well as personnel who are able to deal with economic crises, natural disasters and other non-traditional threats will ensure a more coordinated and efficient response to disparate domestic threats.

It is also expected that consolidating responsibility for managing foreign risks under the same body will reduce the chance of miscalculation in territorial disputes. Shortening the command chain will increase China's ability to manage fluid crises in potential hot spots such as the South China Sea and the East China Sea.

Outlook

China's 18th Third Plenum went beyond expectations in the scope it set for reform through 2020. While IHS is encouraged to see reforms outlined in many essential areas-particularly with respect to financial markets, monopoly powers, foreign investment, and administrative reforms to support urbanization-it is only the first step in a long and arduous process to put China on a sound, sustainable growth path. Moreover, the plenary documents outline only principles and goals; the critical implementing steps are left for government agencies and leaders to pursue in the months and years ahead.

It is not yet clear what the composition or structure will be of the so-called Leading Group for Deepening Comprehensive Reform-the group charged to oversee reforms and to coordinate them across departments. It is hoped that one of the country's top leaders will chair those efforts, as Jiang Zemin did on the Economics and Finance Leading Group starting in 1992. The reform agenda that has been set is far beyond the ability of one or a few departments to spearhead and requires high-level political leadership.

Reforms across so many parts of China's economic and regulatory systems will be challenging to implement, not only because of the entrenchment of powerful vested interests that may oppose such changes, but also simply in determining the best feasible sequencing and speed. Leaders have made it clear that they will maintain an incremental pace by setting a 2020 target for implementing the most "critical" reforms. In several areas, such as financial market reform or implementing a broader property tax, implementation would be ill advised before supporting systems (deposit insurance and a reliable housing registry, respectively) are in place-and installing even the prerequisite institutions could take years.

While progress may not be immediate in all areas, reform targets provide a useful way by which to assess China's progress over the medium term, when policies will begin to be executed. IHS will closely follow developments as they transpire and incorporate them into our outlook.

Contributors to this article include:

Macroeconomics and Economic policy

• Todd Lee, Senior Director
• Brian Jackson, Economist

Country Risk

• Omar Hamid, Senior Manager
• David Yang, Principal Analyst

Energy

• Xizhou Zhou, Senior Manager
• Olivia Boyd, Analyst Asia-Pacific

Chemicals

• Paul Pang, Director

Automotive

• Namrita Chow, Senior Analyst

Healthcare

• Rob McTiernan, Analyst Asia-Pacific

Maritime

• Gary Li, Senior Analyst

Defence & Security

• James Hardy, Asia-Pacific Editor