Sequencing Economic Reform: How does China Compare?

1. Sequencing Economic Reform: How does China Compare? Andrew K. Rose NUS Business School

2. What is the Optimal Sequencing of Reform? THREE RULES OF THUMB 1 2 3 Stabilizationbefore reform Real before financial reform Domestic before international reform • Macroeconomic stability a precondition for success • So international financial liberalization comes last • In these senses, China is conventional • Oddly consistent with “Washington Consensus” as endpoint Rose: Sequencing Economic Reform

3. Target: Williamson’s “Washington Consensus” Fiscal policy discipline (avoid large deficits); Liberal foreign direct investment, especially inward; Government avoids broad subsidies in favour of pro-growth, pro-poor services: a) primary education; b) health care; and c) infrastructure investment; Market interest rates with moderate positive real rates; Limited regulation (focus on safety, environmental and consumer protection, prudential oversight of financial institutions); Tax a broad base with moderate marginal rates; Competitive exchange rates (either fixed or floating); Privatized state-owned enterprises; Liberal trade with little NTB protection; Secure property rights. Rose: Sequencing Economic Reform

4. Tangent: is there a clear “Beijing Consensus”? Most prescriptions not economic in nature Others not specific, consistent with WC as end-point • an absence of political liberalization; • strong leading role of ruling political party; • population control; • down-to-earth pragmatic concern with serving the people; • constant trial and error experimentation; • gradual reform, not shock therapy; • a strong and pro-development state; • "selective cultural borrowing" of foreign ideas. Rose: Sequencing Economic Reform

5. Style of Reforms Rose: Sequencing Economic Reform • Piece-meal or simultaneous? • Critical Insight: behind many inefficiencies lie vested interests • A single reform (e.g., eliminating employment protection) may increase national welfare but reduce welfare of interest group with political sway • So simultaneous reforms may spread wealth, provide payoffs for most/all • Piecemeal reforms may lower credibility, induce fatigue and backlash • Crises are terrible things to waste • Liberalization often follows crisis which provides impetus … temporarily • Often external, IMF • China an exception

6. What is the Optimal Speed of Reform? Rose: Sequencing Economic Reform • Fast or slow? • Key Insight: reform is typically good in long run but not short run • So, partial reforms tend to stall; train never arrives • Big bangs only work rarely (Poland, Baltics, UK) • Motivation: shock therapy too fast for political resistance to build • But usually means reforms end because of short-term pain (Russia) • Still, some reforms must be dramatic, swift to be irreversible (Russia privatization) • Slow also works rarely (France, Italy, Japan) • Time allows losers to coalesce and block reform • China is the exception (as in so many things!), also New Zealand • Tangent: Need social safety to sustain reform for both fast and slow

7. Nexus of Reforms: Factors or Products? Rose: Sequencing Economic Reform • Inputs (land, capital, labor) or output (goods and services)? • Diamond-Mirrlees: want to keep production close to optimal • In practice everyone is a consumer, but not all are employed/capitalists… • Labor market reforms very costly, hence delayed (forever? Europe) • Product market reforms tend to reduce producer rents, often difficult to legislate (large number of reforms, each often bitterly opposed by well-organized lobby groups) • Starting point matters: communism has fewer producer rents, underdeveloped financial markets • True in China; early financial repression translated to growth via financial stability (later repression lead to inefficiency)

8. Financial Liberalization Rose: Sequencing Economic Reform • Domestic before International • Reduce domestic macroeconomic imbalances before international opening • Otherwise provide avenue for capital flight to savers suffering from domestic financial market repression • Need strong domestic financial system with supervisory framework, prudential regulation and controls, risk-management, bankruptcy laws, proper accounting system, capitalized banking system • Banks first: interest rate ceiling/floor decontrol • Bond markets next; then equity • Crises that precipitate reform often external (balance of payments/fixed exchange rates) • Fear of reversal if liberalization precipitates crisis

9. International Dimension Rose: Sequencing Economic Reform • Consensus: Current account (trade in goods and services) should be liberalized before the capital account (trade in financial assets) • Trade barriers create uneconomical import-competitors • With these distortions, capital could be attracted by rents to flow into wrong sectors, lowering welfare and growth (McKinnon) • Also capital flows can adversely affect exchange rate (Diaz-Alejandro) • More generally capital flows MUCH faster than goods/services • Irrelevant for China, since China liberalized trade first

10. Chinese Liberalization China has dual-track reform strategy in three senses 1 2 3 Partial liberalization in factor markets to support SOEs leads to financial repression State presence maintained; non-state has grown Financial repression leads to formal and informal sectors • Initial stability gains can lead to longer-term inefficiency costs • More reform in product than factor markets Rose: Sequencing Economic Reform

11. Chinese Financial Reform Rose: Sequencing Economic Reform • Legacy (“big four”) banks important • VERY large • Substantive state control for loans, interest rates • Substantive (if declining) financial repression • Poor performance, corporate governance • Still, change has been rapid • Off balance products (wealth management), informal sector • Big FinTech presence • Growing capital markets • Equity markets can absorb risk/bubbles easier than loan/debt markets • Improving regulatory, supervisory capacity

12. Chinese International Financial Liberalization Rose: Sequencing Economic Reform • International liberalization proceeding gradually • Capital controls shrinking slowly • Currency international (RMB in SDR) • Sensible focuses: • Maintain official presence in FX market (RMB managed) • Encourage buy and hold investors • Inflows not outflows • Swap arrangements with foreign central banks • Promotion of offshore financial centers • Outflows, short-term, bond and equity markets the last stage

13. Summary for China Rose: Sequencing Economic Reform • China has reformed slowly along conventional lines • Unusually successful to have such a long gradual period of reform • Continued growth has allowed all boats to rise • Perhaps because of political monopoly? • Connection between political and economic liberalization big issue in literature • Still, no doubt of tremendous progress • Longest period of high growth experienced in history (Pritchard and Summers) • Largest experience of welfare increase/poverty reduction in human history • Standard sequencing (real before financial, domestic before international, growing safety net, WC as target) as facilitator?

14. Conclusion: Chinese Dilemma Rose: Sequencing Economic Reform • China looks like the epitome of conventional wisdom • Heading to Washington Consensus • Seems like China is close to end of reform journey • Hence WCY Forum focus on advanced financial markets • Prelude to international financial liberalization, final stage • But, despite growth, Chinese reform has been inadequate at each stage • Factor markets for land, labor, and capital still need massive reform • Ex: financial: need to regulate shadow banking; create clear resolution mechanism; better information, regulation, supervision • Ex: environmental externalities hard to handle without appropriate property rights • Length without breadth: China could end reform having skipped steps • Slowing momentum a danger, since reform consists of many small fights against vested interests; productivity growth becoming more difficult