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Speeches & Transcripts

Deepening of Reforms-the way ahead

Sri Mulyani Indrawati

China Development Forum

Beijing, China

March 25, 2013

As Prepared for Delivery

Introduction

Honorable Ministers, distinguished participants,

I am pleased to join you today to discuss challenges as China enters into a new phase of reforms.

By any standard, China’s economic performance over the last three decades has been impressive.

GDP growth averaged 10 percent a year, and over 500 million people were lifted out of poverty.

But there is no time for complacency in a rapidly changing world where global growth rates and global trade are slowing down.

Growth has come down in China as well: Government’s prognosis for the current year is 7.5%.

In addition, many of the underpinnings for China’s growth are gradually weakening.

The main reasons are well known by now:

First, population growth is low and falling, and the labor force is expected to start declining soon. 

Second, the continued accumulation of capital, while sizable, will inevitably contribute less to growth as the capital-labor ratio rises.

Third, total factor productivity growth—a measure of improvements in economic efficiency and technological progress—is also declining.  The economy has exhausted gains from first-generation policy reforms. 

In addition, China’s rapid growth has come with a considerable burden on the environment and rising income inequalities, both of which are socially undesirable.

The Government has fully recognized this shift in the growth pattern and the need to change course. 

The 12th five year plan reflects many of the needed policies, but more needs to be done.

Let me focus on three broad areas that promise significant gains in efficiency and productivity and a reduction in imbalances:

First, the enterprise sector needs to facilitate more efficient resource use and to motivate innovation and entrepreneurship.

Second, reforms of input markets—land, labor, and capital—needs to overcome severe distortions in factor allocation.

Third, the fiscal system needs to help deliver the level and quality of public social and environmental services.

Increasing competition

China’s own past as well as international experience show that increased domestic competition can raise productivity and efficiency and promote innovation.

The rapid growth of the last three decades has been based on the private sector’s significant role, and this has put competitive pressures on State Owned Enterprises (SOE) to reform.

China’s accession to the World Trade Organization in 2001 triggered economy-wide improvements in efficiency and spurred technology acquisition and adaptation.

More recently, the phasing out of incentives stimulated competition by leveling the playing field between foreign and domestically owned firms.

Relative to the private sector, SOEs consume a large proportion of capital, raw materials, and intermediate inputs to produce relatively small shares of gross output and value added.

“Strategic” sectors or “basic or pillar” industries remain the almost exclusive domain of SOEs.

This undermines efficiency of the economy, limits innovation, hampers the transformation to a new growth pattern, and reduces the welfare of China’s people.

Increasing competition requires the following:

  • lowering entry barriers into State dominated business sectors,
  • dismantling monopolies and oligopolies when competition would yield superior results, for example in petroleum, chemicals, electricity distribution, and telecommunications,
  • introducing oversight arrangements where monopolies are considered necessary to ensure that market power is not abused, such as in railways,
  • a review and modernization of the industrial policies that the authorities have used so far.  In countries that have successfully implemented industrial policies, such as Korea and Japan, State intervention was aligned with competition amongst private firms that had to compete for this support.

The expanded scope for the private sector would have to be complemented by the restructuring of remaining SOEs to mixed ownership enterprises and listed corporations.

China should consider limits on the financial support that its local governments can provide to firms, so that non-competitive firms do not continue to divert resources from more efficient ones.

Overhauling factor markets 

Let me turn to the second reform area.

To complete the transition to a market economy and further strengthen growth, China needs to overhaul its factor markets.

Well-functioning markets of land, capital and labor are also a pre-requisite for efficient and inclusive urbanization, one of the key priorities of the government as Prime Minister Li Keqiang has emphasized.

China’s pace and pattern of urbanization will determine its growth trajectory and its spatial convergence (or lack thereof) in living standards.

Land market

Over the next twenty years, land will become increasingly scarce and its efficient use will become more critical for food security, innovative cities, equality of opportunity, and social stability. 

To increase the efficiency of land use, the most pressing priority is to ensure security of agricultural land tenure.

The recent policy decisions to grant indefinite land use rights to farmers, expand land registration, and strengthen rural land markets are steps in the right direction.

A second priority is reforming land acquisition and compensation practices.

Local governments must not acquire rural land for urban use when the urban development plans have been not been reviewed and approved by a higher level of government.

The current practice of compensation—a frequent cause of complaints—needs to be overhauled.

Anchoring expanded land rights in law would provide farmers with recourse to the courts, which will prevent land conversion abuse.

A third priority is to develop alternatives to land rents and land financing

Opening up more regular channels of local government financing will reduce the need to use land financing. 

China is already piloting property taxes in two cities but is finding that its introduction is usually difficult for technical, institutional, and social reasons.

But such a tax has considerable revenue potential: Countries such as the United States and Canada raise 3–4 percent of their GDP from property taxes, and the average among OECD members is near 2 percent of GDP.

Regular, on-budget local government borrowing should eventually replace the current land-based financing. 

Capital market

Despite impressive progress in reforms, China’s financial system remains repressed and suffers from key structural imbalances.

Not only do these imbalances pose significant systemic risks, they will prevent China’s financial system from serving an increasingly dynamic and internationally integrated economy.

The first priority should be to increase interest rate flexibility and move to a point where interest rates clear the credit market.

China’s authorities would need to introduce a plan that phases out the ceiling on deposit rates and the floor supporting lending rates at the same time.

Second, the capital market will need to be deepened and reformed to make more equity and securitized financing available.

To achieve this, China could reform the system of initial public offerings.

In parallel, China will need to focus on improving the capital market’s legal framework, upgrading the financial infrastructure, and imposing more stringent rules on information disclosure.

Europe between 1945 and 1992 provides an example of how the financial sector can be gradually reformed and liberalized and, ultimately, internationalized.

Of course, there are risks, as we know from the Asian, and more recently the global, financial crises, so reforms need to be defined and developed bearing risks in mind.

Nonetheless, China’s authorities have gained tremendous experience and capabilities to manage and supervise its financial sector. 

Labor market

Developing a flexible and dynamic labor market will be central to China’s future success as a high-income, open economy.

Over the coming decades, the absorption of hundreds of millions moving from rural areas to urban areas in search of better jobs will require labor markets that are flexible and institutions that protect workers.

Reforming the hukou system, a key impediment to mobility, will be a top priority that needs to be completed sooner rather than later.

Advancing hukou reform would include:

  • delinking the hukou from access to public services and using a residential permit, not household registration, to determine eligibility to receive services;
  • encouraging pilot reform programs at the local level;
  • redefining financing responsibilities, and revenue authority between central and local governments as an incentive for reform.

To increase labor mobility, social security (pensions, health and unemployment insurance) should become portable nationwide.

Social security would need to remain affordable for employers and not become an impediment for hiring labor.

Absorbing legacy costs in the general government debt and raising the pension age are options that would reduce social security taxes and increase the demand for labor.

Reforming the fiscal system

I have already touched on fiscal reforms, and this morning Stephen Groff from the ADB also reviewed the fiscal reform issues ahead.

For the sake of time, I will therefore just touch on three challenges.

The first challenge is to contain government spending while changing its composition in line with China’s new priorities, reallocating resources over time from lower- to higher-priority government programs, such as health and education. 

{The revision of the 1994 budget law, which is currently being considered, is an opportunity to modernize China’s fiscal institutions.}

The second, challenge is raising more revenues to meet rising budgetary demands, for example, through: 

  • higher SOE dividends;
  • higher taxes on energy and motor vehicle use;
  • expanding property taxes to residences;
  • personal income taxes as China grows richer (these taxes make up only 1 percent of China’s GDP, compared with an average of almost 6 percent in high-income countries); and
  • expanding the VAT to services (which would encourage firms to outsource services currently produced in-house for tax reasons).

The third fiscal challenge is to match budgetary revenues with expenditure responsibilities.

China is among the most decentralized countries in the world when it comes to government spending. 

But revenues are highly centralized, and rapid urbanization will exacerbate the already large revenue disparities among local governments.

To improve the match between spending and revenues at the local level, three reforms are critical:

First, increasing the scope of local revenues, such as with the property tax, which I mentioned.

Second, centralizing some spending, notably on social security.  This would also increase labor mobility.

Third, developing nationwide rules for more equal distribution of revenues from the provincial level to townships and municipalities.

Conclusion

Over the next two decades, China will face many challenges in its quest to become a modern and creative high income society.

One is how to urbanize.

And, if China can remove distortions in the land, labor, and capital markets; align incentives with responsibilities in the fiscal system; and increase competition across its economy, China will have addressed more than half of the challenges in urbanization.

China’s urbanization could raise and equalize living standards across the vast territory if the nature and form of urbanization are such that they fulfill the objectives of economic efficiency, social cohesion, and environmental sustainability.

If done right, urbanization in China will be an engine of growth in the 21st century. 

There is an underlying vision to all of this:

  • A prosperous China.
  • A China with a harmonious balance between cities and countryside.
  • A China that extends one citizenship to every woman and man, boy and girl, no matter where they were born and where they live.
  • A China where everyone lives his Chinese dream, where effort and labor are fairly rewarded, and where everyone is treated equally and enjoys equal access to basic healthcare, schooling, social entitlements, and jobs.

The World Bank is privileged to support these challenging reforms in close partnership with Chinese counterparts.  

Thank you.