A 5-Year Plan to Change China’s Growth Path

China is poised to begin its transition from middle-income to
developed-country status. Only five economies successfully managed this
transition while sustaining high growth rates, and they are all in Asia:
Japan, South Korea, Taiwan, Hong Kong and Singapore. No country of
China’s size and diversity has ever done so.

China’s 12th Five-Year Plan, adopted last month, provides the road
map it will follow. Yet it is not really a plan. Rather, it is a
coherent interconnected set of policy priorities to support the
economy’s structural evolution — and thus to maintain rapid growth —
over the period of the plan and beyond.

So a great deal is at stake, both internally and externally. Growth
in the world’s emerging economies now depends on China, the main export
partner for a growing list of major economies including Japan, South
Korea, India and Brazil.

There are at least five important interconnected transitions embedded in China’s new Five-Year Plan:

• Changing the economy’s growth model or supply side structure, as
  labor costs rise, global market shares become large enough to limit
  expansion and advanced countries’ growth momentum slows for an unknown
  period of time;
• Rebalancing demand, from investment and exports to domestic consumption;
• Accommodating a rapidly urbanizing population and ensuring that
  incentives are structured to bring about as orderly a process of social
  change as possible;
• Building the institutions necessary for achieving inclusiveness and equal opportunity;
• Assuming international responsibility for stability, growth and sustainability, including tackling climate change.

The challenge for China is implementation, which means reform and
systemic change. International experience suggests that the balance
between planning and markets shifts toward markets as countries becomes
richer. The structural evolution that underpins growth will increasingly
be driven by market opportunities and entrepreneurial initiative. A
huge number of new businesses need to be created.

To support this shift, much is required. Labor-intensive industries
in the tradable sector must be allowed to decline. Many companies may
survive, but only by moving to different parts of the global economy or
up the value-added chain domestically: up or out. A rising nominal and
real exchange rate can propel structural change; a weak-currency policy
is a trap.

The financial sector must be developed to create more savings options
and supply credit and equity capital efficiently to new and growing
businesses, which China needs to attract the rural population to cities,
even as export sectors move up the skill and value-added hierarchy.
Many of these jobs will be in the domestic, urban and nontradable
service sector.

But urbanization faces another obstacle: the hukou system of
residency permits, which restricts mobility and bars migrants — an
estimated 200 million people —from becoming full-status urban citizens.
Chinese officials’ reluctance to eliminate hukou quickly reflects their
observation of the social consequences of rapid or unbalanced
urbanization elsewhere, though problems caused by internal migration in
other countries typically reflect the absence of opportunity in rural
areas, not the attraction of opportunities in urban areas.

As the scope of the private sector expands, legal structures and
policies that support competition, entry and exit, market openness,
intellectual property and social safety nets will also be needed. The
move to higher-value-added links of domestic and global supply chains
will require more effective education and expanded investment in the
economy’s intellectual and technological underpinnings. The balance
between technology imports and domestic innovation will continue to
shift steadily toward the latter.

The Chinese public sector has a huge balance sheet, including land, a
vast array of infrastructure, massive foreign-exchange reserves and
major equity positions in state-owned enterprises, which account for
more than one-half of net fixed assets and one-third of profits in the
corporate sector. In all countries, these assets should be held in trust
for citizens and deployed in pursuit of economic and social
development. China has an exemplary record in this area. Unlike most
countries, China has not struggled to get public-sector investment up to
levels that support sustained high growth.

But there are now issues. Investments are justified and support
economic and social development when they have high private and social
returns. Elements of the investment portfolio in the public sector and
the state-owned enterprises are beginning to fail this test.

To be fair, given the legacy costs of state-owned enterprises — which
stem from their responsibilities for social services and insurance —
together with their financial distress in the 1990s, it made sense for a
while to let them keep their retained earnings and not place additional
claims on them through the government budget.

No longer. If state-owned enterprises’ reinvested income is not
subject to a high return criterion, growth will eventually slow. The
portion that falls short needs to be redirected to higher-return
investments in either the public or private sector, to household income
or to essential public services and social insurance.

The state-owned enterprises compete in product and labor markets with
the private sector, but less so in capital markets. While wages and
incomes are rising now and appear to have broken the iron grip of the
surplus labor pool, the growth pattern requires this structural
demand-side shift toward more disposable income, greater government
consumption and high-return investment. We suspect but do not know that
consumption will increase. Properly recycled savings, including
corporate profits, could go back mainly into high-return public- or
private-sector investments. Both contribute to aggregate domestic
demand, and the structural shifts on the supply side will be driven by
the “right” mix of aggregate demand, with the low-return component on
the investment side removed.

Thus, the Five-Year Plan’s goal is to recompose — not expand —
aggregate demand to sustain growth and avoid the diminishing returns
trap that is the principal risk of China’s current investment pattern.
Changing that pattern will require a restructured financial system that
allocates savings efficiently based on fiscal and capital-market
discipline and corporate-governance reform. Designing that system will
be an important part of achieving the high-return investment and
expanded consumption that Chinese leaders want — and that China’s
economy needs.