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Making a Breakthrough in Reform

[Editor’s Note: China Business News published an article by Xia Bin, the Director of the Financial Research Institute of the Development Research Center of the State Council. Xia argued that urbanization (城镇化), or developing and expanding towns by absorbing peasants from villages, should not be seen as the solution to making a "breakthrough in reform," because it requires a huge investment that the government does not have. He suggested that a real breakthrough should be made by reducing the income gap between city residents and peasants and by giving the land back to the farmers (so that they can enjoy the appreciation in land value).

Xia also acknowledged that a reform that would reduce the income gap would cause a huge fiscal deficit for both the central and local governments. His solution was to re-direct the huge profits from State-Owned Enterprises (SOEs) to cover the losses.

The article advocated reform to tackle a few tough obstacles to economic development inherent in the structure of China’s communist system. However, Chinascope’s editors feel that the author’s suggestion for reform, insofar as it reduces the government’s income to give more to the general public, may fall on deaf ears in the Communist Party.] [1]

Right now China’s problems of imbalanced, unsustainable economic development are becoming more serious. It is not the time to discuss “whether (we) need to reform” since the entire society has already arrived at a very clear understanding that the current reform is incomplete. The more important questions are: “What can we do to make a breakthrough in reform?” “What approach should we take?” and “What is the roadmap and timetable for reform?”

At the current time, where the economy and society face severe conflicts and risks, piecemeal reform can no longer solve our problems. We must have a top-level design and create a clear timetable to resolve the problems completely.

I. The Connection behind the Many Economic Problems

First, if we look at the issue of spending, why has consumer consumption continued to decrease over the past few years? The most direct and the most important reason is that the consumers’ share of disposable income as a percentage of the entire national income has been shrinking rapidly. The second reason is that people want to save more in anticipation of future uncertainties. To change this, we must focus on reforming income distribution and the social security system.

Why, over the last few years, hasn’t people’s income been increasing at the same rate as the growth in China’s GDP? In other words, why hasn’t the increase in people’s income kept pace with the growth of the government’s and SOE’s incomes?

For peasants, the main reason is that the government and the SOEs take the majority of the benefits of land appreciation for themselves, even though they are supposed to go to the peasants. From 2001 to 2010, the national income from land transfers increased by a multiple of 20, from 130 billion yuan (US$20.9 billion) to 2.7 trillion yuan (US$435 billion). However, the compensation that peasants have received for the acquisition of their land for demolition amounts to only 37 percent of the income from land transfers.

Several reasons account for the slow increase in city dwellers’ income.

The first reason is their low wages.

The second reason is the decrease in the value of people’s assets. The stock market went south. The negative interest rate has also hurt savings. From 1996 to 2002, the average real interest rate in China was 2.93 percent. From 2003 to the present, the average real interest rate was -0.3 percent. In the past eight years (96 months), 52 months saw a negative interest rate. Some people estimated that inflation in 2011 reached 1.5 trillion yuan (US$240 billion). For each 1 percent drop in the real interest rate, the growth rate of consumer consumption decreases by 0.287 percent.

The third reason is the strong position that capital has over labor. In the past few years, the traditional manufacturing industry has experienced rapid development, and capital investment has played an important role there. The secondary industries keep growing due to SOEs’ monopoly positions (because these SOEs can keep expanding however they choose to), their imperfect dividend distribution system, and the low prices of natural resources. However, the labor-intensive economy and service economy, whose growth is normally reflected in an increase in workers’ wages, are significantly inhibited due to a number of government controls.

The above analysis indicates that, to change the slow income growth for both peasants and city residents, we have to look at reforming the distribution of the appreciation in the value of land, income distribution, SOEs, and interest rates, as well as adjusting the structures of key industries.

B. Will Urbanization Be the Area Where We Make a Breakthrough in Reform?

There have been many discussions on where the next cycle of reform should start. One popular thought is that “urbanization is an area in which to make a breakthrough in further reform.” How should we understand this?

China’s current urbanization level has reached 51 percent, meaning 51 percent of the total population lives in cities or towns. If we count the number of households registered, city residents represent 35 percent. [2] Another statistic in 2011 claimed that China’s urbanization level had reached 60 percent. Such drastically different numbers tell us that the true urbanization rate is not determined by some numeric calculation. Rather, we should look at whether peasants, after leaving their land to migrate to the cities, really enjoy the same level of public service and welfare as the city residents do and also whether the income gap between city residents and peasants is really shrinking.

After the global recession, the export demands that used to drive China’s economic growth decreased. A high rate of increase in investment in China, such as 50 percent, for example, can no longer be sustained. Therefore it is the right decision for the government to change its strategy to “rely more heavily on domestic consumption.” There is, indeed, significant room for China to improve its land system, convert the agricultural population to city dwellers, and to increase the poor peasant’s income and consumption level.

Does that mean that urbanization should be the focus of further comprehensive reform? In July 2012, I asked what urbanization meant. First, it means that peasants move to town. However, “moving to town” does not end with simple household registration reform. After filing a new household registration form, these off-farm laborers then need the same basic public services and welfare benefits that are available to city residents, such as daycare, schools for their children, hospitals, and retirement services. Some people estimate that, for each off-farm laborer to become a city resident, it will cost the government 80,000 yuan (US$12,900). There are currently 250 million off-farm labors in China. That means the government would need to spend 20 trillion yuan (US$3.2 trillion). Urbanization would mean huge government expenditures.

Second, off-farm laborers need a place to live in the city. In addition to shelter, they need water, electricity, gas, roads, and sewage facilities. Who will provide the funds for construction of this infrastructure? Due to real estate pricing controls and the reform in land appreciation distribution (giving peasants a greater share of the appreciation), the government’s income from land will certainly decrease. Therefore, the government will not have enough money to support this. Can private money invest in this area? How can government policy guide this? This requires a lot of solid, hard work.

Third, if off-farm laborers were to bring their spouses, children, and parents to the city, they would need long-term, reliable income, which means that they would need jobs. Apart from a few cities and towns that have the ability to develop major projects in the secondary industries, most of the small and mid-size towns would rely on developing a labor-intensive service economy. How could they do that? SOEs won’t do that. They would have to rely on private investment, small and mid-size companies, and favorable tax and financial policies. The government needs to reduce investment hurdles and remove excessive administrative controls. This also needs a lot of really difficult work.

Therefore, to increase the urbanization level, we need the following: First, we need to solve the funding issue. Second, we have to reduce the government’s control over investment and carry out financial and tax reforms so that capital can be effectively allocated. Third, urbanization would increase investment in infrastructure; this fits in with the strategy of expanding domestic consumption. However, we must realize that the driving force behind higher consumption is the current city residents, because their consumption level is three times that of peasants. Therefore, objectively speaking, urbanization can’t totally replace the reforms to increase the city residents’ consumption level and to adjust industry structure.

It thus becomes clear: reforming household registration alone will not lead to successful urbanization. There are many funding issues involved. Urbanization is also not simply a matter of real estate development, which would then result in a “dead city.” True increase in the level of urbanization will be the result of a series of policy changes and reforms. It is hard to make it the focal point for the next round of reform. We must look for other areas in which to make a breakthrough in reform.

III. Recommendations

The direction of the next round of comprehensive economic reform should be in the following two areas: to reduce the gap in income between the rich and the poor and to bring down the costs associated with the factors of production.

The government should finalize the reform plan for cities and towns soon. It has already worked on it for over seven years. The final plan should have quantifiable measurements and targets. The plan should include: first, for the next eight years, targets for gradual increases in the minimum wage, the minimum pensions for town residents, and the income level to qualify for a low income subsidy; second, quantifiable targets for the gradual reduction in the gap between city residents and peasants in the delivery of medical care, pensions, education, and other social security benefits; third, a quantifiable target for enhancing social security and welfare benefits so that people no longer feel the need for excess saving.

However, if we truly implement these three reforms and truly increase the standard social security services to both city residents and village residents, it will inevitably lead to national financial deficits.

Reducing the income gap means increasing peasants’ income. At the village level, to truly increase peasants’ income, the key is to reform the system of government land acquisition to give the benefits of long-term land appreciation back to the peasants. We should change the government’s monopoly over land operations and, instead, allow villages to offer their commercial land on the open market themselves for rent, transfer, investment, or trust opportunities. If the government takes the land from the peasants, it should “provide compensation according to the law” but not as it currently does by “providing fair compensation.” We should define clearly the legal procedures for land compensation to prevent any government official from stealing the peasants’ interests while claiming to offer “fair compensation.”

If the benefits of land appreciation are truly returned to the peasants, China’s economy will immediately face a few big problems. One is that the government will not have enough funds for projects and infrastructure construction planned for the town’s development. The other is that funds will be lacking for disbursements according to the current government regulation regarding land transfer profits. The government takes a certain percentage (some are fixed and some are not) to cover eight spending categories: agricultural land water system construction, village infrastructure development, city development, agricultural land development, affordable housing projects, the state-owned land income fund, the education fund, and the “newly increased spending.” The central government takes 30 percent and the provincial government takes 70 percent.

The sudden drastic reduction in land transfer funds would not only impact development in local towns but would also directly impact education, agriculture business, and water system construction in the village. The majority of local governments would end up with fiscal deficits. Eventually, they would demand that the fiscal and administrative power between the central government and the local governments be rearranged and that the fiscal and taxation systems be reformed. The national budget would not be able to cover these items, either.

The decision makers then would have to take on a major reform of the fiscal and taxation systems to resolve this deficit problem. At some point, they would have to tap into SOEs’ deep pockets: increase the amount that SOE’s pay to the government in dividends and also sell some of the SOE’s shares to private investors to raise money. This would lead to a “fewer-SOEs, more private companies” reform.

The reform to bring down the costs associated with the factors of production includes reducing interest rates; exchange rates; and prices of water, electricity, gas, oil, minerals, and other raw materials.

[1] China Business News, “China’s Economic Reform: Logic and Roadmap,” January 21, 2013.
[2] Household Registration (户籍), also called 户口 (Chinese pronunciation: Hukou): A system implemented in China to identify a person as a resident of an area (e.g. of a city or a village). Every person has a household registration record with information such as name, parents, spouse, and date of birth. The system serves to separate people into either peasants or urban residents. Urban residents enjoy significantly superior benefits, such as social security, welfare benefits, and child education. For the past few years, a number of Chinese scholars have been advocating that this system be abolished; however, the government has taken no action.