Tuesday, November 25, 2014
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Europe’s Lessons for China’s Reformers

BRUSSELS – The most important economic-policy decision of 2013 might well have been taken in November at the Third Plenum of the Chinese Communist Party’s Central Committee, which pledged that the market should be given a “decisive” role in guiding China’s economy. Because China is now the world’s largest exporter after the European Union, and accounts for about half of global growth, decisions taken in Beijing could have a more important impact on the world economy than those taken in Berlin, Brussels, or Washington, DC.

But, while China’s embrace of the market and opening to the outside world has enabled it to achieve astonishing economic progress over the last three decades, the country might now have reached a level of income at which the problem is no longer “too little market.” On the contrary, some of China’s key problems today require a stronger role for government.

Air and water pollution, for example, can be addressed only by more state intervention, at both the central and local levels. The authorities have now made solving the problem a high priority, and there can be little doubt that China has the resources to do so – much as it created the world’s largest manufacturing sector. The fight against smog and water pollution plays to the country’s strength: the availability of huge domestic savings to finance the necessary investment in pollution-abatement equipment.

The dilemma for China’s leaders is that meeting the need for more in pollution control and infrastructure makes it more difficult to achieve their goal of shifting the country’s economic-growth model from one based on investment and exports to one based on consumption. But more consumption today would further aggravate the pollution problem. As a result, economic rebalancing may be delayed by the more urgent need for environmental investment.

Other areas of the economy require greater government oversight as well. Network industries like telecoms, gas, electricity, and water tend to become monopolistic or oligopolistic if left to market forces alone. Well-run economies achieve higher levels of welfare not because there is less regulation of these sectors, but because more efficient regulation prevents the emergence of cartels, thereby protecting consumers.

Similar reasoning applies to reform of the state-owned-enterprise (SOE) sector. The key problem is less the form of ownership (state or private) than it is the need to ensure that these enterprises operate according to market principles and within a competitive environment.

The European experience confirms this. The Treaty of Rome, which established the common market back in 1957, did not distinguish between state-owned and private enterprises, though vast sectors of the economy (most of the coal and steel industry, and in many countries banking) were in state hands at the time. Instead, the treaty established internal-market rules that barred governments from giving their companies unfair advantages.

The prohibition of state aid was a game changer for Europe, because it forced SOEs to operate on a level playing field and thus to become as efficient as their domestic or foreign competitors. Once local politicians could no longer use the SOEs for their own goals, most member countries decided that they might as well privatize many of them. Of course, downsizing the SOE sector took time; but the direction of the process was never in doubt, because the SOEs’ foreign and domestic competitors naturally provided strong political support for the European Commission’s vigorous policing of state aid.

In China, too, the key issue today is the rules under which the SOEs’ operate. Instead of large-scale privatization, it might be better to limit state aid and give competitors legal recourse to seek redress if state aid distorts competition.

The area that has attracted the most attention is finance, and for good reason. In most of the advanced world, investment amounts to little more than 15% of GDP, compared to close to 45% for China. Financial markets are thus even more important for China than for the US or Europe, and there are clear signs that the productivity of investment has been declining rapidly in China.

The lynchpin of the China’s planned financial-sector reforms – interest-rate liberalization – might not address the problem. In principle, higher interest rates on lending should help to reduce over-investment. But, in a system with many – often implicit – government guarantees, it is not always the most efficient enterprises that are willing and able to pay more to borrow. Liberalizing lending rates might merely lead those with government guarantees to outbid smaller and more efficient enterprises, resulting in more misallocation of capital. This suggests that financial liberalization might be dangerous until even SOEs are subject to a hard budget constraint.

The global economy’s most powerful growth engine does not need simply “more market.” It needs a stronger regulatory framework to ensure that its markets maximize efficiency and social welfare.

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    1. CommentedEdward Campbell

      While I don't disagree with suggested solutions, the predominant cause of air pollution in China is the same as that afflicting most of the UK in the 1940's and 1950's. Leftover reliance on coal for home heating and cooking.

      That solution is the same. A national grid of pipelines for NatGas and the easier home conversions.

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