The Second Coming of Zhu Rongji?

SHANGHAI – The recent release of a book of speeches by former Chinese Premier Zhu Rongji has refocused attention on his bold – and often highly controversial – economic reforms of the 1990’s, which included reining in state-owned enterprises (SOEs) and overhauling the banking system. But the discussion has taken an unexpected turn, with Chinese media adopting a far less critical stance than that which has prevailed for the last two decades.

Given the apparent parallels between the challenges that Zhu faced and those that current Premier Li Keqiang is now attempting to address, not to mention their shared commitment to economic transformation, this shift could signify rising support for structural reform. But are Zhu and Li really so much alike?

Today, as in the 1990’s, China is experiencing skyrocketing local-government and commercial-bank debt, rising fiscal and financial risk, uncertainty over institutional reform, and declining central-government revenue. According to Bloomberg, Li will be the first Chinese premier not to fulfill the official annual growth target since Zhu. Despite these apparent similarities, however, China’s situation today is fundamentally different from 20 years ago.

In the 1990’s, Zhu’s core mission was to address the consequences of former Premier Zhao Ziyang’s flawed fiscal-decentralization efforts. By pursuing fiscal reform one sector at a time, Zhao left room for local governments to form alliances with SOEs, which provided subsidies to local bodies and enabled them to withhold income from the central government. This led to the build-up of national public debt, which, in turn, compelled the central bank to over-issue currency, fueling inflation.

In this context, Zhu’s reform strategy was aimed primarily at reestablishing a sound fiscal relationship between the central and local governments, rather than at increasing the GDP growth rate. In fact, though Zhu’s reforms were piecemeal, they could easily have led to double-digit GDP growth. But Zhu recognized that allowing such rapid growth probably would have done more harm than good, given persistent inflation and macroeconomic instability.

Critics assert that Zhu’s 1994 tax reform led to the current real-estate bubble, because it drove local governments to use land sales to boost their incomes. But the fact is that replacing the income-sharing system with a tax-sharing system stabilized China’s economy and reversed the relative decline of central-government revenue. Indeed, it was essential to China’s economic development.

By weakening the alliances between local governments and SOEs, Zhu’s tax-sharing system facilitated the strategic restructuring of the state-owned economy. And, by galvanizing local governments to privatize local SOEs (as well as housing and some public services), Zhu’s reform hastened China’s incorporation into the global economy. China’s state-owned economy is far less bloated today; the central and local governments have fewer compatibility problems; the country’s fiscal position is strong; and relative macroeconomic stability prevails.

Zhu’s success means that Li must focus on a different challenge. Li must ensure that China’s economy, which still boasts significant growth potential, does not sink into lethargy and fall into the so-called “middle-income trap.” A developing economy may slow prematurely when external factors alter the conditions supporting growth. Wages continue to rise, reducing competitiveness vis-à-vis low-income economies, but the growth model is not yet equipped to support competitiveness in high-skill industries, leading to stagnation.

In order to avoid such an outcome, Li must adapt China’s growth model to current conditions, which include intensifying trade friction with the European Union and the United States, greater pressure to allow the renminbi to appreciate, an aging population, slowing urbanization, and rising labor costs. The “new normal” that has emerged from the global financial crisis, characterized by sluggish GDP growth and diminished import demand in the West, makes reform even more urgent.

Li should begin by redistributing industrial capital from high-productivity coastal areas. This would instantly augment growth in less-developed regions and boost overall productivity. But, with competition in the global supply chain fiercer than ever, China will need more than capital transfer to achieve high-income status. It will need policies and mechanisms that encourage and guide technological and industrial upgrading.

Fortunately, Li seems to understand this. Indeed, industrial and technological upgrading forms the core of “Likonomics.” But significant uncertainty remains over how to achieve it within the constraints of China’s state-led economy.

Over the last decade – especially since 2008 – China’s central government has been tightening its grip on industrial policy, while enhancing the State Council’s dominance over local governments. By contrast, Li seems intent on returning power to local governments and the market, transforming vertical control into horizontal coordination. Thus, instead of trying to control technological and industrial upgrading with central mandates, Li is giving local governments and the market the space to drive China’s economic transformation.

Zhu and Li do have one thing in common: they both came to power at a critical juncture in China’s development. But, whereas Zhu had to grapple with local officials to increase the central government’s authority and revenue, thereby stabilizing the economy and unleashing China’s growth potential, Li must cooperate with local governments to create a system that fosters and protects new sources of innovation and economic dynamism at all levels. Just as Zhu’s reforms two decades ago laid the foundation for today’s growth, whether Li succeeds may well determine China’s economic trajectory for the next 20 years.