Uneven ground

It may come as a surprise that, amid China’s meteoric rise, its leaders are contemplating cautionary tales of fallen empires. But inside Beijing’s political circles this fall, left-leaning academics and politicians increasingly pointed to the break-up of the Soviet Union as an example of the destabilizing influences of unbridled capitalism. More reform-minded Chinese officials considered the demise of France’s last monarchs; Wang Qishan, one of the seven newly appointed members of the Communist Party’s Politburo Standing Committee, recommended to his colleagues Alexis de Toqueville’s “Ancien Regime and the French Revolution,” which discusses how leaders can avoid violent revolution by carrying out peaceful and incremental reform.

As the country’s fifth generation of leaders comes into power, the perception is growing that China could soon experience a crisis that will threaten its very foundations. Xi Jinping and Li Keqiang, who officially ascended to the top posts in the Communist Party in November, are inheriting a country with far more social tension than when their predecessors, Hu Jintao and Wen Jiabao, took over 10 years ago.

Rising inequality has sparked much of that dissatisfaction. The coming of capitalism to China has raised living standards across the board, but it has benefited some people far more than others. One-tenth of China’s population now generates 56% of the country’s annual income and holds 84% of its wealth, a drastic change in a society where nearly everyone was equally poor 30 years ago.

Much of that wealth has flowed to well-connected officials and state-owned enterprises (SOEs), while households and private businesses struggle with rising costs and limited opportunities. Many economists agree that China’s investment-driven, state-heavy economic system is crowding out private businesses, which tend to be more efficient and deliver benefits to a broader group of people.

This trend is reducing China’s economic potential and, in some cases, driving a wedge between the government and the people.

 “In general in the US, people accept that people who win in the marketplace won because they had better products or a better idea or worked harder, but in China that idea is much less certain,” said Nicholas Borst, a research associate and China program manager at The Peterson Institute for International Economics, a think tank. “I think people quite rightly attribute a lot of business success [in China] to connections and political favors and sometimes even corruption. Because there’s less of a sense of fairness about economic outcomes, inequality tends to be much more sensitive.”

Indeed, income inequality presents perhaps the biggest challenge to its legitimacy that the Communist Party has ever faced. The issue is front and center as China’s new leaders take office, and it will require great economic insight and political skill to resolve.

“If we don’t push forward with structural reform to mitigate social conflict, not only will the economy go wrong in the future, so will social stability,” said Liu Shengjun, deputy director of the Lujiazui Institute of International Finance at the China Europe International Business School (CEIBS). “In the coming 10 years, the new leadership will face the fact that … social conflicts are on the verge of explosion and many factors that have driven China’s growth are disappearing.”

The downside of development

China’s rapid development has ushered in glaring inequalities. The country is home to one of the world’s fastest growing markets for luxury products as well as a population of 150 million people earning less than US$1 a day.

But while the country is unequal by global standards, it is by no means the world’s most imbalanced society. Although income inequality is difficult to quantify due to the vast amount of money moving under the table in China, the World Bank estimated China’s Gini coefficient, a commonly used measure of the inequality of wealth, at 0.425 in 2005. That makes China slightly less equal than the US, which scored 0.408 in 2000 (a higher score indicates more inequality in family incomes), but more equal than countries like South Africa (0.631) and Colombia (0.559). 

But this disparity in China has still become an unprecedented source of tension, partly for historic reasons. While Americans have lived with income inequality for generations, for Chinese it is a new phenomenon. “Some people say [China’s Gini coefficient] is lower than the US, some say it’s higher,” said Wei Yao, chief China economist at Societe Generale. “But I think the trend is that China’s income inequality deteriorated at a much faster rate than a lot of major economies in the world.”

One of the most glaring disparities is between China’s coastal cities, where economic reforms first occurred, and the underdeveloped interior. Average incomes in China’s cities are more than three times the level in the countryside. This is partly because China’s household registration, or hukou, system prevents rural residents from freely moving to urban areas, with the goal of avoiding a population rush that would overwhelm urban infrastructure capacity and social services.

Another major imbalance is that between the public sector, meaning both government and state-owned enterprises, and the sphere of consumers and private businesses.

Both the Chinese people and private companies pay relatively high taxes for few benefits. The effective tax rate for private companies is easily three times that of SOEs; individuals face a higher tax burden than in many wealthy countries, but also receive fewer social services, including education, health care and social security, as a percent of GDP than other major economies, according to a report by Societe Generale. Local government tax revenue has been growing at more than twice the speed of GDP and four times as fast as rural residents’ income for years, said Li Jian, associate professor of macroeconomics at Shanghai University of Finance and Economics.

The state sector also benefits from a steady flow of cheap loans. Most Chinese have no choice but to put their savings in the state-owned banking system, for which they receive minimal returns (the interest rate for depositors was often less than the inflation rate in the past 10 years, meaning Chinese were actually losing money on their investments). Many of these funds are eventually funneled to SOEs, which are fast-tracked for approval.

Virtually 90% of all bank loans are made to state-owned enterprises, which produce only 50% of GDP – meaning only 10% of all official bank loans are supporting roughly half the economy, said Robert Theleen, managing director of investment firm ChinaVest and the 2013 chair of the American Chamber of Commerce in Shanghai.

State companies also benefit from government subsidies, lucrative government contracts, artificially cheap resource prices and barriers to entry for non-state competitors. Stimulus measures aimed at stemming the economic slowdown have left even more assets in the hands of Chinese SOEs – even though small and medium companies generate roughly 80% of the country’s jobs.

The generous funding given to SOEs is too often squandered. Fixed investment by SOEs often costs 20-30% more than that of private companies and takes roughly 50% longer to complete, according to independent economist Andy Xie. If capital markets were reformed to allow private and public companies to compete on even footing for funding, China’s economy would be more efficient and distribute economic benefits to a wider range of people – not just the wealthy and well connected.

Many Chinese recognize that SOEs are offering tougher competition to private enterprises than in years past; “guojin mintui,” meaning “the state advances and the private sector retreats,” has become an economic catchphrase in recent years. However, few Chinese ap
pear to understand the broader link between growing income inequality and the state monopolizing resources.

In a 2012 poll by the Pew Research Center, while 45% of Chinese respondents agreed with the statement “most people can succeed if they work hard,” one in three disagreed – indicating that Chinese see not just income, but also opportunity as unequal. However, those who said that hard work is no guarantee of success – in other words, those who felt powerless to advance their situation – also professed less faith in the free market and a greater desire for the state to play an active role in the economy.

So long as the understanding of how a freer market could narrow income inequality is limited, so will be political pressure for change. As a result, Chinese leaders may be tempted to focus on superficial measures to help the poor, rather than truly reforming the way income is distributed.

Where to begin?

Many economists argue that China’s state-owned sector has begun crowding out economic activity, and that the investment- and manufacturing-heavy SOE model has largely run its course. Channeling more of the country’s wealth toward average consumers and small businesses could provide China with a strong, sustainable source of growth for decades to come, economists from the World Bank and China’s Development and Reform Commission concluded in a report released earlier this year.

But reforming the distribution of wealth will be difficult, said Li Shi, an economist and executive dean of the China Institute of Income Distribution at Beijing Normal University. Making such a shift would require a slew of complex social and financial reforms involving the financial system, employment, household registration and social security that many Chinese do not understand and some fervently oppose. “It will take systematic and comprehensive changes to solve the problem. Incremental reforms will hardly be effective,” Li said.

Observers disagree on where the incoming government should begin. One popular initiative is building out the social safety net, meaning providing greater funds to subsidize health care, housing, pensions and education. Chinese have among the world’s highest savings rate, in part because of their need to shoulder these costs independently. A stronger safety net would allow many Chinese to spend a greater proportion of their income on consumption, driving economic growth.

The government has taken big steps toward building out these social services. In just the past few years, China eliminated fees and taxes imposed on farmers and extended a limited pension scheme to all rural residents. It abolished tuition fees at all government schools for children below the age of 16 and encouraged massive investment in affordable housing. And it expanded the health insurance system until 95% of all Chinese have some kind of coverage, up from just 15% in 2000. Other initiatives under discussion include relaxing the hukou system to allow greater urban-rural migration, requiring SOEs to put some profits toward the social welfare system and giving rural residents ownership of their land.

These highly visible measures are popular among average Chinese, said Borst of the Peterson Institute. But while improving the social safety net is a necessary initiative, it will go only partway toward fixing income inequality.

These reforms address the umbrella of what economists call the secondary distribution of wealth – measures like taxation, social security and transfer payments that reshuffle income after it has been generated. Economic studies suggest that reforms to secondary distribution methods are less effective at reducing income inequality than structural reforms that influence the primary distribution of income.

Chief among these measures would be increasing economic efficiency by opening up state-dominated sectors to private competition. Also effective would be removing government subsidies of resources, including electricity and water, which tend to benefit resource-intensive manufacturing industries, many of which are state-owned. “China has been sort of overweighted on industrial firms, industrial growth over the past decade, partly because of these price controls and subsidies. So removing those would be a very gradual but effective way of boosting household incomes,” said Borst of the Peterson Institute.

But the most effective way to narrow income inequality in China would be reforming how capital is allocated, by reducing or eliminating the advantage that state-owned companies have in securing funding. That would allow private businesses to prosper, employing a greater number of people and distributing wealth more evenly through the economy.

“Income inequality is the same thing as asset allocation inequality or capital inequality. They go hand in hand, and it’s very important to link the two,” said Theleen of ChinaVest. “If income inequality is a problem, part of the solution is access to capital for small businesses.”

Those in favor of providing more capital to private businesses argue for a variety of reforms, including liberalizing interest rates, opening the banking sector to private lenders and deepening bond and capital markets.

None of these initiatives will be easy to implement, and some will spark opposition from powerful people and organizations. Officials may also be tempted to disregard the most crucial reforms in favor of those that are easier both for the public to understand and for leaders to accomplish, such as improving the social safety net.

Middle of the road

Chinese leaders have gradually carried out reforms to liberalize the economy over the past three decades, but progress has been uneven. Reforms largely stalled under Hu Jintao and Wen Jiabao during the last decade. Some observers accuse Hu and Wen of merely biding their time while enjoying the benefits of the economic reforms implemented under Jiang Zemin and Zhu Rongji, such as China’s acceptance to the WTO. “The current government has done nearly nothing in the past 10 years,” said Liu of CEIBS.

Reforms may have slowed in part due to a backlash against the sweeping changes Jiang Zemin and Zhu Rongji carried out in the 1990s, in which 40 million SOE employees were laid off, said Borst of the Peterson Institute.

In addition, the huge challenges Hu and Wen confronted in their second term as the financial crisis reshaped the global economy undoubtedly waylaid planned reform. “The last five years have been unprecedented … If we want to compare the reforms of the last five years with the previous five years, I think you’re comparing apples with oranges,” said Bala Ramasamy, an economics professor at CEIBS.

To their credit, Hu and Wen have led China through the financial crisis and are bequeathing to their successors a still-vibrant economy with ultra-low inflation. But even so, the absence of reform in the last decade has left some observers impatient and pessimistic.

There are some signs that China’s incoming fifth generation of leaders will adopt a more aggressive agenda. Xi Jinping was known for cultivating private enterprise as party secretary of Zhejiang. Li Keqiang backed the DRC/World Bank “China 2030” report, which set out a series of ambitious reforms to limit the role of SOEs and refigure the economy to benefit consumers and private enterprise.

But those hoping for quick progress seem likely to be frustrated. History and official rhetoric suggest that these men will favor consensus and incremental reform over any dramatic action.

In his November 8 work report to the party congress, former Communist Party Secretary Hu Jintao gave a goal of doubling per capita incomes and GDP by 2020 and emphasized the need to build a “moderately prosperous” society, meaning one in which all people benefit from economic growth. But he also indicated that the government should forge a middle path between a reform agenda and the status
quo. “We must not take the old path that is closed and rigid, nor must we take the evil road of changing flags and banners,” Hu said.

China’s governing process has become more consensus-driven with each generation of leaders, and no consensus yet exists on how exactly these reforms should be carried out. “The intention to reform is genuine, and I think the willingness is high. But at the end of the day, it’s about how to change the incentives within the party, within the government. So they still have a lot of hurdles to overcome,” said Yao of Societe Generale.

One example of this stasis is the blueprint for reforming income distribution. The plan, which has the strong backing of Wen Jiabao, will include measures that address minimum wages, the dividends state firms must pay back to the state, taxes on high-income earners and the salaries of SOE executives.

Chinese media report that it will be released before the end of the year, but Liu of CEIBS cautions against excessive optimism. The blueprint has been on the drawing board since 2004, and the State Council has rejected the plan twice. “Those who will see their interests hurt will surely stand in the way of the reform. Therefore, we should not hold too high hopes for the plan,” said Liu.

Others say the measures will die with the Hu and Wen Administration. “My opinion is that new leaders may not want to be tied to what the previous generation was planning,” said Zhang Lifan, a historian. “So it will probably take them more than a year to figure out how they are going to address these problems.”

But to solve the problem of income inequality, Xi and Li may have to do more than merely forge a consensus. The most influential measures to reform income inequality – those that transform how capital is distributed – will be the most politically difficult to implement. Realistically, there may be no sufficient compromise between this reform agenda and the strong opposition that some SOEs and government ministries present. By trying to walk a middle road, the Chinese government may end up in the same unsustainable place that it started.