New Push for Reform in China

The Limits of Statism

Influential Report to Warn of Economic Crisis Unless State-Run Firms Are Scaled Back

By BOB DAVIS

BEIJING—An exclusive preview of an economic report on China, prepared by the World Bank and government insiders considered to have the ear of the nation's leaders, offers a surprising prescription: China could face an economic crisis unless it implements deep reforms, including scaling back its vast state-owned enterprises and making them operate more like commercial firms.

"China 2030," a report set to be released Monday by the bank and a Chinese government think tank, addresses some of China's most politically sensitive economic issues, according to a half-dozen individuals involved in preparing and reviewing it.

It is designed to influence the next generation of Chinese leaders who take office starting this year, these people said. And it challenges the way China's economic model has developed during the past decade under President Hu Jintao, when the role of the state in the world's second-largest economy has steadily expanded.

The report warns that China's growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the "middle-income trap." A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, the report warns, and could prompt a crisis, according to those involved with the project.

It recommends that state-owned firms be overseen by asset-management firms, say those involved in the report. It also urges China to overhaul local government finances and promote competition and entrepreneurship.

"China's state-owned sector is at a crossroads," said Fred Hu, chief executive of Primavera Capital Group, a Beijing investment firm. The Chinese government must decide "whether it wants state-led capitalism dominated by giant state-owned corporations or free-market entrepreneurship."

It isn't known whether "China 2030" will project a certain growth rate when it is released next week. But current forecasts by the Conference Board, a U.S. think tank, see the Chinese economy growing 8% in 2012, and slowing to an average annual growth rate of 6.6% from 2013 to 2016. Economists Barry Eichengreen of the University of California at Berkeley, Donghyun Park of the Asian Development Bank and Kwanho Shin of Korea University, after studying the history of other onetime growth champs, argue that China's annual growth rate will begin to "downshift" by at least two percentage points starting around 2015.

While some reduction in growth is inevitable—China has been growing at an average of 10% a year for 30 years—the rate of decline matters greatly to the world economy. With Europe and Japan fighting recession and the U.S. experiencing a weak recovery, China has become the most reliable source of growth globally. Commodity producers in Latin America, Asia, North America and the Middle East count on China for growth, as do capital goods makers, farmers and fashion brands in the U.S. and Europe.

How much the report will help reshape the Chinese economy is unclear. Even ahead of its release, it has generated fierce resistance from bureaucrats who manage state enterprises, according to several individuals involved in the discussions.

China's political heir apparent, Xi Jinping, now vice president, has given few clues about his economic policies. Analysts expect the high-profile report will encourage Mr. Xi and his allies to discuss making changes to a state-led economic model that has alarmed Chinese private entrepreneurs while creating tension between China and its main trading partners, including the U.S.

The report's authors argue that having the imprimatur of the World Bank and the Development Research Center, or DRC—a think tank that reports to China's top executive body, the State Council—will add political heft to the proposals. The World Bank is widely admired in Chinese government circles, particularly for its advice in helping China design early market reforms.

They are also counting on the clout of the No. 2 official at the DRC, Liu He, who is also a senior adviser to the all-powerful Politburo Standing Committee, to help ensure that its findings are considered seriously by top leaders. Mr. Liu declined to comment.

Mr. Liu was among the top Chinese staffers who drafted China's current five-year economic plan and is considered close to China's current leaders as well as Mr. Xi, the presumptive next leader of China's government and party. Mr. Liu, who meets regularly with U.S. officials, has argued publicly that foreign pressure and ideas can help build momentum for change in China.

"Liu decides the flow of information, gives policy makers recommendations and organizes meeting agendas," said Cheng Li, a China scholar at the Brookings Institution in Washington, D.C.

World Bank President Robert Zoellick, in a statement announcing the report would be released, said, "The report lays out recommendations for a development growth path for the medium term, helping China make the transition to become a high-income society."

Neither the World Bank nor DRC would comment specifically on the "China 2030" findings.

Chinese Vice Premier Li Keqiang, who is expected to be named premier next year, endorsed the Chinese-World Bank project when Mr. Zoellick proposed it during a trip to Beijing in September 2010—another hint that the new crop of leaders will closely examine the report.

Currently, state-managed enterprises tower over the Chinese economy, dominating the nation's energy, natural resources, telecommunications and infrastructure industries. Among other things, they have easy access to low-interest loans from state-owned banks.

U.S. Treasury Secretary Timothy Geithner and other Western officials argue that the subsidies to those firms distort international competition. Domestically, critics complain that the firms choke off internal competition, use monopoly profits to expand into other businesses and pay only meager dividends. A U.S. Treasury official said Wednesday the U.S. supports reforms that increase the ability of private firms to compete with state-owned enterprises.

The World Bank and DRC argue that asset-management firms should oversee the state-owned companies, say those involved in the report. The asset managers would try to ensure that the firms are run along commercial lines, not for political purposes. They would sell off businesses that are judged extraneous, making it easier for privately owned firms to compete in areas that are spun off.

"China needs to restrict the roles of the state-owned enterprises, break up monopolies, diversify ownership and lower entry barriers to private firms," said Mr. Zoellick in a talk to economists in Chicago last month.

Currently, many state-owned firms have real-estate subsidiaries, which tend to bid up prices for land, and have helped to create a housing bubble that the Chinese government is trying to deflate.

The report also recommends a sharp increase in the dividends that state companies pay to their owner—the government. That would boost government revenue and pay for new social programs, said those involved with the report.

"It's an innovative proposal," said Yiping Huang, a Barclays Capital economist. Neither the World Bank nor the DRC proposed privatizing the state-owned firms, figuring that was politically unacceptable.

Chinese and U.S. economists say that dividend money from profitable state-owned firms now is often directed to unprofitable ones by the State-owned Assets Supervision and Administration Commission, or SASAC, which regulates the firms and tries to ensure their profitability.

SASAC and the Communist Party's personnel agency name heads of state-owned firms and can replace them, giving the government great sway over the firms' decision-making. It isn't clear whether the report recommends changing that arrangement or proposes how the asset managers should be hired and fired.

How to handle such personnel "was the most contentious issue and was debated until the last hour," said a "China 2030" participant, who added that participants often differed on how much credit should be given to the state for China's economic development and how big a role the government and party should continue to play.

Even so, said individuals involved with the report, SASAC bitterly criticized the proposal in meetings of the "China 2030" group and is expected to try to block its adoption, out of concern it could lose power. Indeed, many of the recommendations are considered so politically fraught that the Chinese insisted that the report be labeled a "conference edition"—meaning that it is subject to change after comments at the Beijing conference where it will be presented Monday.

SASAC didn't immediately respond Wednesday to a request for comment.

In a signal of the challenges now faced by Chinese businesses, a gauge of nationwide manufacturing activity was slightly higher in February but remained in contractionary territory for the fourth straight month. The preliminary HSBC China Manufacturing Purchasing Managers Index was 49.7 in February, compared with a final reading of 48.8 for January, HSBC Holdings PLC said on Wednesday. A reading below 50 indicates contraction from the previous month.

China is vulnerable to a sharp slowdown, said Jun Ma, a Deutsche Bank China economist, because it relies too heavily on industries that copy foreign technology and doesn't produce enough breakthroughs of its own. South Korea was able to keep growing rapidly after it hit a per-capita income level of $5,000—about where China is today—because it pushed innovation. However, China lags behind South Korea badly in patents produced per capita, he said.

Chinese local governments often draw much of their revenue from the sale of land, rather than from taxes. The report urges that Chinese social spending be funded more by dividends from state-owned firms and by property, corporate and other taxes. "We'll be recommending that all resources be put on budget," Mr. Zoellick said in his Chicago talk, and "that public finance needs to be transparent [and] accountable.