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China Walks Tightrope Between Stability and Reform

Thursday, 18 Aug 2011 | 4:49 AM ET

For weeks ahead of Vice President Joe Biden's visit to China, the country's government, news media and people cranked up pressure on the US to deal with its debt burden. However, as it enters a period of leadership transition, Beijing faces a difficult balancing act to reform its economy and maintain stability and control, analysts said.

Philippe Lopez | AFP | Getty Images

Through stimulus packages and five-year plans (FYPs) China hopes to reduce its dependency on fixed asset investment and exports. The country's government wants to increase urbanization, move its industries up the value chain into high technology and strategic sectors, improve household income and consumption, boost its private sector and liberalize its financial sector.

A new report from political risk consultancy Eurasia Group says that China is likely to meet its targets on urbanization and strategic industrial rebalancing, but that other reforms may prove far more difficult.

Prospects for financial sector liberalization are "bleak" the report said, and while the People's Bank of China (PBOC) might be able to win some battles over banking practices, vested interests at state agencies and quasi-state banking players will ensure that the sector largely remains focused on policy-led lending.

"This will keep smaller private sector players deprived of access to capital and perpetuate suboptimal capital allocation," according to the report, China's Great Rebalancing Act.

"The powerful nexus of corporate and state interests will also stymie a shift towards a more market-based economy," the report said. "Broad-based household income growth must ultimately be underpinned by the development of vibrant private indus­try, and the likely absence of policies to that end means that much of China’s needed rebalancing will have to come in subsequent FYPs."

Balancing out the distribution of wealth so that households both improve their standard of living and their levels of consumption is vital if the economy is to reorient itself toward domestic demand, rather than relying on exports and investments. This will mean large hikes in wages – the government has targeted a doubling of the minimum wage within five years – and a huge improvement in social safety nets to encourage ordinary Chinese workers to spend, rather than save.

"You have to start with the fact that wages, as a share of GDP, have been falling in China ever since the 1990s. You've got an unbalanced economy with dependence on fixed asset investment and exports, and not on consumption," Jonathan Fenby, head of the China team at consultancy Trusted Sources, told CNBC.com.

"China still doesn't have a proper health system, so you save for health, for education. The pension system is a black hole, so you save for old age. That reduces the amount of new money that goes into consumption," Fenby said.

Other areas of reform, including managing urbanization and land ownership, create major policy problems, he added.

Farming reform would take money away from local authorities, who make as much as 40 percent of their income by auctioning off land.

To make urbanization work, significant investments would need to be made in infrastructure and services. However, that means ramping up the kind of fixed-asset investment that the government is trying to move away from.

Dealing with the rampant waste of electricity and water that has been encouraged by subsidized pricing would mean feeding more inflationary pressure back into an already worrying inflation picture.

Giving migrant workers from the countryside rights – currently denied under the "Hukuo" registration system that ties people to their place of origin – would mean giving municipal authorities the financial and political firepower to deal with providing education and health services.

"There are a lot of policies in China that are, if not contradictory, going in different directions," Fenby said.

"Ideology doesn't count that much in China nowadays. It's more a matter of everything interlocks with everything else," Fenby said. Every action prompts another round of reform and decentralization of decisions, which the Communist Party, still the most powerful body in the country, will not countenance, according to Fenby.

"The Communist Party wants to remain in power, and it doesn't want the government to take any steps that might upset the power structure as it is. We're in a very political country. People look at China and say: There are no elections in China, so therefore are no politics in China. In fact, there are politics everywhere," Fenby explained.

Xi Jinping,heir apparent to the leadership of the Communist Party and the presidency, is expected to finally take office in October 2012, and analysts said that during this coming period of flux, it's unlikely that major social reforms will take place.

"My feeling is that during this leadership period, which we're in now and lasts until the spring of 2013, we're not going to see any major initiatives. Nobody's taking any risks. This is quite a careful 'steady as she goes'. Of course," Fenby said, "you can say that if you're getting 9 percent growth, then the argument for the status quo is quite strong."

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