Chinese President Xi Jinping has taken charge of drawing up ambitious reform plans to revitalize the economy, sources close to the government said, shunning policy stimulus for fear it could worsen local government debt and inflate property prices.
A consensus had been reached among top leaders that reforms would be the only way to put the world's second-largest economy on a more sustainable footing, said the sources, who are familiar with the plans and Xi's involvement.
China's economic growth is at its weakest in 13 years, although still the envy of any major economy.
Xi will present the reforms at a key meeting of the ruling Communist Party later this year that will set the agenda for the next decade, signaling his seriousness to see breakthroughs, the sources told Reuters.
Some of the sources cautioned that the reforms could face resistance from vested interests, especially state firms.
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Broadly, the measures would liberalize interest rates and overhaul the fiscal system for local governments to ensure they had a steady stream of tax revenues rather than relying on volatile land sales to raise funds.
The reforms would also free up China's rigid residence registration, or hukou, system that precludes people from access to basic welfare services outside their official residence area, the sources said.
"A top-level team has been set up to draft reform plans for the party meeting, with Xi taking personal charge," said a senior economist at a top government think-tank in Beijing.
"Xi is keen to see some real changes," said the economist, who requested anonymity due to the sensitivity of the issue.
Big injections of policy stimulus appear to be off the table after Premier Li Keqiang was quoted by state media as saying on Wednesday there was limited room to use government spending to boost the economy.
"China's economic model has reached a point where it must be overhauled, although reforms are probably easier said than done," said Shi Xiaomin, vice head of the China Society of Economic Reform, a government think-tank in Beijing.
"The sense of crisis of Xi and Li is significantly higher than their predecessors."
Xi and Li assumed their government posts in March during a once-in-a-decade leadership transition.
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Some critics said the previous administration of President Hu Jintao and Premier Wen Jiabao had delayed economic reforms and failed to deal with the fallout from China's 4 trillion yuan ($650 billion) stimulus package in 2008.
The package insulated China from the global financial crisis but left a mountain of local government debt and record house prices.
Xi and Li, by contrast, have been leaning toward reforms rather than short-term policy stimulus to bolster the economy.
"They are more eager to tackle long-term issues through reform measures. China's economic slowdown is mainly caused by structural factors," said Wang Jun, senior economist at the China Center for International Economic Exchanges (CCIEE), a well-connected government think-tank in Beijing.
Focus on Urbanization Drive
Such structural drags have become more obvious this year as annual economic growth slowed to 7.7 percent in the first quarter from 7.9 percent in the fourth quarter of 2012. Full-year GDP growth of 7.8 percent in 2012 was the slowest since 1999. Weakness has persisted in April despite a credit boom.
Freer interest rates would help curb China's sprawling shadow banking sector - lending by businesses other than banks - because state controlled bank deposit rates are fanning a boom in risky alternative investments. At the same time, state firms with preferential access to credit are profiting at the expense of cash-starved private companies.
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The most pressing reform is to overhaul the fiscal system for local governments since Beijing is counting on a new urbanization program to drive economic growth by unleashing the spending power of rural workers.
China plans to spend 40 trillion yuan to bring 400 million people into its cities over the next decade. But local governments don't have steady tax revenues to back the issuance of bonds that would finance spending on roads, apartments and other infrastructure. The central bank has turned down the option of using bank loans.
Under China's current tax structure that has been in place since 1994, the central government gets the lion's share of receipts while local governments do most of the spending, forcing them to rely on land sales for survival.
Linked to the urbanization drive is reforming the hukou system, which economists say would turn millions of migrant workers into consumers if they had access to welfare services outside their home region.
Ratings agency Fitch has estimated local government debt was 12.85 trillion yuan at the end of 2012, or about 25 percent of GDP. The latest official data put the figure at 10.7 trillion yuan by the end of 2010.
Not All Smooth Sailing
The reforms will be presented at the third plenum of the 18th Central Committee of the Communist Party of China, expected in October.
Many economists see this as a critical period for China if it wants to avoid the so-called middle income trap, where wealth creation stagnates as market share is lost to lower-cost competitors and the attainment of high-income country status stays out of reach.
Third plenums have been the springboard for key changes in China in the past. Former leader Deng Xiaoping launched historic reforms at the third plenum of the 11th party committee in 1978 to rescue the economy from the verge of collapse after Mao Zedong's disastrous Cultural Revolution.
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The third plenum of the 14th committee in 1993 endorsed the "socialist" market economy, paving the way for sweeping reforms spearheaded by former Premier Zhu Rongji.
China's new leaders have installed several Zhu lieutenants in top government posts, including Vice Premier Ma Kai and Finance Minister Lou Jiwei, while central bank governor Zhou Xiaochuan was kept on after the leadership transition.
Still, pushing reforms looks harder than in the 1990s as the economy has become more sophisticated and questions remain over whether economic reforms could run into political roadblocks.
Xi recently launched a frugality campaign to target official extravagance, but there has been little apparent progress to get officials to publicly disclose their assets.
"It won't be smooth sailing," said Lian Ping, chief economist at Bank of Communications, the country's fifth biggest lender, in Shanghai.