by SHENG Hong, Director, Unirule Institute of Economics

Translated by MA Junjie, Researcher, Unirule Institute of Economics

There has been a big fuss about the so-called supply side structural reform lately in China. The theoretical basis of this reform is the supply economy. And the essence of the supply economy is Say's Law that stipulates aggregate production necessarily creates an equal quantity of aggregate demand. This supply must be valid supply, i.e., supply that can be sold. When the supply gets sold out, income is created, and income creates demand.

Apparently, the precondition of Say’s Law is an effective market. The correct signal in such a market will inform the suppliers to provide in accordance with the demand. There are three conditions for an effective market: firstly, the factor of production can be freely exchanged; secondly, enterprises are free to enter any industry; and thirdly, the price is set by the market. Only when the factor of production is freely exchanged, can reallocation of resources take place from places of low productivity to those of high productivity; only when enterprises are able to enter any industry, can the distortion of industrial structure be corrected quickly, and temporary shortages be compensated; only when the price is set by the market, can correct price signals be produced to direct the resources.

Taking a look at China’s institutional environment, we’ll see it’s far from the ideal situation. Firstly, a large proportion of resources are possessed by state-owned enterprises (SOEs), especially central government owned enterprises. However, SOEs are not playing according to the market rules. Even though they are making huge losses, they won’t quit. Therefore, a huge amount of resources cannot be reallocated. According to Unirule research on SOEs, deducting the government subsidies and the underpaid costs, the real net RoR of industrial SOEs in 2013 was -3.8%. In the same year, the total assets of SOEs accounted for RMB 104 trillion, and the net assets accounted for RMB 37 trillion. It means if these assets could be reallocated, and the net RoR was raised by 10% to 6.2% (the non-SOEs’ net RoR was 15.6% in the same time period), a total of RMB 3.7 trillion of GDP could be achieved, which accounted for 5.4% of the GDP in 2013.

It can be seen that the problem with SOEs has nothing to do with corporate governance, but it has a lot to do with macro-governance. Were SOEs really reformed, the implications could influence the macroeconomy. According to the National Institution for Finance and Development, the total assets of China amounted to RMB 691.3 trillion in 2013, and the net assets amounted to RMB 352.2 trillion. The total assets of SOEs accounted for 15% of the national total, and the net assets of SOEs for 11% of the national figure. As we see, the SOEs with such a big proportion of total and net assets and at such low efficiency are undertaking no tangible reforms due to the stubborn resistance of the SOE executives for the sake of their own interests. As a result, SOEs have been stalling China’s economic growth. Therefore, the major aim for the supply side reform is the SOE reform.

Secondly, enterprises are not allowed to enter all sectors of the economy due to monopolies and entry barriers, take the oil industry, for instance. There is monopoly in the oil industry from the top to the bottom. In order to maintain this monopoly, the import of crude oil was shut down to non-SOEs. As of this moment, the capacity of refineries other than the Three Buckets of Oil, i.e., the three state-owned oil companies including CNPC, SINOPEC, and CNOOC, is about 1.88 trillion ton. However, due to the crude oil import control, most of these refineries have to import fuel oil or process for the three SOEs. That is about 60% of the capacity stand idle per year. If the import of crude oil is open, these refineries will create another RMB 300 billion industrial added value in addition (2011).

Thirdly, some of the prices of essential resources are regulated by the government, such as the price of gas. In fact, the price of gas is heavily influenced by the SOE monopolies. China’s economy fails to enjoy the benefits of the decrease of fuel prices. The pricing of China’s petroleum products is set with reference to the three largest international oil exchanges. However, against the backdrop of the plummeting oil price in the global market, this mechanism is halted in various names. Apparently, the monopoly of the Three Buckets of Oil has a say in this. As Unirule research estimates, for the oil of the same quality, the price of China’s gas in 2015 was 21% higher than the weighted average of that in other major countries of the world, and the price of diesel was 28% higher. The cost for fuel accounted for 3% of the GDP as petroleum products are widely used in China. If the price is 25% higher, that accounts for an extra 0.8% of the GDP in cost. This increase of cost will set off the effect of the interest rate decrease due to the macroeconomic policy, which will set back the recovery of the economy.

Lastly, due to the institutional obstacles, the biggest resource in China, land, is not effectively reallocated. On the one hand, much of the state-owned land is used for free by SOEs, accounting as assets without paying the land rent, which leads to a loss of land rent revenue amounting to trillions per year. That is to say, SOEs are not able to put the land into effective use, and not willing to reallocate the land to other enterprises. Therefore, SOEs cause the loss of land rent. In Unirule research report “The Nature, Performance, and Reform of State-Owned Enterprises” (2nd Edition), the underpaid land rent by SOEs in 2013 is estimated to about RMB 1240.9 billion, which is 2.1% of the GDP that year. 

On the other hand, much of the land cannot be freely exchanged. This land is the land owned by the rural residents. Though these residents have owned the land for generations, the Constitution stipulates that rural land is collectively owned, which means rural residents don’t have the full property rights of their land. The Land Administration Law, in accordance to the Constitution, stipulates that rural collectively owned land has to be transformed to state-owned land before construction is undertaken upon it. And the compensation for acquiring the rural land is 6-19% of the yearly yield of the land. That is way lower than the agricultural use of the land.

Against the backdrop of the development of automobiles and the Internet, cities are becoming flat and suburbanised, while tourism will flourish. If rural residents have full property rights over their land and are free to change its use, for example, from agrarian to touristic or real estate, then their income could increase by ten times. My personal investigations of some touristic areas show that the household income of the rural residents increased from several thousand to tens of thousands. These residents not only have the income from their estates, but also the revenue of other touristic operations. A local market of goods and services comes into being as more tourists and urban residents come pouring in, which is good for the local economy. Of course, not all the rural areas are fit for developing tourism. But simply consider that 1% of all Chinese villages take this path, a significant increase of GDP can be anticipated.

The static estimation above shows that the reform of SOEs and the land institution will bring about significant GDP increase. For example, if the SOEs begin to eradicate monopoly, abandon possession of the state-owned resources they use for free or at a low price, a 1% GDP increase per year is to be anticipated, should the reforms be completed within five years. What’s more, the dynamic repercussions are even more exciting if such reforms are to be taken. As SOEs become fair players in the market place, various factors will be freely exchanged, which will promote the development of division of labour and professions, the innovation of technology and institution. All this will have a long-term effect on China’s economic development.

This article is a speech of the author on the Chinese Economist 50 Forum, Feb. 19th, 2016.