China’s Economy: Complacency, Crisis - Specialized Research AI at MIT

China’s Economy: Complacency, Crisis
& the Challenge of Reform

Barry Naughton

Abstract: China’s economic success has bred a new complacency and resistance to change. This in turn
has created a credibility crisis, as many Chinese citizens believe the opposition of vested interests makes
reform impossible. However, proponents of economic reform argue that the current economic strategy is
unsustainable. They point to reform backsliding, overinvestment, and ½nancial fragility as problems that
will collide with an inevitable economic slowdown caused by rapid demographic changes, and that will
potentially cause economic and political crisis. Renewed economic reform is thus the only prudent and
viable choice. The November 2013 Third Plenum shows that China’s leaders have tentatively accepted
the need for reform.

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At ½rst look, it seems that China’s new leadership

assumed power at the pinnacle of economic success.
Immediately upon putting their new administration
in place, General Secretary Xi Jinping and Premier
Li Keqiang made clear their belief that China’s new
economic clout entitles it to a position of greater
respect and global influence than ever before. In fact,
China’s economy had already become a certi½able
“growth miracle” when the previous administra-
tion of General Secretary Hu Jintao and Premier
Wen Jiabao took power in 2003. At that time, China’s
economy had already sustained a torrid annual
growth rate of 9.6 percent over twenty-four years, a
period begun by the major economic reforms of
1978. But in the decade spanning 2003 to 2012,
which included the global ½nancial crisis, China’s
growth actually accelerated, reaching 10.4 percent
annually.1 China overcame the global crisis by
pouring resources into investment and accelerating
the already eye-watering speed of its infrastructure
build-out. Per capita gdp has pushed over the upper-
middle income threshold. Not surprisingly, then,
an air of triumphalism began to creep into Chinese
attitudes and government proclamations. Surpassing

BARRY NAUGHTON is Professor
of Chinese Economy and the Sok-
wanlok Chair of Chinese Interna-
tional Affairs at the University of
California, San Diego. His books
include The Chinese Economy: Tran-
sitions and Growth (2007), Growing
Out of the Plan: Chinese Economic
Reform, 1978–1993 (1995), and the
edited volume Wu Jinglian: Voice of
Reform in China (2013).

the Japanese economy in aggregate size,
and becoming the second largest economy
in the world, was a particular point of pride
for China.

Transformation at this pace inevitably
creates enormous stresses and strains.
Besides the dislocation, the inequities, and
the environmental costs, headlong growth
also led to another problem: as incomes
grew, the impetus for market-oriented eco-
nomic reforms diminished. As Wu Jinglian,
the dean of China’s reform-oriented econ –
omists, put it, “As life got comfortable,
reforms stopped.”2 During the 1990s,
driven by profound economic and politi-
cal crises, the Chinese government had
pushed through a procession of funda-
mental economic reforms. Under Premier
Zhu Rongji, China between 1993 and 1999
enacted a series of deep and dif½cult
reforms of the ½scal, ½nancial, and market
systems. These reforms culminated in
the massive downsizing of the Chinese
state enterprises sector from 1996 to
2001, and were sealed by China’s entry
into the World Trade Organization in 2001,
thereby locking in many of the most
important reforms. As a result of these
reforms, the Hu–Wen administration
inherited a highly favorable economic
position when it took power in 2003: the
previous administration had paid a sub-
stantial price to break down the old system
and lay the foundation for a new, better-
functioning economy, but had only just
begun to enjoy the bene½ts. Hu and Wen
were poised, as the Chinese saying puts it,
to enjoy the shade of the trees planted by
the ancestors.

At ½rst, the Hu–Wen administration
seemed ready to follow the reform trajecto-
ry of the previous Jiang Zemin–Zhu Rongji
administration, retaining many of the
same economic technocrats. The admin-
istration’s initial economic proposals were
full of good ideas, and represented a robust
program for a continuation of reform.

But nothing much happened, and there
was no follow-through. Today, in Beijing,
there is a widespread perception that the
past ten years have been a “lost decade”
insofar as market-oriented economic re –
form is concerned. This does not mean that
Wen Jiabao presided over a do-nothing
administration. Rather, on the social front,
Wen cut taxes on the rural economy and
boosted spending on education and med-
ical care; he created the foundation for
rudimentary national systems of health
insurance and pensions; and he increased
defense outlays, contributing to a stronger
military, which most Chinese citizens
certainly see as a positive. The Hu–Wen
administration was energetic in spending
money, which was acceptable simply
because they had the money to spend.
However, in terms of creating the institu-
tional framework on which future pros-
perity would depend, the outgoing admin –
istration achieved almost nothing.

It is common for Chinese citizens to

explain reform stagnation, or the defeat
of individual reform initiatives, by refer-
ring to the increased strength of “vested
interests.” Even the current Chinese pre-
mier, Li Keqiang, regularly refers to the
need to manage and minimize interest
group opposition if his current reform
proposals are to advance successfully.3 But
who, exactly, are these vested interests?
The idea of “vested interests” covers a
broad spectrum. At one extreme, the op –
position of interest groups to reforms
shades into and becomes identical with
the problem of corruption. Some vested
interests are well-connected families, cor-
rupt of½cials, and even criminal gangs. But
at the other end of the spectrum, the prob –
lem of vested interests is created by the
stabilization of the entire Communist
Party–dominated economic and govern-
mental system. The easiest way to see this
is through China’s budgetary history

Barry
Naughton

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143 (2) Spring 2014

China’s
Economy:
Compla –
cency,
Crisis
& the
Challenge
of Reform

(Figure 1). From the beginning of reform
in 1978 until 1995, budgetary revenues as a
share of gdp declined nearly every year.
Indeed, the productive era of the 1990s
reforms was driven by an acute budgetary
crisis. Zhu’s reforms included a new tax
system and new ½nancial discipline that
staunched losses in the state enterprise
sector. As state ½rms were chopped back
and restructured, the few that survived
made a sustained return to pro½tability,
which increased resources available to na –
tional leaders both directly and indirectly.
Figure 1 also shows that after 1995, the
trend turned dramatically, and budgetary
revenues as a share of gdp increased every
year between 1995 and 2012. The result
was an enormous increase in the volume
of resources available to the system.

A few numbers can give a sense of the
magnitude of this transformation. As
Figure 1 shows, Chinese budget revenues
increased from 10.8 percent of gdp in 1995
to 22.6 percent of gdp in 2012. Doubling
the budget’s take of gdp in seventeen
years is a substantial achievement, but
we must also consider the rapid growth
of gdp itself: real budgetary revenues
(deflated by the Consumer Price Index)
were almost exactly twenty times in 2012
what they had been in 1995. In 2012-con-
stant usd, the value of Chinese budget-
ary revenues has increased from $113 bil- lion in 1995 to $1.86 trillion in 2012. These
numbers look like some kind of spread-
sheet error, but they are not.4 Chinese
government revenues (central and local
consolidated) are about equal to the U.S.
federal government on-budget revenues,
excluding social security, which are esti-
mated by the Congressional Budget Of½ce
at $1.97 trillion for 2012. Less than two decades since the coun- try faced a potential crisis of state capacity, the Chinese system is now awash in cash. Money is available not just for the critical necessities, but for elective projects as well. Technology megaprojects, cultural vanity projects, global propaganda initiatives: if a top leader wants it badly enough, the mon ey can be found. Even the universi- ties have plenty of money. Virtually every- one in a position of authority has a bigger budget, is better off, and has plenty to do. Bitter disputes over resource allocation are less salient, and side payments can be made to buy off dissenters. As the flow of resources through the party- and state- dominated sectors of the economy in – creased and stabilized, the system naturally became organized around that flow. State- owned enterprises returned to ½nancial health, bene½ting from the radical down- sizing and restructuring that Zhu Rongji had pushed through at such cost in the late 1990s. With a few entry barriers, and a lit- tle manipulation, combined with genuine bottom-up economic growth, the state- owned enterprises were transformed from a burden to an asset. The most extreme example is China Mobile, the state-run com pany that not only is by far the largest telecom operator in the world, with over 700 million subscribers, but also sits on one of the biggest corporate cash piles in Asia, with $64 billion in the bank.5

At the same time, the reconstruction of
the party apparatus and the rationaliza-
tion of party-state career paths have given
the system a new stability and predictabili-
ty. Trajectories of a career in government
have become more knowable, as the re –
quirements for promotion have become
increasingly routinized. Steady promotion,
in turn, leads to abundant and increasing
opportunities to earn outside income. Stu –
dents in elite universities have increas-
ingly come to see government as the most
attractive career option. In other words,
the stagnation of reform was not merely
short-run complacency and procrastina-
tion; rather, it reflected the long-term sta-
bilization of the system. The hierarchical
Chi nese political system, which had to be

Dædalus, the Journal of the American Academy of Arts & Sciences

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Figure 1
China’s Budget Share in gdp, 1978–2012

Barry
Naughton

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Source: Chinese of½cial data, updated most recently with the National Bureau of Statistics, Zhongguo Tongji
Zhaiyao 2013 [China Statistical Abstract 2013] (Beijing: Zhongguo Tongji, 2013).

constantly remade in the 1980s and 1990s in
order to adapt to new challenges, is today
no longer driven by any immediate, inter –
nal sense of crisis. Instead, the Chinese sys –
tem–perhaps like most systems in the
world–is engaged primarily in reproduc-
ing itself more or less as it is. The biggest
vested interest, then, is the interest repre-
sented by the Communist Party itself.

The new stability of the system is viewed

warily by those outside its embrace. In
the ½rst place, there is a widespread
perception–both inside and outside China
–that it is increasingly dif½cult to do busi-
ness in China without political connec-

tions. Of course, at the same time, the
private sector has grown tremendously;
and while the state sector has stopped
shrinking in absolute terms, the growing
private sector makes up a steadily larger
share of the overall economy. However,
private business owners now sense in –
creased competition from state ½rms, and
an increased need for accommodation
with savvy power holders–with “vested
interests”–who can help extract bene½ts
from the booming economy and from pri-
vate businesses.

Even more important, an awareness of
the stagnation of reform in China over
the past decade has gradually seeped into

143 (2) Spring 2014

China’s
Economy:
Compla –
cency,
Crisis
& the
Challenge
of Reform

public consciousness, producing an inter –
esting disconnect. Over the past ten years,
the government’s propaganda organs
have continued to trumpet the indispens-
ability of economic reform. Every few
years, major new reforms are discussed,
and policies are implemented, but they
have little impact. As a result, of½cial pro-
nouncements have lost credibility, and
this loss, combined with the stabilization
of China’s system and the greater influ-
ence of interest groups, has led to a crisis of
con½dence in China’s ability to change.
This type of credibility crisis is something
quite new in China, although it has been
commonplace in the United States and
other economically developed societies
for some time. Such a crisis in con½dence
is characterized by the belief that prob-
lems are peculiarly entrenched and in –
tractable, and nothing really can be done
about them, with only the extremely
naive believing otherwise. This type of
cynicism was, until recently, almost com-
pletely absent in China. China had been
changing so rapidly that it was apparent
to everyone that the future was, if nothing
else, full of different possibilities, even if
the present was impoverished. That sense
of con½dence about the future seems to
have vanished in China.

Understanding this facet of the public
mood is important to understanding the
recent pronouncements of China’s new
leaders, and their reception. Both Xi
Jinping and Li Keqiang made rather bold
pronouncements in favor of restarting
market-oriented reforms in the early
stages of power transition in late 2012.
Yet the popular response to these procla-
mations was only mildly positive: “Really?
We’ll believe it when we see it.” A palpa-
ble skepticism about reform is thus part
of a broader crisis of con½dence. Can
China change? Has government and pol-
icy been captured by interest groups, such
that no change is possible? Is China slip-

ping backward? Acutely aware of this
public sentiment, both Xi Jinping and Li
Keqiang have been critical of the gap
between rhetoric and action: Xi spent his
½rst months in power denouncing “empty
talk.” It is clear that those engaging in
empty talk are, in fact, Xi’s predecessors,
but is it clear that Xi will be any different?
More broadly, why would those who
bene½t so abundantly from the current
system act to change it? Why would any-
body change a model that seems to have
delivered such abundant resources and
success?

Remarkably, economic reform is not

dead in China and is in fact experiencing
a resurgence. Reformers have important
positions in the new government and in
the country’s most influential business
media. At their core, these reformers
have only one argument, but it is a pow-
erful one: that the current economic situ-
ation and policy trajectory are simply not
sustainable. Economic conditions are
changing rapidly, and the current way of
doing business risks serious crisis. The
most dangerous course of action is there-
fore not to reform, in effect remaining on
the current course. If policy-makers do not
preempt the changes that are coming, then
change will be disruptive and potentially
devastating. But there is still time to act.
The unsustainability argument has four
key components. First, the failure to sub-
stantially improve the quality of China’s
economic institutions will begin to grad-
ually erode the pace of productivity im –
provement. China’s total factor produc-
tivity has increased dramatically during
the reform era, and grew strongly through
most of the ½rst decade of the century.
This productivity improvement has been
diffuse and attributable to multiple causes,
including the learning and adoption of
new technologies, as well as improved
institutions. A key link has been the will-

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ingness to let underperforming entities
fail, concentrating production in the most
competitive and productive ½rms. How-
ever, the strength of this competitive
mechanism seems to have waned in recent
years, and without a new wave of reform,
productivity growth will continue to slow.
Productivity is not simple to measure;
there are time lags both in the appearance
of productivity effects and in our ability
to measure them. So by the time econo-
mists have formed an academically rigor-
ous judgment, it is quite late to do any-
thing about it. But in the interim, policy-
makers will look at growth rates com-
pared to investment rates. There are many
reasons why growth should slow, but as
long as investment rates stay high, policy-
makers will take declining growth rates
as evidence that something is wrong with
their system’s productivity, and will be
motivated to push harder for reforms.

Second, the limits to investment-driven
growth are appearing. China was able to
sidestep the worst of the global ½nancial
crisis by increasing domestic investment.
gdp growth scarcely dropped because the
increase in domestic investment almost
completely offset the drop in net exports.
But this success was achieved at substan-
tial cost. Because the stimulus program
was so rushed, some unknown proportion
of new investment was doubtless wasted
on useless projects, although we have no
way of knowing how large that propor-
tion is. More fundamental, as Figure 2
shows, the investment surge of 2009 was
not a one-off stimulus. Instead, China’s
investment rate moved more or less per-
manently to a higher level. Since 2009,
China has been investing a remarkable 48
percent of gdp. An investment effort of
this magnitude is completely unprece-
dented for a large economy. Japan, Korea,
Malaysia, and Thailand all drove growth
with investment, but none of them ran
investment rates that exceeded 40 percent

for more than a couple of years. In 2007,
Premier Wen Jiabao described China’s
economy as “unstable, unbalanced, un –
coordinated, and unsustainable,” and
since that time, the unprecedented de –
pendency on state investment has only
further unbalanced the economy.

What’s wrong with this investment-
driven, unbalanced growth? After all,
investment-led growth has served the
Chinese economy well over the past two
decades. One of the great paradoxes of the
Chinese economy is that although house-
hold consumption is an unusually low
share of total gdp (35 percent), household
consumption has also grown extremely
rapidly over the past decade, only not as
fast as overall gdp. And if you can have
both more consumption and more in –
vestment, why not have it all? Well, be –
cause it is probably just not possible.
Economists do not have any logical limit
to how high a country’s investment rate
can be, or for how long. But all previous
high-growth economies have eventually
come to a point where investment rates
subside, and usually at levels well below
the current Chinese level. In the past, with
unlimited supplies of labor, investment
was the key growth driver. All that was
needed to bring that labor out of the coun-
tryside was new industrial plant and infra –
structure. Moreover, as a follower econo-
my, planners and businesses could focus
on transplanting business models, tech-
nologies, and infrastructure layouts from
developed countries. The system delivered
investment, and investment delivered
growth. That equation is no longer so sim-
ple. Matching the right investment to the
evolving needs of the economy is becom-
ing much more dif½cult. The fundamental
infrastructure framework China’s plan-
ners copied from more advanced econ –
omies is nearing completion. Meanwhile,
excess capacity has emerged in many in –
dustrial sectors as the economy has slowed.

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143 (2) Spring 2014

Figure 2
Investment and Net Exports (Share of gdp), 1978–2012

China’s
Economy:
Compla –
cency,
Crisis
& the
Challenge
of Reform

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Source: Chinese of½cial data, updated most recently with the National Bureau of Statistics, Zhongguo Tongji
Zhaiyao 2013 [China Statistical Abstract 2013] (Beijing: Zhongguo Tongji, 2013).

These suggest that China may be ap –
proaching the limits of this development
strategy. Moreover, investment has an in –
herent tendency toward instability, since
it is driven by investors’ expectations of
the future. While consumption is relatively
stable, investment is subject to the “ani-
mal spirits” of those making decisions. In
China, the government’s willingness to
serve as the reliable investor of last resort
has also kept the investment propensity
of private businesses high. The two have
been in a productive symbiosis that thus
far has served the economy well. As the
momentum of the economy slows and
existing opportunities close off, the danger

rises that investment from the private sec-
tor will drop.

Third, past investment excesses have
already created ½nancial fragility. The huge
quantity of new ½xed assets the Chinese
economy has created over the past ½ve
years is just now coming onstream. Many
of these assets are housed in corporate
structures that have no good business
model. The extreme example is China’s
gleaming new high-speed rail network.
The system has a current debt load equiv-
alent to $429 billion. Whether or not a massive high-speed rail is worth building is one question–about which opinions differ–but whether there is a revenue 20 Dædalus, the Journal of the American Academy of Arts & Sciences model to service this enormous debt is another question altogether. Outside of a few high-capacity lines like Beijing-Shang- hai, most observers doubt it. The challenge is mirrored by literally thousands of local government projects and “funding plat- forms” around the country. Encouraged to invest following the global ½nancial crisis, these local governments now face debts they cannot service with the income streams they can plausibly generate through user fees and sales revenues. In the aggregate, this debt amounts to more than $1.6 trillion, by of½cial estimates. Put to –
gether, these two debt loads amount to 25
percent of China’s gdp.

Chinese regulators and ½nancial sector
of½cials are well aware of these problems.
They have been pushing China’s state
banks to increase bad loan provisions and
raise capital; they will certainly not be
caught by surprise. Nonetheless, the hard
work of actually restructuring these cor-
porations has barely begun. Indeed, it can
hardly proceed in the current inherited
environment: credit is still flowing freely;
shambolic state-backed corporations have
easy access not just to bank loans but also
to nascent bond markets; and govern-
ments turn to short-term ½nancial mar-
kets to fund long-term debts. Some kind
of credit squeeze will be necessary to
drive forward ½nancial restructuring,
and both the squeeze and the restructur-
ing will be painful. Yet the longer ½nancial
restructuring is delayed, the longer re –
sources will flow into low-productivity or
no-productivity projects and corporations.
The creation of a vast sector of “zombie
½rms,” neither dead nor alive, would ulti-
mately create a far larger and more dan-
gerous risk of ½nancial panic and collapse.
The relevant comparison is with Japan in
the 1990s, when the delay of ½ nancial re –
structuring kept numerous zombie ½rms
alive, and kept the economy from recover-
ing for an entire “lost decade.”

Fourth, China is going through profound
changes in its labor markets that point to
substantially slower growth. For decades,
employers had been able to hire at will
new workers migrating from the country-
side, offering a wage that changed little
through the 1990s and early 2000s. But
some time after the mid-2000s, competi-
tion for workers began to drive up un –
skilled wages. By 2012, real wages for mi –
grant workers were two and a half times
what they had been in 2003, increasing
by 10.8 percent annually. This dramatic
change in labor market conditions led
many observers to proclaim “the end of
cheap China.” The sudden change also
revived interest in a so-called Lewis turn-
ing point, a structural shift that occurs
when the reservoir of surplus labor in the
countryside is ½nally depleted, and em –
ployers have to pay higher wages to draw
people out of agricultural work.6 In past
Asian growth “miracles,” the arrival of a
Lewis turning point often signaled the end
of the very-high-growth period. Rapid
growth of unskilled wages tends to force
the end of an early growth phase led by the
export of labor-intensive manufactures.
Economies start to lose comparative ad –
vantage in clothing, shoes, and toys, and
export growth becomes a less important
demand-side driver of growth. These
forces are now operating in China, and
since export demand from the European
Union, Japan, and the United States is likely
to be weak for the immediate future, ex –
ports will make a much smaller contribu-
tion to China’s future growth than they did
during the past decade.

Just as rural labor surpluses were be –
ginning to disappear, China reached
another crucial turning point. In 2012, the
population at working age began to de –
cline. This is an entirely different type of
demographic transition, accelerated by
China’s draconian birth control policies.
Previously, China had been experiencing

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143 (2) Spring 2014

China’s
Economy:
Compla –
cency,
Crisis
& the
Challenge
of Reform

a “demographic dividend” in which the
population at working age was growing
more rapidly than the overall population.
As a result, dependency ratios decreased
and the work force became younger and
better educated. However, as the essay by
Deborah Davis in this issue details, China’s
demographic dividend is now exhausted–
as it eventually had to be–and China’s
population has begun to age and experi-
ence a higher (elderly) dependency ratio.
The working age population has reached
a plateau, and will start to decline rapidly
in absolute size by 2020. The fact that the
Lewis turning point and the end of the
demographic dividend are occurring at
the same time means that the shift in
labor force conditions will be unusually
abrupt. For comparison, Japan’s labor
force began to shrink about twenty-½ve
years after the end of its high-growth era–
when the country was already quite rich–
and Korea’s labor force began to shrink
about ½fteen years after the end of its high-
growth era. In China, these two changes
are occurring simultaneously.

The structural changes in China’s labor
force mean growth is bound to slow; but
this does not have to be a bad thing. After
all, higher wages mean that incomes are
growing, that people are better off, and
that there is an opportunity to shift the
pattern of economic development so that
it provides a greater share of output for
household consumption. Moreover, China
is a huge continental economy and does
not have to tie its economic growth only
to its export strategy. Chinese incomes
overall are still relatively low and there is
plenty of room for catch-up. So this struc-
tural change is a huge challenge, but not
necessarily a looming disaster. This is a
transition that must be managed carefully,
but one that can lead to a much more pro-
ductive and capable society overall. Here,
though, the record of Asia’s earlier “mir-
acle economies” advise caution. When

economies such as Japan, Korea, and Tai-
wan moved out of their very-high-growth
phases, they each faced major challenges
to their growth models. Japan’s growth
rate dropped sharply in 1973, and then
again in the 1990s. Never again did Japan
come anywhere close to replicating the
high growth rates of the 1950s and 1960s.
Similarly, the end of the Korean high-
growth phase in 1997 arrived with the
Asian ½nancial crisis, massive ½nancial
distress and restructuring, and a perma-
nently lower growth rate. The evidence is
clear that if China does not handle this tran-
sition well, it could have a substantial eco –
nomic price to pay.

At this point, a broader argument about

the nature of China’s economy and society
comes into play. Typically, as forerunner
economies have reached the end of their
high-growth phases, they have upgraded
into high technology and more sophisti-
cated sectors. China clearly hopes to follow
this lead. To prepare, China has invested
massively in university education since
2001, and has also begun to pour govern-
ment money into research and develop-
ment in promising “emerging” industrial
sectors. Last year, China invested just shy
of 2 percent of its gdp into research and
development, a sum much greater than
that of other economies at comparable
levels of gdp per capita. But ordinarily,
forerunner economies have facilitated this
upgrading process by transitioning into
more of a “light touch” role for government
support for development, and a broader
liberalization of economic and social con-
ditions. Thus, the government typically
hands off more of the responsibility for
development to the private sector, and
relies on dispersed entrepreneurship to
identify and exploit the promising new
sectors. In China, the movement in recent
years has not been in this direction. Gov-
ernment, flush with money, has stepped

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up its own direct role in technology
research and innovation. Entry barriers
that have long since fallen away for ordi-
nary manufacturing sectors are still in
place for high value services such as ½ –
nance and information (including Internet
businesses). There is a very real danger
that a top-down, state-directed program
of innovation, combined with state con-
trol of large swathes of the economy, will
end up retarding China’s essential gradu-
ation toward an innovative, diverse, and
resilient economy.

Today’s China clearly faces a set of
challenges that are different from those
in the past. China must upgrade the quality
of its human resources; identify the sec-
tors, products, and services where oppor-
tunities lie; and transition from a follower
economy to a position at the global fron-
tier in numerous sectors. Can it do those
things without also further scaling back
the power of the state, eliminating visible
and invisible barriers to the growth of
innovative businesses, and empowering
households to make more of the funda-
mental economic decisions? It seems un –
likely, which leads us back to the problem
of economic reform.

The reform proponents’ arguments

about sustainability have a high degree of
internal coherence, and also great immedi-
acy. In the ½rst place, the current changes
in the external economic environment
are obvious for all to see. Slowing labor
force growth, soaring wages, and rapidly
changing cost structures and competitive-
ness are part of daily life for all Chinese
citizens. But these changes directly imply
that the existing economic strategy has
reached its limits. In fact, all four of the
fundamental challenges described above
are reaching a climax at the same time.
Investment-led growth is running out of
steam just as the productivity dividend
from previous reforms risks reversal.

Structural changes in the growth poten-
tial are intersecting with ½nancial fragilities
linked closely to the post-2009 investment
surge. Growth slowdown will force the
hand of policy-makers. Otherwise, the
danger that unaddressed problems will
lead to a broader loss of con½dence may
grow, and threaten the system’s ability to
stably reproduce itself. The reformers
argue that without further market-oriented
reform, there is no way to resolve these
challenges. In a sense, Xi and Li have in –
herited a situation that is the exact oppo-
site of the one inherited by Hu and Wen ten
years earlier. The Xi–Li economy looks
good, but it comes with a legacy of deferred
problems and unresolved issues. Xi and Li
still have a chance to address these prob-
lems, to move China toward a path of sus-
tainable, but slower, growth, but they have
to do so promptly, before a host of bills
comes due. The timing of this is not under
the control of Chinese policy-makers.

By tradition, one year after the Com-
munist Party Central Committee is ½rst
empanelled, each new Chinese adminis-
tration convenes a Third Plenary Session
in order to lay out its economic program.
In the past–especially in 1978 and 1993–
this Third Plenum has marked a turning
point, the initiation or revitalization of a
major reform program. Xi Jinping and Li
Keqiang convened their own Third Plenum
from November 9 through November 12,
2013, and produced a strong reform docu-
ment that addressed key economic issues
while also expanding well beyond the
strictly economic realm. The document
that emerged is best characterized as part
vision statement and part to-do list. The
vision statement is an essential part of a
document of this type, which emerges out
of a long consensus-building process with-
in the Communist Party leadership. This
process tends to generate broad statements
of principle, plus (at best) a few compelling
slogans. To a certain extent, the 2013 Third

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143 (2) Spring 2014

China’s
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Compla –
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Crisis
& the
Challenge
of Reform

Plenum resolution shares these features,
but the content is surprising. It calls for a
rede½ned role for government, with gov-
ernment playing a reduced role in micro-
economic decision-making, the market
playing a “decisive role” in resource allo-
cation, and the development of new
models of social governance. It does not
shy away from key areas of ½nancial and
½scal reforms, and it marks a clear effort
to revitalize reform in the state-owned
enterprise sector. This vision is surprising
because it revives a rhetoric and vocabu-
lary not much in evidence in China lately,
and it charts a course that is very different
from many of today’s policies. The to-do
list, meanwhile, is extremely ambitious.
Laid out in sixty articles and comprising
well over three hundred policy measures,
the to-do list commits the regime to an
impressively broad array of actions, rang-
ing from relaxing the single-child birth
control policy to increasing the share of
dividends that state-owned enterprises
hand over to the government and its social
welfare funds.

The Third Plenum resolution is best
understood within the context of achieve-
ment, change, and credibility crisis de –
scribed above. Xi Jinping and Li Keqiang
–and their secretaries and advisers–
clearly exerted a major effort to make the
Third Plenum resolution a credible docu-
ment that would generate momentum for
the reform process. In the ½rst instance,
they did so by producing a plenum docu-
ment that was simply bigger than many
people expected: it was both broader and
more detailed than most previous docu-
ments. Moreover, the overall approach of
the document has the potential to create
a coherent response to the multiple eco-
nomic challenges that China faces. Fi –
nancial reforms, ½scal reforms, and state-
enterprise reforms are all cued up in the
Third Plenum, and pricing reforms and a
reduction in administrative barriers round

out the core economic elements of this
initial reform package. It is striking that
the framers of the document have provided
a number of tangible commitments that
will serve as benchmarks by which to
judge whether or not the reforms are
actually implemented. Further, Xi Jinping
personally and publicly identi½ed with
the resolution in a remarkable account he
published the week following the Third
Plenum, stressing his chairmanship of the
drafting committee and his deep engage-
ment with the entire process. Xi, we would
say, took personal ownership of the docu-
ment. By crafting a document designed to
impress, by including concrete and observ-
able contents along with the more abstract
goals, and by encouraging personal iden-
ti½cation with the resolution, Xi Jinping
is clearly signaling his intention to pur-
sue this agenda.7

Of course, actually implementing these
ambitious goals is far more dif½cult than
merely stating them. This, in turn, leads
to our ½nal question: can Chinese policy-
makers act preemptively, dismantling their
own special privileges, before the arrival
of a serious economic crisis? The ques-
tion is not only whether reform propo-
nents can overcome the entrenched power
of vested interests, but also whether they
can overcome such power in the absence
of a full-blown crisis. If the chances for
renewed market reforms were assessed
solely on the basis of short-run economic
and political conditions, it would be hard
to be optimistic. In that sense, both the
complacency and the crisis of con½dence
would be justi½ed; it is dif½cult to make
an argument for change based on a crisis
that has not yet hit.

But at the end of the day, the reformers
are right that only major institutional
changes that make the economy more
open, competitive, and rule-bound can
avoid the serious problems looming over –
head. Even these reforms will require

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adept policy-maneuvering to avoid sub-
merged obstacles. The reformers are right
about impending changes and potential
crises, and they are right about the type of
economy and society that China must
become in order to be technologically
creative, institutionally flexible, and sup-
portive of a high standard of living for a
majority of its citizens. China must make

Barry
Naughton

the transition to a lower growth rate, but
in the context of a wealthier, better-off
society. It absolutely has the capability to
do so, but policy-makers must summon
the will and determination, craft an ef –
fective proposal, and push for a renewed
domestic and foreign opening of the
economy.

endnotes
1 National income, expenditure, and ½scal data in this paper, including those used in Figures
1 and 2, are Chinese of½cial data, updated most recently with the National Bureau of Statistics,
Zhongguo Tongji Zhaiyao 2013 [China Statistical Abstract 2013] (Beijing: Zhongguo Tongji, 2013).
gdp from the production and expenditure side, see p. 19, 33–35; ½scal data, see p. 72–73.
2 Wu Jinglian, “Toward a Renewal of Reform,” in Wu Jinglian: Voice of Reform in China, ed. Barry
Naughton (Cambridge, Mass.: mit Press, 2013), 12. Wu is quoting his close friend Zhang
Zhuoyuan.

3 Li Keqiang’s remarks reported in Du Yongtao, Fu Yingnan, Wei Xi, and Liu Yang, “Li Keqiang
Emphasizes that the Biggest Dividend that China Enjoys is the Reform Dividend” (in Chinese),
People’s Daily Online, November 22, 2012, http://½nance.people.com.cn/n/2012/1122/c1004
-19667962.html.

4 Chinese currency values have been converted to U.S. dollars at prevailing exchange rates,

and deflated by the U.S. Consumer Price Index.

5 Daisuke Wakabayashi and Min-jeong Lee, “Samsung’s ‘Good’ Problem: A Growing Cash Pile,”
The Wall Street Journal, May 8, 2013, http://online.wsj.com/article/SB10001424127887323798
104578454440307100754.html.

6 Migrant wages from Feng Lu, “Consolidation or Stimulation? Remarks on China’s macro-
economic situation and policy,” U.S.-China Economics Dialogue, Beijing, June 19, 2013. For a
good collection of academic articles on the Lewis turning point, see the 2011 special issue of
China Economic Review, especially the article by the leading proponents of this view, Cai Fang
and Du Yang, “Wage Increases, Wage Convergence, and the Lewis Turning Point in China,”
China Economic Review 22 (4) (2011): 601–610. The empirical evidence in favor of the Lewis
theory in other developing economies is mixed, but China ½ts many of the Lewis model’s
predictions. Moreover, China has unique institutions that make the basic Lewis assumption
of surplus rural labor more plausible, including collective land ownership and institutional
barriers that retard rural-to-urban migration.

7 Chinese Communist Party Central Committee, “Resolution on Several Important Issues on
Comprehensively Deepening Reform” (in Chinese), November 12, 2013, http://news.xin
huanet.com/politics/2013-11/15/c_118164235.htm. Xi Jinping emphasizes his personal role in
Xi Jinping, “An Explanation of the ‘Resolution on Several Important Issues on Comprehen-
sively Deepening Reform’” (in Chinese), November 15, 2013, http://politics.people.com.cn/
n/2013/1115/c1001-23559327.html. As of mid-December 2013, there is still no of½cial English
translation of the Third Plenum resolution.

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3 China’s Economy: Complacency, Crisis image

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