Understanding Chinese Economic Reform: Where Foreign Investors Go Wrong

By Chet Scheltema
Regional Manager at Dezan Shira & Associates
Shanghai

Recently announced Chinese economic reforms were greeted with fanfare by foreign investors, stirring expectations that broad, truly liberal economic change was just around the corner. The BBC responded by claiming that the new Shanghai Free Trade Zone is “the most important attempt at reform since Communist leader Deng Xiaoping, the architect of China’s transformation to a market economy, designated Shenzhen . . . a special economic zone in 1980.” China was finally opening up, or so foreign investors thought. Yet elation soon turned to disappointment. The Wall Street Journal noted that “one year after the launch of the Shanghai free-trade zone, promoted as a landmark effort to remake China’s economy, the project has generated few significant reforms.”

What has made the initially optimistic foreign investors grow disillusioned so shortly after?

The author would suggest that foreign investors are guilty of misunderstanding how reform is occurring in China and are victims of undue optimism. Reform and liberalization have indeed been taking place, often at a startling, break-neck pace compared with other economies; it’s just that foreign investors have misinterpreted Chinese government pronouncements, read into them their own hopes, and overlooked historic lessons about how change happens in China. It is suggested that the following three-point interpretive framework will help foreign investors more realistically assess Chinese reforms and properly set expectations.

Chinese Pilot Reforms Are “Experimental”

Recent Chinese history has been scarred by reform gone wrong. Attempts in the 20^th century to accelerate modernization and “leap” into the future led to catastrophe, the failures of which no doubt made an impression on subsequent reformers like Deng Xiaoping. As Deng opened China to market reform in the 1970s after the dark night of the Cultural Revolution, he began with a series of cautious experiments to test what worked and what didn’t, the goal of which was to find a way forward and yet contain the adverse consequences of failure. Having experienced the chaos resulting from previously ill-conceived reform, Deng was clearly determined to move cautiously and to balance the need for reform with the need for stability. According to Deng, “Not only should we push up the economy, we should also create a good social order and a good social mood.” 

Typically these “pilot” reforms (i.e. experiments) were confined to limited geographic regions in the countryside or in such places as the famous and seminal Shenzhen special economic zone. Once specific reforms within such experimental zones were tested and proven, they were then rolled out nationally or, alternatively, the aggregate of reforms of a given “pilot” could be expanded into adjacent areas or related industries, or duplicated with a new “pilot” zone in another geography. The objective was to move cautiously and deliberately to identify constructive reform, discard undesirable reform, and to then quickly implement what was proven to work well, not to rapidly introduce untested reforms with no way back, which might give rise to economic and social disruption previously experienced.As Deng once famously described such approach, China is “crossing the river by feeling for the stones” (摸着石头过河). 

So it is suggested here that one of the fundamental misunderstandings of foreign investors is that they overlook the experimental nature of “pilot” reform when it is announced, that the reform is in an experimental phase and has not yet taken final form. Only the general concept and direction have been finalized. What specific reform and change will ultimately be implemented (or be abandoned) is still very much up for discussion.

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There are numerous examples of successful reforms that have been drawn out of the Pilot Shanghai Free Trade Zone and are now being implemented more broadly. The Pilot Shanghai Free Trade Zone has been experimenting with looser capital account exchange rules. During the establishment of a foreign invested company in China, it was previously required that all required capital be injected with a two year timeframe and about one-third within six months. Nevertheless, even after the capital was committed and wired into China, it was still not freely convertible into local currency. There has historically been a tedious process for conversion where documentary support to justify such conversion needed to be produced in order for the injected foreign capital to be converted into local currency for use in business operations. These rather strict foreign currency controls have been relaxed over the past two years in the Pilot Shanghai Free Trade Zone, and the results have sufficiently satisfied Chinese authorities that there would be limited risk in implementing the reforms more broadly. Both of these capital account restrictions have officially been lifted and are now being implemented nationwide.

Reform “In Principle”

The American aerospace industry executive stared at the commercial contract worth millions of US dollars. After extensive discussions with his Chinese counterpart and careful drafting by legal counsel, the finalized document had been returned with the following words hand written across the top, “agreed in principle.”

There is much commentary on how Chinese and westerners have a different view of legal contracts. Actually, the truth is that contracts matter immensely in China, but just for different reasons and in different ways. Comparisons can be drawn between how Chinese officials pronounce reform and how Chinese businessmen prepare and use commercial contracts. Chinese leaders seek to lead in broad strokes and lofty principles leaving flexibility to work out the specifics as one goes along. Chinese history prides itself in the visionary idealism of its poet revolutionaries. These motifs remain in the official dialogue of Chinese leaders.

There is another, practical reason for remaining vague. Reform and change in China can be personally dangerous. Detailed and legalistic commitments that restrict the ability of a leader to adapt and adjust to the situation will be viewed suspiciously. When reform fails, someone will be blamed, so it is advisable to leave room to distance oneself from failure.

The author recalls a meeting with Chinese leaders where, after the author had reviewed organizational goals and objectives for the company, commented to his Chinese counterparts that the proposals should be revised to make them more practical and achievable, to which his Chinese colleagues responded dismissively. Much to the author’s surprise, practicality and achievability were viewed negatively in that context. High-level pronouncements were meant by his colleagues to be aspirational and motivational and, as said, to leave some room to distance oneself if failure occurred during implementation.

RELATED: China Announces Location of New Free Trade Zones, Expands Shanghai FTZ

And so herein lies a fundamental problem when foreign investors interpret and react to Chinese leaders’ pronouncements. They may be moved by the high-sounding language surrounding pronouncements and may also see a commitment to reform akin to a legal contract; therefore, they are understandably disappointed when the scope of actual reform is more limited than the pronouncement suggested and when the commitment they undestood and the detailed implementation they anticipated do not come to fruition.

Reform Meets Bureaucracy: Central vs. Local

Americans have a saying something like the following “all politics is local,” suggesting that the real locus of political power is found at the local level, not with the federal government. China is no different. “Heaven is high and the emperor is far away,” say the Chinese (天高皇帝远). Before foreign investors allow themselves to succumb to high hopes of Chinese reform, remember also this one thing. Change across such a vast geography and large number of giant state-owned enterprises must inevitably meet with resistance from local interests and bureaucratic inertia.

China is a vast place, and each new Chinese leader struggles to extend his influence to the hinterland. Entrenched local interests seek to preserve power and resist change. This is not only true geographically; it is also true by industry and market. In order to be successful, Chinese central-level reform initiatives have to strike a balance between pushing and cajoling a region and industry in a new direction and giving local practice and vested interests time to find a profitable adjustment. As reform progresses, some initiatives may be left behind as it becomes clear they are not workable at the local level. On the other hand, some local adaptations of reform may prove so successful and attractive that they may be adopted in reverse by the center in a new permutation as official reform.

And what about China’s vast bureaucracy of state-owned enterprises? All foreign businessmen must deal with Chinese banks, such as Bank of China, International and Commercial Bank of China (ICBC), and China Construction Bank. It can be one of the most frustrating experiences of life in China. Because each serve hundreds of millions of depositors and, at the same time, also act as the enforcement wing of Chinese government policy related to foreign currency exchange, lending, and other financial policy, they have developed immense bureaucracies. Each of these in turn have their own extensive set of internal rules and guidelines to implement both government policies and business strategies. As one might imagine, for such large organizations to change direction and implement new sets of rules and guidelines is a process that requires years. Central government pronouncements may excite foreign investors that banking reform is imminent, but one should remain cautious that actual implementation will take time and the final outcome may not be the same as initially envisioned.

Conclusion

As China reforms and liberalizes its economy, foreign investors and press should acknowledge that it is actually occurring rapidly and with great success. China’s implementation of value-added tax nationwide is an example. It began only three years ago in seminal form in Shanghai. In a surprise announcement mid-way in 2013, it was extended to all of China, excluding certain industries such as real estate and financial services. Even in these remaining sectors, value-added tax reform should be complete by the end of 2015. It is hard to imagine a more rapid implementation of a complex reform across such a vast region and economy.

But it’s just not what foreign investors were interested in, and herein lies the problem. Reading into Chinese pronouncements one’s own expectations for reform will of course lead to disappointment.

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