China: Impact of the Thirteenth Five-Year Plan

Gao Xiqing, professor at Tsinghua University; Karen Harris, managing director at Bain & Company; and CFR's Brad W. Setser join Forbes Asia's Tim W. Ferguson to discuss China's domestic economic policies and provide their perspectives on China’s influence in Asia and around the world. The panelists consider the effects of last year's turbulence in Chinese equity markets, China's official GDP growth statistics, and ongoing economic reform programs.

FERGUSON: Well, welcome this morning. Meaghan has taken care of the housekeeping announcements, so I can be even briefer before we get going here. Just to welcome you to a discussion today of the impact of the 13^th five-year plan in China. This is being held with the cooperation of the Tsinghua University Center for China and the World Economy. One bit of housekeeping, just if all of us are making the rounds in this beautiful week in New York, tomorrow evening the president of Namibia will be speaking here at the Council, so it might be a good stop as you traverse the upper east side.

This discussion today obviously is focused on the—one of the two most important economies in the world. And it is with the christening last month of the latest five-year plan after a two-year development process. It’s providing a moment in time for looking at, evaluating, and forecasting what effects that will have on the Chinese economy. I will welcome today a very knowledgeable panel. Next to me is Mr. Gao Xiqing, the professor of law at Tsinghua University and, among his many other accomplishments, the former president and investment committee leader at the Chinese Sovereign Wealth Fund. Karen Harris of the Macro Trends Unit at Bain & Company is joining us. And Brad Setser, of the Council’s Greenberg Center for Geoeconomics. So we have a very versed panel here for discussing this.

Let me set the stage for this very briefly. As I say, the five-year plan just christened now. It is like State of the Union addresses in the United States, a bit of a laundry list—60-some items included. But it is basically the agenda for Xi Jinping’s first and, likely, second term as the paramount leader, if you will, in China. It is an extension of themes that were set at the third plenum two years ago. Broadly speaking, and these are somewhat blurry and perhaps contradictory, but they are a road map for restructuring of the Chinese economy, innovation being stressed, higher-quality growth, more of a consumer economy, inclusion, shared prosperity, and an increase—an enhancement of the social safety net, an even-handedness with regard to rural and economic development and across various industries, openness, use of the markets, transparency and rule of law—with Chinese characteristics—and, of course, social cohesion and order, along with a heavy overlay of green policies in regards to China’s further development.

So let’s get into some of the specifics of that five-year plan. Professor Gao, could I ask you to focus in on a couple of them that you regard as particularly important? And I hope you will address ones that are also very difficult to achieve in this five-year span.

GAO: OK, well, thank you. I think the biggest confusion people have—or, I have, I will say—about this—the present situation is that when you—on one hand, you see a lot of things going wrong, or going down, going to certain unproductive areas. On the other hand, if you actually look at all the documents, look at all the party documents which for over the past 60 years we have been holding in our people’s words, higher than a constitution, which is the party—you know, party communique and all these party conferences. And you look at the 18^th Party Congress, you look at the third plenary, fourth plenary Party Congress, you read all these documents, it’s probably more exciting and more encouraging than anything that we’ve produced over the past 60 years, you know, including the 11^th Party Congress, which laid the map for the whole reform process because, you know, at the time, if you read the 11^th Party Congress you see—at the time, you see had a lot of the ideologically charged jargons and things you have to read between the lines.

But in the third plenary of the 18^th Party Congress, which you know only happened two and a half years ago, you read through those things. All these items, they’re all—you know, they’re so much closer to anything people would call the universal values, even though our Congress doesn’t want to say that. You know, it’s something not everyone thinks, well, OK, this seems to be the right thing to do. But first time to me, in our history, in our past 60 years of history, that the party said something, and you wait and wait and wait, and you didn’t see anything happening, or in some areas it started sort of going back almost. Some people kept wondering—and then, of course, that’s why, you know, people outside of the country are so caught up with the—you know, the five-year plan. But within China people say—you know, most people—you know, there’s nothing new there. I said, there’s something new. They said, oh no, that’s something new about the third plenary. It’s almost the same thing.

To me, it’s encouraging because at least two and a half years after, when you have the concrete plan, you know, ostensibly implementing the third plenary, you have all the right things—you know, sort of the right things to say. I mean, for instance, you’re cutting the power of the government in various ways. You are trying to streamline all the state control apparatus. You are trying to reform state enterprises. You are addressing the major issue of overcapacity in many different lines, you know, within the rust belt industries. So when you look at that, these are all correct. And the citizens there are saying, OK, so what’s new about that? They’ve been saying that for three years and it hasn’t happened yet. But to me, I said, well, at least you are not saying things to the opposite side, because, you know, if after three years you didn’t get it implemented, then you may expect someone coming out and saying: OK, that’s wrong. Now we’re doing some things differently. We’re not doing things differently. That’s the interesting part.

FERGUSON: No retreat.

GAO: At least in all these major lines, if you read the five-year plan. The problem, of course, that people ask, is that, but I still don’t see it implemented. Only last week, we got this sort of new set of the policy issues coming out, you know, basically talking about streamlining the businesses and trying to cut down overcapacity in state-owned, in coal, in these things. The interesting thing is that, you know, people keep talking about zombie companies, talking about very inefficient state enterprises. Most people, you know, wouldn’t say state-owned. They’d say, inefficient companies that we need to get rid of. But in fact, people know, 99 percent of them are state-owned, you know, inefficient companies.

For a long time the government, you know, especially State Council—we call it the North Court and the South Court. You know, in the Forbidden City, the North Court is occupied by the State Council and the South Court is occupied by the Central Committee of the Communist Party. But it was, like, well, the North Court has been, you know, doing all these things. So they’re trying to say things, but it’s not done yet. They’re always saying, well, let’s get rid of the overcapacity. But have we gotten rid of them? The State Council has been telling everyone, OK, you need to cut—especially Hubei province—which it surrounds Beijing. This is one of the largest provinces. And that province alone has the steel capacity of over 300 million tons. You know, the whole world produces about, you know, twice as much of that much steel. And China has the capacity of one billion tons almost—you know, closer to that.

So the reason why Beijing’s so polluted is simply because of all the steel mills around Beijing. And we’re all saying, OK, try to cut that down. And for the longest time, you know, you say, well, that’s all state enterprise involvement. First time last week we heard that, OK, they are seemingly giving up the effort to say, let’s get rid of the inefficient, lumbering companies, just allow the better ones to function. What they are saying now is that, OK, we don’t care which companies you cut down, just cut down by 13.5 percent—period. I don’t care if you cut down the most efficient ones, so be it. Every province is getting the order to cut down by 13-some percent of their capacity. This is—you know, this is—again, to me, this is very interesting because it shows—first of all, it shows that central government is finally coming out with a number. That’s good.

But, you know, on the other hand it’s so bad that, you know, finally they are admitting that they are not going to be able to control—you know, to control the overall, you know, comparison between the efficient and inefficient. And they’re basically giving up what the party said, you know, the 18^th Party Congress, that let market be the decisive force of allocating resources, which to me is the most exciting thing. Over all these years, because all these years we’ve been trying to push it, you know, to make it more market-oriented. And we’re always saying a little bit—you know, haphazardly saying, OK, let’s allow the market to play a little bit of a role. Finally, the 18^th Party Congress, let the market be the decisive force. Are we allowing to be the decisive force? It doesn’t look like it.

FERGUSON: Is this tension, which is manifesting itself in the efforts on the one hand to restructure the big state-owned enterprises, but also now to extending more credits to them, keeping as much as possible the employment base, does your analysis of the South versus North Court explain this tension, the State Council versus the Central Committee?

GAO: I understand that this is open to the media?

FERGUSON: Indeed it is.

GAO: So I personally do not have any comment on that, in case—because I’m still under heavy supervision on these things. But my sense basically on these things is that it’s not even a—you know, because in many—the historical junctures in the past, in ’89 or, you know, ’76, you always—you could see some sort of opposing factions there. This time around, you just—you know, my biggest fear is not even that. If there are two factions fighting with each other, at least you know which side you want to be with, right? And there what I’m saying is that, you know, everyone seems—it makes perfect sense for both sides, or, if you have two sides, to agree on certain things.

But it doesn’t seem to be the ability or—you know, when you say—when you say—in law when you say able and willing to do things, right? But the first thing—the most important thing, of course, is whether you’re willing to do it. And I mean, I start reading all the party documents and, yes, everyone’s willing to do it, but somehow it doesn’t work. Why? So my explanation of that is that it’s—this government in economic terms is very much captured by different interest groups. The biggest interest group, really, is the state-owned enterprises. That’s how I see it. And I know our government doesn’t like this sort of a statement, but it’s true.

You know, because I, myself, come out of a state enterprise. I worked for several different ones. I was the CEO of Bank of China International and I was president of the Chinese Investment Corporation. But when you—you know, when I was there, I was always encouraged because I could do things. Today, you know, if you talk to individual CEOs and some people say, well, I’m pushing forward, I’m trying to do things. But overall—if you look at overall, across some spectrum, then many people say, OK, we don’t want to do too much because of various reasons. But everyone, of course, is laying the blame on someone else. Saying, oh, it’s anticorruption thing. Oh, they are overextending on these things, so that our people are not incentivized to do things, things like that.

But my problem is, I’m confused because, you know, if you have all the willingness, it’s so much easier, you know, for the parties just to push something if there are these people—and try to go out and identify these people who are against these things, you can’t see any particular person. Nobody comes out and says: I’m against it. I want to say, you know, Mr. Xi’s great and let’s all follow him. You know, we have these problems.

FERGUSON: Going back to the five-year plan, and its laundry list, if you had to identify one bellwether for whether the great reform movement is going to succeed, and we can all be watching this over the next year or two, is there a particular one you’d point to?

GAO: Well, I usually point to two indications. It’s not on they—you know, not clear on the plan itself, but it’s very clear on the moves. If you—let’s say in the next year or so if you hear one of two things you think, well, this is better, this is going more proactive. One is for the streamlining of the government. You know, this is something that has been said by both the Party Congress and by the premier himself, repeatedly. You know, Mr. Li over the past two years, every time he comes out he would almost always mention these two terms, called the power list and an negative list.

And especially that second one, an negative list, because lawyers here all know that here, you know, you have in this country your government—your, you know, Congress or whatever—they always have sort of enumerated power. So for those powers that are enumerated in your, you know, Constitution or something, they have that power. Anything that’s not written there, you don’t have that power. This concept is not accepted by the Chinese government for the past 2,000 years. Our government has always been on the position that, you know, I’m everything, you have nothing sort of thing. But then for the negative part, you know, it’s like—it’s, again, this is 800 years of history in Europe and here, that that which is not prohibited is all allowed. But that has always been the opposite in China for all these years. We always say that which is not allowed is prohibited.

But now, the government, first time over the past three years, repeatedly come out and say: OK, let’s come out with some negative list to tell people these are the things you cannot do. If it’s not listed in this list, you do it. So far, we’ve seen that only in international arena, in Shanghai free trade zone. They say, OK, Shanghai finally came out with an negative list. Some people criticized that, oh, that list is too long, you know, 20-something list. I said, this 200-something list is much better than 2 million list, OK? It’s very good. And then they came down to 100-some items. So if you see that—but, Mr. Li Keqiang, the premier, repeatedly tells people, OK, why don’t you, all these ministries, come out with an negative list? So far, we haven’t seen many. But we see, you know, very little in small places.

But we need to have these things come out. And I think it’s imminent. If things go as what I wish, or what most people think it should—well, I’m not sure about that, most of my—many of my friends say, OK, things are not going that way. But if you see things coming out like that, you know, I think things come out like that. You know, Supreme Court in China, you know, supreme—you know, you got a People's Procuratorate, which is a different system there. It’s like the top of the prosecutors. These institutions are coming out with a negative list. But of course, most people in China say, well, that doesn’t count. That’s the legal part. We don’t, you know, see that.

But even ministries come out with these things. Then you see that the government is getting serious, because first time in our history over the past 2,000 years, people can come out and say, OK, I’m doing this because you are now saying I cannot do it. Even as of today, just as of, you know, last week, when I tried to do something I say, well, I want to do this, our people out there say, no, you can’t. I said, why? He said, because this document doesn’t say you can do it. You know, that’s today. So you need that. That’s one indication.

Another indication is this whole thing that the SASAC—this is the State Administration of State Enterprises—keeps saying for the past three years that they’re coming out with a plan for state enterprise reform. We haven’t seen it yet. It comes out as some sort of a draft, not totally open, but, you know, sort of sneaking up to people and saying, you know, comment on that. And most of these plans are so bad and so—you know, it’s just the opposite of what we think it should be. So if it comes out finally and say, OK, we need to get rid of, say, 80 percent of the state enterprises, which I believe should be the case, then things would be much better.

In fact, in the past two year(s) or so it’s sort of a regressing, because in quite a few industries the oligopolies that were—you know, those were broken up, monopolies from the Zhu Rongji days. And in the past year also, several of those re-monopolized. They got together, and then formed, and they’re—with the encouragement with SASAC. So if this thing, you know, comes around the other way, then now we know that’s the indication that it’s going to a better direction.

FERGUSON: All right. Karen Harris, that brings us to the question of the use of foreign investment, foreign competition as a sort of market-driving exercise. This, again, has been somewhat contradictory in practice, if not in words, in China over the last year or two in particular. How do you see the prospects for genuine foreign investment and competition, given the counterbalancing push to aid Chinese industry?

HARRIS: I think the starting point for that is really the lens through which you view your investments in China. And many private sector executives in Europe and U.S. are used to viewing China through a similar lens, which is to say that the security of the state exists to help support wealth creation. In China’s that’s inverted. Wealth creation exists to enhance the security of the state. And that’s not to say that doesn’t happen in other countries. An example that is in the U.S., if you are doing military procurement, good luck if you’re not a non-U.S. company being the supply-chain provider for the U.S. military. So there’s a value judgement there. But it does tell you what the priorities are.

And it’s fascinating listening to Gao, because the consensus around what needs to happen to really save China from being over its skis for 20 years on the investment side is narrowing. We need to increase household consumption, while not increasing debt. Yeah, it’s simple, right? No problem. And this is complicated. But that goal is getting subsumed under security concerns. So if economic reform is seen as a lesser lever to pull in order to enhance the stability of the state, then it’s going to be sidelined. And I think your point is we’ve seen that happen repeatedly over the last five years, because of those priorities.

So as a multinational company, if you’re thinking about foreign investment into China, that’s a pretty critical lens for your success. If you’re not going to be—if you’re not understanding that priority list and where your investment sits on it, then it’s going to be challenging. So certainly there have been some investment successes, but those have been quite narrow. And I think reading the kind of economic indicators that business people are used to reading—the topline GDP growth, or numbers of X job creation—aren’t helpful.

And those average numbers in China, of course, are tremendously misleading, if you think about—look at our panel, right? So the average panelist is three-quarters male, one-quarter female, and, you know, about five-foot-eight. (Laughter.) That’s not all that helpful, right, from a diligence perspective. And that’s exactly what’s happening if you’re looking at some of these topline numbers and not really digging into sectors. But I think really it’s that—it’s that prioritization that matters. And that’s going to, again, have an impact on whether or not the partnerships with foreign companies are successful.

FERGUSON: Is there a bellwether reform that you would look to, either a symbolic or a substantial one, that would reassure you that they’re serious about market reform?

HARRIS: Well, there are two pieces that I haven’t seen yet in any meaningful way, that I would look to. And it’s, again, those two basic metrics: Is credit being contained? As we see sort of lurching reforms there with some pullback in credit. We’ve seen loosening of credit, and of course the property market in tier one cities reacted accordingly. We haven’t seen meaningful reform in terms of household spend. And the numbers that have been thrown out as indicative of it I find uncompelling. For example, yes, service-sector jobs have been growing. That is—that could be positive.

But if you, again, break that number down—first of all, service sector jobs aren’t necessarily higher paying jobs than factory jobs. In fact, you get a lot more productivity by adding a machine to a human than you do by creating a noodle vendor on the corner. And if you look at where the service-sector jobs are coming from, a third of them are large companies—or it’s somewhere between a third, maybe 30 percent. Between two-thirds and 70 percent are sole proprietorships, which is to say bodegas, right, or single-operators operating companies.

And those are not jobs that are leading to higher wages, high household spend. You can put a hoodie on a noodle vendor, but that doesn’t make him a tech entrepreneur. And so when you have that kind of—those sort of numbers, you’re not really—household spend, the average wages are going down. And without big wealth transfer—so if you followed the Gao plan—it’s not the Gao plan, for the media—if I drew my—Karen’s version of what I heard Gao said, and if we got rid of 80 percent of state enterprises and somehow transferred those assets to households, that would be a huge step forward, because you wouldn’t be raising debt, you’d be taking away excess capacity and be increasing household spend.

I’m not holding my breath for that to happen. And that’s hard. This is not—this is not a criticism of the Chinese government. That kind of dramatic reform is not something that can be undertaken easily or lightly. But within the absence of that kind of strong activity, it’s going to be very challenging to see China get anywhere near the growth rates that it projects. Could it grow at 2 percent? Maybe. But 6 to 7 percent seems ephemeral in light of the kind of structural changes that are needed.

FERGUSON: Brad Setser, China, of course, is an increasing influence on the global economy—what happens in China. But also the global economy influences events in China. Is the carrying out of this five-year plan in some sense dependent on what’s happening in the world economy around it?

SETSER: Yes. You know, the external environment supports China through China’s export sector. And the external environment, given that China’s currency is still more or less linked to the dollar, the path of the dollar has a rather significant impact on China, on China’s monetary policy, and on China’s capacity to achieve some of these goals, at least in a sense of how supportive the external environment will be. I think actually China’s impact on the world, though, is in some ways more interesting, because many of the reforms which are positive for China’s long-run development, as I think we have seen over the past two years, can be quite negative on other parts of the emerging world.

And by that, I mean, if you think about China’s macro economy, China stands out along two dimensions. One is that the state plays a much bigger role across a much broader set of sectors than is typical in any advanced economy, any big economy, and it’s hard to find other emerging economies, although I’m sure you can find one. But then the second is that China has an exceptionally high level of savings that has supported an exceptionally high level of investment. And a lot of the reforms have the character of lowering, at least in the near turn and probably over time, that level of investment.

And it turns out that Chinese imports, at least under the current structure of trade, are much more tied to the investment side of China’s economy than to the consumption side of the economy. So as investment pulls back, you have a very clear impact on commodity exporting economies throughout the world. And there is, in the short run, at least over the past couple of years, there’s been a pretty significant negative shock from reforms that are viewed insufficient inside China. And so I do think that there are very profound spillovers there. And there are also fairly profound spillovers if the rebalancing that everyone discusses comes through a significant fall in investment, but there’s no change in savings.

In macroeconomic terms, that means a bigger current account surplus. In domestic terms, that means there won’t be enough jobs. And in external terms, that means there will likely be a devaluation. All of which would imply that China, rather than shifting its economy towards the consumer would be shifting back to exports. And I think that is a very real risk if the rebalancing and restructuring of China’s economy is not carried out successfully. And that’s, in my view, why some of the reforms that would lower savings and support the consumer side of the economy are vital not just for China but for the world.

FERGUSON: What about one Chinese export that is very much a matter of the moment, but really isn’t dealt with directly by the five-year plan, the export of capital—the outflow of capital from China and its potential effect on the currency. Is that kind a joker in this deck that could change the picture in terms of implementing the reforms?

SETSER: Yes. You know, let’s—I kind of push back a little bit against implementing reforms, because it leaves out the question of the sequencing of reform. And to my mind, China has already made an error, not by—in the sequencing of its reform on the financial account liberalization. China pushed forward quite far on financial account liberalization. And there was a big run-up in short-term cross-border borrowing, which after the August devaluation, August reform of the fixing, reversed itself very suddenly and led to very large capital outflows. The classic sequencing is that you first need to recapitalize your banks and first need to move towards more flexibility. And only after you’ve done those two things do you liberalize the financial account.

So this is not a case of where China didn’t reform, but it is arguably a case where China got the sequencing off. And that contributed unquestionable to the pace of outflows. The difficulty China faces is that the choices in China’s exchange rate management could quite easily trigger large-scale outflows. We saw that. The classic case for outflows comes if you signal that you want a weaker currency but don’t allow the currency to move today to its weakest state, because everyone says, I want to get out ahead of the next big move. And that process clearly played its way out in August, and it clearly was what was sort of so heavily on the market’s mind in December and January.

However, when China has taken steps to signal that it wants currency stability, the pace of outflows seems have to have moderate—seem to moderate. And so I do think there is a path by which China can both reform and avoid a big depreciation. But it’s a difficult one.

FERGUSON: We’ll go to members’ questions in just a moment, but, Gao, I’m interested in your view on this, about the ability to essentially control the capital outflow dynamic, and how it might bear on the reforms. Do you have a sense of whether that’s within the management capability of the state?

GAO: Capability, I would say, yes. Willingness, I don’t know. About two months ago in—during the Davos conference, many people were talking about the problem with the Chinese currency and other things. And at the time, people thought that China wasn’t going to be able to control it. And I talked to many CEOs of major investment banks and companies when I saw them and they all said, oh, when do you expect the Chinese government to totally close off the—you know, to have a sudden break on capital outflow? And we’re—you know, I said I wasn’t sure. I thought it could happen anytime, you know, based on my past experience. But, you know, two months has passed and the government doesn’t—you know, hasn’t done anything on that. In fact, the things—the fear, the sort of panic seems to have subsided.

So, you know, when I talk to many of my former colleagues at the Central Bank. And as soon as you touch this point, they all stop short of saying anything. But I get a sense that it is a problem, but they have to juggle these two very difficult decisions. And one thing particularly that, to me, enlightening, is that—this is the word of a very important person there—he said, just think about it. You know, so much, as we’re saying, we try to control, you know—capital account, you know, we allowed the current account. But when you—when you actually look at the difference between these two accounts, the line between them becomes so blurred over the past 10, 20 years, it’s no longer possible to, you know, take it apart.

And now, if you consider the number of Chinese, overseas Chinese, who deal, you know, substantially with the Chinese economy, it’s 50 million—50 million Chinese outside of China, OK? Second number they gave me: last year 120 million Chinese traveled outside of China and, you know, did all these sightseeing tours, and all that sort of thing. And then, as of now, about 3 million Chinese students are studying, you know, mostly in this country and many in other countries. So the person told me—he said, look, if you think about these numbers, you know—you know, you can’t actually—you know, it’s very difficult for them to really put a wall somewhere and pull China back into the old days of total foreign exchange control.

So that’s why the—I think that at least the present leaders should be—in the Central Bank—you know, they are definitely—they are—you know, they are known to be illiberal on that side. But even with the pressure from—(inaudible)—they still—you know, there’s a lot of pushback there. Even with the people who are saying, no, you should close it down, you stop the capital outflow, they can’t do it. If they start doing that, things will be a lot worse. And right now it seems like, you know, things are much better for them with, you know, the recent change of the—of the trend.

FERGUSON: Mmm hmm. Yes, at least two months now, right? (Laughs.)

GAO: Right.

FERGUSON: Well, there must be some follow up on our interesting start of the discussion. It’s a long list of five-year plan items, or other matters related to China. You have some real experts here willing to jump into this. Until we have a question, I want to raise the issue of—oh, Liz, you jumped to the fore.

Q: Sorry, I was going to be generous and let the members start, but let me—let me start. Thank you for just really a terrific discussion already. I want to pick up on Karen’s humorous remark about putting a hoodie on a noodle vendor, and does that make a tech entrepreneur, and ask anybody on the panel to talk a little bit about the tech sector, because we read a lot about what’s happening in sort of Chinese, you know, college students now being much more entrepreneurial, being willing to drop out and, you know, start their own firms. Can you talk about how you anticipate the tech sector developing in China, given sort of the educational system, given any other constraints you might sort of see around it? Is it real, or is it a bunch of froth, or what’s going on?

FERGUSON: Anybody want to jump in on that? Gao?

GAO: Of course, as in anything else, in China you always see this bifurcating development. On the one hand, you see all these cynicisms, you know, skepticism about this thing. And you read probably, you know, over 80 percent of the comments on the free, you know, Internet part—the part that’s free—saying that, no, this is nonsense, you know, the call from the State Council saying—(speaks in Chinese)—10,000 people being innovative, you know, like everyone trying to get into that. People say, oh, that’s another round of having old retired people giving money to their kids to squander, and then eventually lose all their retirement.

But, on the other hand, you see a lot of encouraging trends there. First of all, it’s true that—you know, because I teach at university now. I teach at Tsinghua University now. On a daily basis, I deal all these youngsters. And people are getting much more enthused about coming out, working on something new, something technical, rather than going into a state enterprise, or going into—like, for many years in the past, going into the government. Because, you know, the national exam as a public servant had been the largest exam in China other than the—you know, the college entrance exam, because everyone wanted to get into the government, even though government pays so little.

So people always thought, well, it’s because these people want to get in and to get benefit from the—you know, either corruptive practice, or anything else. But this—now that trend seems to be slowly changing to the other side. Youngsters no longer, you know, treat that as the most important thing. And secondly, you know what, I have a group of people in Beijing. At first it was supposedly retired government officials trying to learn things, but eventually now—within just a little more than a year, now it’s developed into a major platform in China. We call it understanding future.

You know, a few years ago another friend of mine, who was the minister of commerce, and, you know, two other friends, we said we needed to call these youngsters, young scientists, to come in to explain to us. Once a month we had this gathering, like this, explaining to us, you know, any particular line of science. After three of those, we eventually start to control the crowd. And January of this year, we had this first annual meeting. We said, OK, finally, we are making it formal. Annual meeting, we had 800 places; we had 2,800 applicants trying to go in. And we invited all these inventors from this country, from France, from Germany, from Japan to talk in the conference.

And it got so much enthusiasm, so much attention, that eventually we were able to—this only happened one or two month(s) ago. We were—we got these entrepreneurs to donate the money to establish a Nobel Prize-type science prize, two. One is called material science, $1 million each year for the next 10 years. Another called a life science prize. And this is widely, you know, now in China now everyone’s getting excited about it. So I think it’s a—you know, it’s getting there.

But, you know, at the same time, we try to—we try to stay away from the government side, because the minister of science comes in and says, OK, well, we’d like to incorporate into our system. We say, that’s great you want to support it, but our committee is totally independent. So now they make me the chairman of the supervisory committee to make sure it’s not being interfered by anyone. So this is—I think these things are coming out. And, you know, China’s a big country. Even though many people criticize our educational systems, they are not—you know, they’re stifling, you know, they make people tunnel vision—the issue is that, with that many people, even if you get 1 percent of people coming out of it, you have a lot.

FERGUSON: Well, there’s no question that online commerce is absolutely booming there. A lot of it’s, as far as I can tell, pretty heavily subsidized by the equity investors as well as the lenders. But the social media sector is something of a conundrum. Karen or Brad, any thoughts on that, or?

HARRIS: No, I would just say, first, is it frothy? Yes. Is the tech sector in the U.S. frothy? Maybe just a little, right? So there’s a universal enthusiasm. Some of the—to the point about online—some of the most successful tech companies so far in China are what one very clever commentator terms Galapagos companies, right, uniquely situated for their isolated environment. So if you’re regulatorially protected from international competition and you have a huge domestic market and good role model, and they’ve been very success at creating last kilometer delivery and all of the items that you need. They’re not employing millions of people. So it’s not ultimately going to solve of all of China’s problems.

And it does—the tech sector actually brings up the point—and, Gao, you had raised this criticism of the Chinese education—there is an interesting conundrum about what is going to make a successful company over the next decade. And what we’re observing is that with capital labor substitution, we’ve seen the labor advantage in China collapse relative to places like Mexico, what makes a company really innovative and thrive now is a normative understanding of what delights its customers, right? And that is a lot easier to develop through proximity, but you need to have the wealth to create those—to support those companies and a lot less of this sort of export-led growth, where the cheapest product can go anywhere to serve customers. Much more localization, customization, and so forth.

That could be an advantage for China, or it could mean they are cut off from being able to access the European wealthy customers, the U.S. wealthy customers that help drive growth. So in my mind, it’s a double-edged sword, but certainly there is—there’s a there there in the tech sector, I just don’t if it’s—much like even Silicon Valley, will it save China? No, probably not. But it’s certainly an interesting element.

FERGUSON: Brad, would you put China in the top ranks technologically in the world, in terms of—just focused on the Internet here for a moment?

SETSER: It’s a small subset of top ranks, but sure. I mean, Alibaba’s a really big company. There aren’t that many non-Americans, so it’s not that hard a thing. I wanted to go in a different direction, though, because I think—let’s, instead of talk exciting high-valuation, software, social media, let’s talk boring old tech world supply chain and component manufacturing. And China is increasingly dominant in that sector. The old notion that China just assembles products at their last stage is way out of date.

What is clearly happening is more and more of the high-end components are being made inside China. And that shows up in range of data, including a very sharp fall in the ratio of so-called processing or component imports relative to China’s exports. And it’s causing important stresses on some of the other Asian economies. And yeah, you can talk about the Internet and the sexy bits, but this does have, much more so in China than in other parts of the world, a very big impact on the economy.

FERGUSON: And it is that high-quality growth that the State Council is looking for.

We have a question—two questions, three. So I’ll start with you, please.

Q: Bhakti Mirchandani, One William Street. Thank you for a wonderful discussion.

The five-year plan has a couple of elements that would promote greater societal stability, from rebalancing wealth from the cities to the countryside, to improving welfare and health care as a way to encourage households to increase consumptions, as well as social reforms, such as changing from the one-child policy. And at the same time—so all those should increase societal stability and reduce the likelihood of unrest. And at the same time, the economy is slowing, which moves it in the opposite direction. I’d love to understand what your thoughts are on that issue.

FERGUSON: Brad.

SETSER: So I actually think those soft reforms are absolutely essential, for the reasons I articulated earlier. A high level of investment, as it comes down, is a large economic drag in a narrow sense, even if it is a movement towards a more efficient allocation of capital and therefore positive over the long run. How do you offset that? You offset that by giving people confidence that they can spend, which means giving people confidence in the quality of the public health system, which in China is still fairly weak, and does need significant investments. By cross-country comparisons, China still spends relatively little on public health. And public health is one of the most important determinants of savings.

And then the other thing which is quite critical, and I think it’s critical to be able to effectively carry out the restructuring of steel companies, is that remember that a steel company, when it fires people—or, when it shuts down it fires people. And if the people are tied to their province, which probably does little more than produce steel, and cannot move without giving up their hukou—their capacity to obtain public services like education and health care is tied to remaining in a depressed community. And broadly speaking, that doesn’t work. We have a lot of experience with that in our country. What works is when people have the freedom to move within the country to places where there are jobs, and where there are better opportunities.

And in order to do so, to some meaningful extent, access to public health and to public education has to be decoupled from residency or your hukou. And the five-year plan makes some important moves in that regard. But to my mind, it doesn’t go nearly far enough. It’s incremental rather than revolutionary.

FERGUSON: So the social reforms are in the race with the restructuring and need to at least stay even. A question right here at that same table.

Q: Hi. I’m Jim Shapiro from Tata Group.

So Chinese government has made a fairly significant commitment to the Sustainable Development Goals. Could any of you comment a little bit on how serious that—you think that commitment is, and whether you think it sort of helps or hurts in terms of leveraging reform, for example, on pollution, or the environment, or climate change?

GAO: Well, I think in a way it’s—just like what Brad just said, it’s incremental. And you can see, you know, the government is making a lot of noises. And every time, you know, you keep hearing. So people become a little more cynical now, because in the early days when the government says something, we do something. It was very effective. And the causal—the relation was very clear. But now you hear a lot of noises, and on the other hand there are all these different interest groups which are so difficult to be pushed around. But it’s getting, you know, a little more and more in that direction because, you know, pollution is the one thing that’s totally different from all these other sort of, you know, types of social resources, where the government could sort of still cover up and, you know, put it under the table. But this thing, everyone breaths the same kind of air.

And there have been rumors in Beijing two years ago that—the Forbidden City’s building up a big dome over it. You know, I thought it’s a joke, and some people truly believed it. They said, well, they’re going to do that so they’re going to not worry about us. I go, that’s not possible at all. So, in fact, many people are—you know, people are getting more and more vocal about it. And, you know, so much of the control of the media—this is something that you can’t really control. You know, for quite a few years when, you know, the government was trying to stop—you know, this is only in Beijing. The government would not allow the media to report on the numbers as publicized by the U.S. embassy on the pollution, only allowed by the Chinese side. Which sometimes is the same. I’ve been comparing the two. It’s more or less the same. But sometimes, you know, American side would have, like, much more serious pollution because of where they are located.

But only in Beijing. In Shanghai, in Xinji, and other places, Americans’ would be, you know, treated the same, and you can read both. And the government is sort of—I don’t know, it’s not the government, per se. When people ask me if the government, I said, it’s one head of the nine-headed animal. So that one head probably is afraid that, you know, we don’t want people to know that. But, you know, the general awareness of it is so much so that I don’t think any government agency can really cover it up.

FERGUSON: Question back here.

Q: Hi. Matthew Hurlock. I’m a lawyer.

 My question is, with—when we saw each other in Beijing last year, one of the themes that I heard talking to people was that SOEs were not investing abroad because of the anticorruption drive, and they were afraid. My question now is with Xi—the impression from abroad is that Xi is strengthening the center, to keep stability, to be sure he’s in control of China. What effect is the fear that that is generating having on economic activity in China? Particularly, what’s it doing to SOEs in terms of freezing them or keeping them still. And also, what effect is that sort of having on sort of the dynamism of the private sector? If you don’t know what the rules are, you don’t know what the government’s going to say, that has to slow you down. What’s your perception of that?

GAO: Well, if you look at the numbers that was just out for last, you know, quarter, they—you know, on the surface it’s more encouraging because, you know, the numbers are going up. But if you actually dissect them, you find that it’s all old story of, you know, heavy investment in all these—you know. It’s almost, you know, 90 percent state enterprises going into it. So they are sort of encouraged to invest more. And the service industry is actually coming down a little bit. That’s mostly private enterprises. So, in a way, many of these private enterprises are not being, you know, very much encouraged in doing that, because of various reasons.

One of the reasons, when you—you know, when you talk about going abroad—you know, because I’ve been teaching this course on cross-border mergers and acquisition. If you look at the numbers, you know, last years—you know, these past few years there’s been an exponential increase in that number. But the number—you know, it’s interesting, because if you look at the state enterprises and the private enterprises, more and more private enterprises are to go out and start to buy things outside. And we sort of, you know, guess. And I tried to confirm that with my Central Bank and save people, and they wouldn’t—they wouldn’t want to disclose their views.

But I think they sort of—you know, they were nodding when I said, look, you know, all these—all these private enterprises are going out. Many of them, I ask them, and they say, well, it’s not only because I want to—I think it’s cheaper to buy things outside, but it’s safer to hold things outside. So many of the people are doing that. And the state enterprises are always encouraged to go out, if they can. But now, with the anticorruption, people basically start to sit there and say, OK, whatever I do, you know, there’ll be something wrong. So why don’t I just not do anything?

And my former employer, CIC, now is being very careful with whatever decision-making. Because in my days, when our typical length of decision on any particular investment would be, you know, within probably a month or two, now it’s, they say, average is six months. And most—many of my, you know, former colleagues on the lower ranks complain to me—they come to my office all the time and say, OK, well, I’ve been working on this for four months, and now, you know, we took it to the investment committee, within 10 minutes it was vetoed or it was, you know, turned down, simply because most people want to—want to see—want to be put on record that, OK, this is risky. They just want to say it so that, you know, whether or not it gets anything, we don’t care. But so long as I don’t—you know, I’m not getting criticized later if something goes wrong.

Now, that in itself is not an indication that the state enterprises are not going to work, it’s just this particular type of fear at the present time. So as soon as it changes—because you got to see Mr. Xi, Mr. Li constantly come out and say, OK, we’re not—and Mr. Wang, the czar of party discipline—saying that it’s—corruption itself is bad enough, but those people who do not work, those people who sit there not doing anything, is bad too.

So now you can see, there’s probably going to be some pushback in that regard, and by fall of next year, by summer—late summer of next year, you’ll see a lot better in that regard. You were asking about indications. By that time you will see the change of heads of many industries, many major state enterprises, and many ministries, and possibly the Central Bank, possibly the Ministry of Finance, Ministry of Commerce. If you see people coming in, then by, you know, knowing who the person will be, then you know—you get a better indication as to whether or not the government is staying forward or staying still.

FERGUSON: Interesting. Karen.

HARRIS: Well, there’s also—there’s an economic reality, Matthew. I mean, if you—there was a study done at Peking University that compared what banks were declaring as their interesting income, versus what companies were paying on their interest income. And it turns out that the return on those investments was actually 2 percent. That’s what was being collected. So if you’re a company getting a 2 percent return in China, where the laws are shifting, where there’s a lot of liquidity, where there’s not opacity, versus the same return on a corporate investment in the United States, the risk premium does kind of weight you towards looking abroad. And that’s going to be true for Chinese investors, for multinational investors too.

That has certainly had to have had some influence on the outbound M&A activity that we’re seeing there we’re seeing as well. I mean, the reality on the ground is absolutely fascinating. There was also that topline sort of outside and return aspect that will influence investment going forward.

GAO: I can give another indication of what’s going on, which is sort of what I would say is wrong with the financial system. When you—because I’ve been serving as an arbitrator in many cases in the past two years. I restarted my lawyering, but I usually—I only do the head arbitration. The one interesting thing I found is that, you know, over the past two and a half years I had all together about 15, 16 cases. Ninety percent of them were all about loan problems—someone, you know, go back on a loan. And the average contract of these loans for the—the rate of the loans, take a guess? You know, the Chinese—you know, Chinese banking loans are always regulated, and so you always have a number that’s stipulated by the Central Bank. And they always have—you have a very narrow tunnel, you know, where you can move. So it’s basically within 6, 7 percent.

But I was surprised. You know, I had more than a dozen of these cases. Every one of them has a loan rate much higher than that. And the lowest, guess—lowest loan rate for these contracts? Twenty-four percent is the lowest on these. And the highest, of course, is over a hundred percent.

But the more interesting thing is this. Last year, the Supreme Court came out with a set of what they called explanation of the laws, because our Congress moves very slowly in changing the laws. So the Supreme Court now is getting bolder and bolder, coming out to explain what the law is. And last year—last September we had a new set of rules which says—this is by the Supreme Court, not by the law—which says the courts should recognize the legality of loan agreements with a—with a rate below 24 percent. You know, 24 percent to us was always a usury rate. You know, we always thought 6, 7 percent is all right. Maybe, you know, 8, 9 (percent). But 24 percent? And then you read on, the Court says: If it’s below 36 percent, we’re not going to overturn it. So basically what they’re saying is we’re going to say it’s illegal. If it’s beyond 36 percent, that’s illegal.

So what happens is when you—so I dig harder into it and I said, why would anyone be willing to pay that much? Now you realize that most of the private enterprises do not have enough, you know, resources, and they can’t go to the banks to get loans. And the very inefficient state enterprises, and old people with power, with, you know, strings to pull, they get loans from the state banks, they turn around—you know, because steel mills and these people, they can get a loan. But even putting in—as they say, for every thousand dollars I put in, I lose, you know, a hundred dollars, so why do I want to do it? So they turn around and they give the loan to someone else, with a markup. So now from 6 percent they get to 8 percent. Then you have all these people in the middle, eventually it gets to 24 percent. And the interesting thing is that the law—you know, at least the legal system now recognize(s) that.

FERGUSON: We’re almost out of time, so let me wrap up with a pop question here, that’s not—certainly not in the five-year plan, although it has a lot to do with China and the world economy. Will we see Facebook in China in some form in the next year?

GAO: You already have it. We have a much better one, WeChat. (Laughter.) I don’t know how many of you use that. Of course, WeChat from time to time will be blocked by the government. You know, people always have ways to get around. I get WeChat every day. And every day I get a certain information which says blocked, or been reported for pornography or incorrect, you know, things. But still it’s—you know, it goes very fast. Over almost 600 million people use it now. This is the largest thing. You know, so it’s not Facebook, but in today’s world it’s become increasingly more difficult to really control information flow.

FERGUSON: Hmm, OK. Either of you happen to have a view on this?

SETSER: I think we got the answer there.

HARRIS: Yeah, that’s right. They have a better one. (Laughter.)

FERGUSON: Favorite Chinese enterprise. Well, thank you very much to the panel. Thank you to the members.

(END)