China Analysis – Third Plenary Session Part 2

CHINA & THE THIRD PLENUM Part 2: Analysis of the Decision on Major Issues Concerning Comprehensively Deepening Reform

20th November, 2013

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China Issues Framework to Deepen Reform Deepening economic liberalisation and enhancing the role of market forces

BACKGROUND

On 12th

November the Central Committee of the Communist Party of China (“CCCPC”) issued its communiqué marking the end of the Third Plenary meeting. The communiqué provided an overview of reforms aimed at supporting sustained economic growth and addressing core societal concerns. During the evening of Friday 15

th November the CCCPC released the more detailed Decision

on Major Issues Concerning Comprehensively Deepening Reform (the Decision) – an extensive list of more than 300 reform measures in 60 clauses across 15 chapters that will have far reaching implications for doing business with or in China over the coming years. This is the second part in our series looking at the Third Plenum. This edition focuses on the details of the Decision. Our 13

th November analysis of the communiqué is available online

1.

THE DECISION ON MAJOR ISSUES CONCERNING DEEPENING REFORM

The detail contained in the Decision reaffirms the importance of Third Plenums as a platform for instituting significant change. The Third Plenum in 1978 served as Deng Xiaoping’s platform to launch China’s opening up and reform. This latest Third Plenum may prove to be an equally important juncture in China’s development and will have far reaching implications for those inside China and those doing business with China. This Plenum put any questions on whether Xi Jinping would genuinely push reform to rest. According to State media, Xi personally oversaw the working group that led the drafting process for the reform blueprint. The process started in April this year, involved more than 60 experts and officials, and dealt with more than 2,500 suggestions from more than 100 organisations. The reform plans are characterised by a pragmatic approach that pays respect to the past while introducing important new concrete goals and actions. Gradualism will continue to define the overall process, and there will be no overnight break from current policy frameworks. The blueprint does not specify timelines for the proposed reforms beyond setting 2020 as a deadline for achieving “decisive results”. Given the nature of the blueprint and the fact its originating body is the CCCPC, this is not surprising. The government, with oversight from the newly established Central Party Leading Group on Comprehensively Deepening Reform, is now tasked with creating detailed and actionable plans to move the objectives forward. The 2020 timeline was first set in 2006 at the Sixth Plenary Session of the 16

th CCCPC with the

goal to achieve “a harmonious socialist society” by that time. Over the coming months further details will be unveiled and the actions will be incorporated into the 13

th Five-Year

Plan (2016-2020) thereby aligning critical state planning development tools and timelines.

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The reform blueprint issued in the People’s Daily on Saturday

16th November, 2013

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Core Principals Underlying the Deepening Reform As we noted in our 13

th November analysis of the communiqué, the reforms detailed in the

Third Plenum are built on a number of important principals:

Economic Reform, Not Political: Economic reform remains paramount to transform China’s economic growth away from exports and fixed investment. Western political reform is not on the cards.

Strengthening the Centre: The CPC will act as the paramount designer, coordinator and supervisor to the proposed reform. The Party will establish the Central Party Leading Group on Comprehensively Deepening Reform to design reform plans and to coordinate and supervise the implementation. The Party will continue to play a leading role in overseeing reforms decided at the Plenum.

Role of the Market: A greater emphasis will be placed on allowing the market to play a “decisive” role in the allocation of resources. The core solution to economic reform lies in defining a proper relationship between the government and the market.

Role of Public Sector: Equal importance is placed on the development of the public and non-public sectors. However, the basic economic system depends on public ownership as a cornerstone of its long-term success.

Changing Role of Government: The role of government in the economy must adapt to match the developmental position of the country. The authorities will continue to reduce bureaucratic red tape and improve coordination between the centre and the provinces with the support of fiscal and taxation reform. At the same time, the public should have the ability to scrutinise the use of power and “let power operate under the full glare of the sun”.

Balancing Power and Supervision: Many of the policies and directives ultimately balance the authorities desire to decentralise power regarding day-to-day operations and management of the country while maintaining a centralised supervisory power.

The basic philosophy embedded in the reform programme is to differentiate and redefine the roles of government, market and societal entities so that the government can focus on ensuring fairness, justice, rule of law and providing services. The role of the market can then be allowed to have greater play in efficiently allocating resources and determining pricing, while social entities can support dispute resolution and provide stability. The full implementation of the reform programme will fundamentally change the way the authorities govern China, accelerating the shift away from a planned economy to one based more genuinely on market principals. While easy to set out in words, the change required in the mind sets of long standing officials and established interest groups will take far longer. In traditionally poetic style, the blueprint notes that reform has entered a period where it is necessary to storm the established fortifications and be prepared to pass through an area of deep water – which will challenge the tested method of crossing areas of water by feeling the stones.

Investment and Foreign Investment

Unified Market Access and the Expansion of Negative Lists The reform plans call for the creation of a “unified market access system” built on the development of “negative lists”. The negative list concept governs the Shanghai Free Trade Zone, announced on 29

th September, and allows investment in any area outside the list on an

equal basis– including foreign investors. Over time it is likely that the negative list system will replace the Catalogue for Guiding Foreign Investment in Industries which governs foreign investment currently; however, implementation will take time.

Foreign Investment Catalogue

Foreign investment is currently governed by the Catalogue for Guiding Foreign Investment in Industries. The Catalogue classifies investment as encouraged, permitted, restricted, or prohibited.


The authorities are also reviewing a new method to manage foreign investment with pre-entry national treatment, in combination with the negative list concept. At the same time they are striving to make industry and enterprise registration systems more expedient, while evaluating investment not just on scale, but on the quality and the comprehensive benefits it will bring to the local market.

New Liberalised Sectors for Investment A number of sectors are earmarked for further opening up, including finance, education, culture and healthcare. At the same time the plan calls for lifting limits on foreign investment in childcare, care for the elderly, architectural design, accounting and auditing, commerce and logistics, e-commerce and general manufacturing (including, for example, the manufacture of iron, steel, chemicals and vehicles). The reforms will include a loosening of restrictions on registered capital, equity stakes and business scope.

Continued Levelling of Playing Field In recent years the authorities have been working to remove a number of policies that were perceived to be creating a market biased in favour of foreign investors at the expense of local competitors – for example the standardisation of corporate income tax in 2006 that launched the equalisation of former preferential tax policies towards “non-resident” or foreign enterprises. The latest round of reform plans call for further unifying regulation over domestic and foreign capital, including further standardising preferential taxation policies and improving national and local taxation collection mechanisms.

Creation of Multiple Free Trade Zones – The New Special Economic Zones On 29

th September the Shanghai Municipal Government announced the establishment of the

Shanghai Free Trade Zone. At the time of the launch some questioned whether it had the genuine backing of the leadership team given the absence of members of the Politburo or State Council at the opening ceremony. However, the latest reform package notes that its establishment is “a major measure to move reform and opening up forward” and encourages the establishment of additional free trade zones. The Free Trade Zone initiative is an important testing platform for further reform and may be as critical as the use of Special Economic Zones in the early 1980s that ushered in broader reform.

Operating Environment

Financial & Market Liberalisation The authorities intend to further liberalise financial markets and once stronger supervision mechanisms are in place will move forward with allowing domestic private capital to establish financial institutions (i.e. no commitment to foreign investors). In addition, the plan calls for the liberalisation of a range of important financial mechanisms including accelerating renminbi convertibility, interest rate liberalisation, facilitating cross-border capital flows and trading, establishing a national deposit insurance system, and developing and standardising bond markets. Currency convertibility is expected to come in phases with a gradual widening of the renminbi’s daily trading band. The blueprint aims to reform share issuance systems and procedures. Plans include the development of a new registration system for initial public offerings to replace the current administrative system, reforming the securities law, creating a compensation mechanism for investors and improving the delisting system to remove unprofitable companies from the stock market. Comments by the chairman of the China Securities Regulatory Commission in the days since the conclusion of the Plenum have indicated a desire to raise the quota for Qualified Foreign Institutional Investors (QFII). He also indicated that it is still not the right

Special Economic Zones

The Special Economic Zone model was created in 1980 by Deng Xiaoping with the establishment of the Shenzhen SEZ. This expanded over the following five years to approx. 20 additional locations. The SEZ model was a pragmatic method to support economic reform in the face of internal Party disagreement and is attributed as one of the important steps that ushered in the reform era.


time to establish the long discussed international board in China that would enable foreign companies to issue stock locally.

Local Protectionism and the Role of the State Owned Enterprise Sector The communiqué and the Decision both make it clear that state ownership must still play a key economic role. The blueprint recognises the equal importance of both state and non-state ownership – a shift from previous formulations which always gave primacy to the state sector – meaning that under the new era private capital will be granted easier access to state-sector investment. Moreover, the blueprint also calls for a shift from managing state assets to managing state capital by establishing and restructuring qualified SOEs into state-owned investment companies, which will serve national strategic goals and industries as well as public services. Complementing this is an edit that 30 per cent of gains from state-owned capital should in the future be turned over to the public purse to be used to replenish social security funds, to “guarantee and improve people’s livelihoods”. This continues a recurring theme around what the government should be accountable for (public services, social stability and welfare), and what the market should be responsible for (prices, competition and realising productivity). At the same time, the authorities have clearly stated a desire to address local protectionism, monopolies and unfair competition.

Law Enforcement Reform All the reforms that have been set in motion will be undone without confidence in a just legal system that protects individuals and also commerce. The authorities have outlined a number of legal reforms designed to enhance the structure of law enforcement, the management of central and local judicial bodies, and the link between administrative law enforcement and the criminal judiciary. Ultimately the plan has set a goal of building a fair legal system that safeguards people’s interests. In addition to reducing law enforcement complexity, the plan aims to strengthen local legal enforcement in certain areas – including food, drugs, production safety, environmental protection, labour protection and maritime issues.

Survival of the Fittest – Enhancing the Bankruptcy System As part of the commitment to enhancing the role of the market, the plan repeatedly returns to the role of survival of the fittest and the creation of a system that allows the efficient exit or withdrawal of those not suited for the market. The plan mentions the withdrawal mechanism broadly, but also in relation to two specific industries – financial institutions and the cultural sector. As a result, the authorities will enhance the bankruptcy system.

Innovation Another focus is on deepening reforms on government funded science and technology research and innovation projects to encourage more original innovation. The plan avoids calling out indigenous innovation, given the consternation these policies caused among foreign businesses in the past, but instead discusses creating an environment that encourages and protects innovation in both State enterprises and small and medium sized enterprises. It notes that private business has an important role to play in stimulating innovation and points to the market to determine the success of technological innovation, the allocation of funding and the value of specific inventions or discoveries. At the same time, however, the State does not intend to entirely withdraw from playing an active role in encouraging and supporting basic, strategic and pioneering scientific research.

Managing Local Protectionism

The reform of the judicial system to create greater independence is not just designed to increase fairness, but simultaneously reduce local protectionism.

The Bo Xilai Case – Open Trials

On 25th October 2013 the high court in Shandong rejected the appeal of Bo Xilai, the powerful former Party Secretary of Chongqing and Politburo member, upholding his life sentence for bribery, embezzlement and abuse of power. Bo’s case gripped political watchers and his court hearing surprised many due to the unprecedented level of public disclosure, including the court authorities “live blogging” the proceedings. The authorities have committed to expanding the use of open trials, ensuring all court proceedings are recorded, and promoting openness of court judgements.


In addition, the plan notes the importance of attracting more young and mid-career professionals engaged in the field in order to support innovation. Also aimed at supporting innovation is the emphasis in the plan on strengthening intellectual property rights use, enhancing intellectual property and copyright protection, and exploring the establishment of intellectual property rights courts.

Environmental Protection The environment remains high on the government’s agenda as the country continue to battle the effects of significant historic environmental degradation. The current 12

th Five-

Year Plan (2011-2015) already built in robust commitments to enhancing environmental protection. The blueprint has placed the same weight on ecological system reform as other priorities including economic, political, cultural and social agendas. The output from the Third Plenary builds on this with a desire to achieve a “harmonious society and ecological civilization”, drawing an explicit connection between a harmonious society and China’s environmental conditions. Achieving this will require the implementation of stringent protection mechanisms, stronger penalties for violations, and the strengthening of China’s expertise in environmental rehabilitation via centres of excellence.

Taxation reform (see below) will also be used to incentivise a change in operating conduct – in particular by levying higher tax on high-energy consumption and high-pollution products and industries. This will be complemented by the implementation of a new user-pays resources system that will significantly increase the cost of operations that are not environmentally friendly in China. Those that pollute will be punished to the full extent of the law. The current punitive thresholds, which are often criticised as being too low to act as any genuine deterrent, are also likely to be strengthened.

Tax Reform Significant work has been taken in recent years to reform the tax system. That commitment continues. The authorities will further expand the rollout of value added tax system and raise the proportion of direct taxation, while also refining the local taxation system and the overall tax collection system. For individuals, the authorities aim to establish an individual income tax system that is more sophisticated than the current regime. In the real estate sector, a critical source of local government income, there is a commitment to accelerate property tax legislation as part of market-oriented measures to control the property price.

Societal Issues

The One Child Policy Many have noted the fundamental change to China’s one-child policy with reforms allowing families to have two children if either the husband or wife is an only child (currently families are eligible to have a second child if both parents are from one child families). Many businesses serving children and young families saw an immediate jump in their share price after the announcement. As China is facing serious issues related to aging, labour shortages, gender imbalances and social constraints as a result of one-child families, relaxing the one child policy will gradually reduce these pressures and support a future aging population.

Urbanisation, Hukou Reform, Land Reform and Migrant Rights The reforms of the household registration ("hukou") system for rural residents will ensure equal access to public services, including social security, education and healthcare. These reforms help address significant urbanisation challenges. At the end of September approximately 270 million rural residents – or half the country’s total rural labour force –

Value Added Tax

VAT trials started in Shanghai in January 2012 and covered the local transportation and shipping industry and six other modern service industries. Approval was granted in August 2012 for VAT trials to expand to ten other provinces and municipalities, including Beijing and Tianjin. In August this year, the national transportation and modern service industry was subject to the new VAT system.

Foreign Investors and Innovation

Foreign investors are encouraged to invest in technology platforms that encourage greater innovation – such as supporting innovation incubators and productivity centres.

Price Reform

The blueprint calls for accelerating price reform of natural resources and utilities, such as oil, gas, electricity, water, transportation and telecoms.


were working in non-agricultural industries and many of them were working beyond their hometowns in urban areas. Reform of the hukou system will facilitate a greater level of urbanisation in China. This is being backed up with reforms that will ensure equal access for urbanised rural hukou holders to social services, such as healthcare, and also land reforms that will give rural residents greater ability to leverage their land. The core concept behind the land reform plans is to protect and grant more property rights to farmers, which is the precondition for the national urbanisation process in China. The blueprint calls on creating “fair open and transparent market rules” and establishing market-oriented trading schemes and a unified market for construction land in rural and urban areas. The blueprint attributes the same land rights in rural areas as in urban ones, which is a significant step forward from the previous dual-structure system for urban and rural land. As well as facilitating the modernisation and scalability of Chinese’ agricultural sector, the changes aim to increase farmers’ income and narrow the rural-urban income disparity. These are fundamental changes to long-standing policies that will change the make-up of China’s land and residential demographics. However, the government is keen to ensure urbanisation is managed gradually, given the immense size of China’s rural population.

Labour Re-Education The reform plan also announced the abolishment of re-education via labour systems thereby ending a system established in the mid-1950s. The system typically allows police to detain individuals for between one to three years for minor crimes (e.g. petty theft) without a legal charge and were used by the police as an administrative measure. These are significant changes to long-standing policies and demonstrate the strength of the current leadership team in that they have been able to achieve this break with historical institutions.

Engaging in the New Environment

Understand Your Stakeholders – Evaluation Methods The Third Plenary has reinforced the importance of creating evaluation metrics for China’s officials that are significantly more diverse than measuring performance based on the rate of economic growth. The new appraisal system for officials will evaluate against not just simple GDP growth, but also resource conservation, environmental protection, technological innovation, employment, residential income levels, social security and healthcare. As companies engage in China it will be critical that they consider the increasing diversity in officials’ evaluation metrics and calibrate engagement programmes and narrative according to the new diversity seen in the Third Plenary objectives and goals.

Understand the Local Value Proposition The goals and principals laid out in the Third Plenary blueprint provide clear insight into the objectives of the leadership and should be reviewed carefully against corporate development plans in China. Opening up and reform will continue – and foreign investment will continue to have a role to play – but, it is critical to articulate a company’s local value proposition clearly and consider how it can complement or support critical national goals or even incorporate politically important language into company’s narrative locally.

National Security Council

One of the few concrete actions announced at the conclusion of the Third Plenum was the creation of a National Security Council. In part reflecting China’s growing confidence on the global stage, it also points to a determination to ensure a focused and robust response to issue of domestic or foreign security. Despite the deepening reforms across the economy, foreign companies in sectors such as networks or telecoms may find the operating environment in China could become more challenging. At the end of the day, domestic concerns will always trump foreign interests.


Implications Beyond China

Going Global 2.0 Chinese companies continue to receive encouragement to “Go Global” and the latest Plenum stresses the importance of doing this better than before. Chinese companies will be allowed to go abroad to whatever country or region they deem fit for their business, with whatever investment structure they deem appropriate, and based on their own assessment of risk. In the years ahead, one can anticipate a further increase in the role of Chinese investment overseas.

Culture and Soft Power An entire section of the Decision details the importance of enhancing the cultural sector – including increasing the presence of Chinese culture internationally as a form of soft power. The plan calls for the opening of more Confucius Institutes and overseas cultural centres while also exporting greater amount of Chinese culture.


POLITICAL BACKGROUNDER

THE COMMUNIST PARTY OF CHINA The Communist Party of China (“CPC”) was founded in 1921 and today has a membership of approximately 82.6 million citizens including government officials, military officers, state owned enterprise workers, private business people, farmers and students. Membership has grown from less than 40 million members at the 12

th Party Congress in 1982 to 66 million

ten-years ago when Hu Jintao and Wen Jiabao took the helm of the Party at the 16th

Party Congress. Over the last decade more than 17 million members were added.

CENTRAL COMMITTEE OF THE COMMUNIST PARTY OF CHINA The Central Committee of the Communist Party of China (“CCCPC”) is responsible for managing the Party’s affairs for a five-year term. As of the 18

th Party Congress, the Central

Committee is composed of 205 permanent members and 171 alternate members; 184 new members were introduced in to the 18

th Party Congress. Permanent and alternate members

were elected during the 18th

Party Congress meeting that concluded on 14th

November, 2012 by the delegates who attended the Party Congress. Appointees to the top Party and government positions, including the leaders of China’s provinces, are drawn from the members that make up the Central Committee. One of the key functions performed by the Central Committee is electing the Politburo (currently 25 people) and in turn the Politburo’s Standing Committee (currently seven people).

THIRD PLENARY SESSION OF THE 18TH CPC CENTRAL COMMITTEE The Central Committee (中国共产党中央委员会), considered the highest ranked organ within the Party, holds plenary sessions that gather all members of the CCCPC and special guests to discuss and approve major policy decisions. The Third Plenum traditionally focuses on economics while other sessions deal with areas such as ideology and propaganda or specific tasks such as electing members of the Politburo and Standing Committees. Over the last 30+ years the Third Plenum has been the launch pad for many of China’s major reforms. One of the most significant Third Plenums took place in December 1978 and marked the beginning of market reform. In 1993, the Third Plenum endorsed the “socialist market economy”, which laid the foundation for fiscal, state-owned enterprise and banking sector reforms that were driven by former Premier Zhu Rongji.

Third Plenary Session of the 18th

CPC Central Committee

Date: 9th

November to 12th

November, 2013 Participants: 204 Central Committee members and 169 Alternate

Central Committee members

POLITBURO AND THE STANDING COMMITTEE The CCCPC is led by the 25-person Political Bureau or “Politburo” (中国共产党中央政治局) and the seven-person Standing Committee which sits at the top of the Politburo. The CCCPC is responsible for appointing the General Secretary, members of the Politburo, the Standing Committee, and members of the Central Military Commission.


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China Analysis – Third Plenary Session Part 2