China’s State Council recently unveiled a comprehensive blueprint for capital-market reform until 2020, in which it identifies two key objectives: “to support open, fair and integral market processes, and to protect investors, particularly the legal rights of small investors.” Achieving these goals, as the blueprint recognizes, will require policymakers to weigh market autonomy against state authority, innovation against stability, investor protection against caveat emptor and the temptation of rapid reform against the need for pragmatism. Can it be done?

From a policy perspective, the goal should be to strike a balance between competition (which spurs growth-enhancing innovation but can also generate instability) and cooperation (which promotes long-term social cohesion but can also lead to stagnation). In doing so, China’s leaders must account for three levels of competition: inter-enterprise competition, intersectoral competition, and competition among the interests of citizens, businesses and the state.

The implementation of a competition framework for enterprises is a work in progress. In 2008, the government enacted an anti-monopoly law aimed at preventing anti-competitive or “monopoly” agreements among enterprises, minimizing abuse of market dominance, and blocking mergers and acquisitions that would eliminate or unduly restrict competition.

But managing competition in a market that has three major players — state-owned enterprises (SOEs) and domestic and foreign private companies — is a complex task. Private-sector firms are frustrated with the privileges that SOEs enjoy, while foreign-owned enterprises complain that they are at a disadvantage vis-a-vis domestic companies.

The management of intersectoral competition is even more complicated. In banking, for example, competition is extremely fierce, and China is one of the few economies where concentration (the market share of the top five players) has declined in recent years. But more than a decade after China’s accession to the World Trade Organization, foreign banks’ share of the Chinese market stands at a minuscule 2 percent — a reflection of Chinese regulators’ failure to create a level playing field.

The challenge is intensified by technological advances and regulatory arbitrage. E-commerce platforms like Alibaba have not only breached banks’ payment business; they have also begun to offer wealth-management products. And regulatory arbitrage has fueled the emergence of shadow banking, which is competing actively with traditional financial institutions for wealth-management and lending business.

Regulatory arbitrage arises from competition among central government agencies for the authority to regulate — competition that often delays market reforms and institutional change, owing to agencies’ unwillingness to accept one another’s authority. For example, overlapping regulation by at least five agencies and ministries has delayed the development of China’s bond market considerably.

The best example of healthy competition in China is among cities. China has 287 prefecture-level cities, with a median population of 3.7 million and median per capita GDP of $5,800. Sixteen cities have already crossed the World Bank’s threshold for high-income status, with annual per capita incomes of more than $12,616, and four — Beijing, Shanghai, Guangzhou and Shenzhen — have global reach. These cities hold the key to the ability of China as a whole to avoid the middle-income trap.

That should come as no surprise. The secret of China’s economic success since 1979 has been the easing of central-planning rules to empower cities, markets and private businesses to experiment, innovate and grow. Given the difficulty of identifying which of the old rules needed to be reformed or eliminated, the process depended on the delegation of central-government powers to local governments, which were better equipped to experiment with market rules to boost economic growth.

At the same time, in order to preserve the system’s stability and integrity, these efforts were accompanied by the centralization of fiscal authority and certain oversight powers. This balance between horizontal competition and vertical regulation was critical to promoting growth and dynamism in Chinese cities.

But the balance has been far from ideal. Indeed, competition among cities — intensified by the large role that municipal-level GDP growth plays in determining the career paths of local officials — went too far, creating destabilizing imbalances.

Yes, local autonomy facilitated bold productivity-enhancing activities such as the use of rural land for industry and commerce and the creation of public-private partnerships to finance major infrastructure projects. Private enterprises were thus able to seize market share from SOEs in the service and manufacturing sectors.

But cities’ hasty efforts to imitate one another’s growth models also led to overwhelming environmental pollution, mounting debt, excess infrastructure capacity, rising inequality, depletion of farmland, and rampant corruption, including administrative abuses that encroached on citizens’ property rights.

Competition-fueled growth propelled China’s emergence as the world’s second-largest economy. But it is unsustainable. The need now is to rebalance competition to address the negative externalities of state and market activities that harm citizens’ interests.

The central government’s recent removal of certain judicial powers from local governments, thereby strengthening protection of property rights, is an important step in this direction.

But it is not enough. Enabling the market to drive resource allocation, while ensuring a level playing field for all participants, will require the establishment of clear competition principles, possibly supported by a powerful “competition commission.”

No competition can work without clear, fair rules. That is the real challenge facing China’s leaders today. If they succeed, a high-income China will be only a matter of time.

Andrew Sheng is a distinguished fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng is director of research at the Fung Global Institute. © 2014 Project Syndicate (www.project-syndicate.org)

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