The external payment imbalance refers to China’s current account, trade account and private financial account surpluses.

Tackling China’s economic imbalances requires major changes to the current industrial structure and the institutional arrangements associated with it. The rebalancing policy objective must be to raise the domestic absorptive capacity of China’s economy by raising the relative share of consumption in final expenditure, rather than reducing the net role of exports and to direct resources into the more productive sectors of the economy through an improved market mechanism.

Three sets of market-enhancing institutional reforms are necessary: reform of the labour system, reform of the financial system and reform of the government system, particularly in regards to the local government and state-owned enterprise sectors.

Urbanising China’s migrant workers is the most effective and realistic mid-term policy strategy for rebalancing China’s macro economy. Institutional reform, particularly the elimination of the hukou laws, will accelerate the long-run processes of migration and urbanisation by encouraging migrant workers to entirely relocate to cities rather than just working there. These newly ‘official’ urban workers would have higher wages and a desire to buy appliances and other furnishings for their permanent homes, leading to an increase in domestic demand and consumption.

Accelerating urbanisation would encourage investment in both urban infrastructure (such as mass transit and utility provision) and service industries. Urbanising China’s rural migrant workers would also help to integrate China’s still segmented labour markets and provide a basis for long-term real wages to rise. Real wage gains can accelerate structural change by raising household consumption in domestic demand and by providing a basis for real currency appreciation.

Capital market reforms are necessary for China to rebalance in three related areas: the allocation of capital, the cost of capital and the link between domestic financial reform and exchange arrangements. Although China’s bank-dominated financial system deepened its asset base considerably over the reform period, China’s system of formal credit allocation has remained narrow, and is mainly directed to the state sector as state-owned banks (SOBs) continue to dominate. China’s state-owned commercial banking sector allocates capital at rates that are low relative to those prevailing in private markets, which reinforces the wider structure of investment and expenditure imbalances.

It will be difficult to develop domestic financial markets without further liberalising the foreign exchange system and financial (capital) account controls. The two spheres are mutually reinforcing, even circular. But the exchange rate remains the anchor for China’s monetary policy and any move toward a flexible currency needs to be accompanied by a shift to a different anchor. Such a shift is a distant surmise.

Local governments remain responsible for the majority of public and social expenditure in China. For this reason, local governments have a powerful incentive to maximise growth by driving new investments — in real estate, for instance — rather than by raising consumption. The current property tax system, which is based on land transactions, should be augmented with a property valuation and rates system. This would reduce reliance on turnover and land sales, which are heavily pro-cyclical, by introducing a new revenue base more closely resembling an annuities stream, and thereby mitigating incentive distortions in the current system.

The monopoly position of China’s SOEs poses a longer-term challenge to the reform of China’s industrial structure towards a more balanced trajectory. Although the non-state sector accounted for the majority of industrial output in 2007, the SOEs accounted for more than 53 per cent of non-agricultural fixed investment while employing only 13 per cent of the total workforce. These discrepancies reflect the fact that SOEs operate in capital-intensive heavy industries. But they also suggest an inefficient allocation of capital across sectors and underline that there are still large distortions in China’s factor markets. These disproportionately benefit the SOE sector. Rebalancing China’s economy toward domestic demand will require better access to capital for non-state enterprises, reduced barriers to entry in SOE-dominated sectors, a greater openness to foreign direct investment in those same areas, further privatisation and a greater insistence on shareholder rights regarding dividend payments.

Competition and anti-trust policy is needed to more fully redistribute monopoly rents, especially in China’s strategic monopoly and pillar industries. Opening up share ownership and trading could potentially redistribute savings to a wider range of investors and allow new commercial entrants. Unifying the corporate tax rate for all firms, including private and foreign firms, could potentially redistribute more of these profits to consumers. This suggests that the task of rebalancing will also depend on how China reforms and strengthens its regulatory system, especially with respect to competition, market entry and taxation.

Market-enhancing institutional reforms will be central to the reduction of China’s macroeconomic imbalances. The reforms will have strong positive multiplier and spillover effects in a range of sub-aggregate arenas relevant to achieving greater equity, balance and sustainability.

Ligang Song is Associate Professor at the Crawford School of Public Policy, the Australian National University.

Huw McKay is Senior Economist at Westpac Bank and a doctoral candidate at the Australian National University.

This article is based on the authors’ book, Rebalancing and Sustaining Growth in China, which is the 2012 instalment of the China Update Series. The China Update Conference will be held from 10 July at the Australian National University. It will feature the Book’s other contributors, including Dr Cai Fang (CASS), Guonan Ma (Bank of International Settlements), Xiaobo Zhang (International Food Policy Research Institute), and Zhong Xiang Zhang (East-West Centre). The event is open to the public. Registration and program details are available here.