On November 12, 2013, 373 delegates participating in the four-day Third Plenary Session of the Communist Party of China’s (CPC) 18th Central Committee concluded their deliberations on China’s ten-year reform program. On November 15, the CPC Central Committee published a landmark reform manifesto entitled “A Decision on Major Issues Concerning Comprehensive and Deepening Reform” (Decision). The Decision is 20 pages long and lists 60 reforms items under 16 categories, covering a wide range of areas ranging from economic, political, social, cultural and environmental reforms, to institutional CPC and defense transformation. In this alert, we highlight some of the key initiatives contained in the Decision, including state-owned enterprise (SOE) reform, greater openness for foreign investment, anti-corruption efforts, financial reforms, strengthening of the rule of law and reform of the judiciary, rural land reforms, pension system reforms and the new environmental protection regime.

SOE REFORM

The Decision states that reform of China’s economic structure is a critical part of its comprehensive reform initiative. A key issue in this regard is the proper management of the relationship between government and the market in order to ensure that the market plays a decisive role in resource allocation. For the first time, the role of the market has been elevated to the level of playing a "decisive role," which is an important change from previous characterization of the market as playing a “basic role.” Emphasis on the market is intended to promote fair competition, remove entry barriers to industry sectors and eventually lead increased efficiency and fairness.

The Decision outlines a number of measures to reform SOEs, but does not contemplate outright privatization. Instead, the intention is to expose SOEs to increased competition in order to encourage them to become more efficient, while at the same time provide more opportunities for private companies. It appears that the government may be willing to let the previously dominant position of state enterprises erode at a more rapid pace than in the past.

Among other things, the Decision sets SOEs the goals of diversifying equity holders, introducing innovations to the state assets management system, and introducing market competition in certain “natural” monopoly sectors. The Decision states that China will actively develop a mixed ownership economy, allowing more SOEs to be converted into mixed-ownership enterprises and encouraging private investors to participate in state capital investment projects. Mixed-ownership enterprises will be allowed to utilize employee stock ownership to align the interests of investors and employees.

The Decision references a new state assets supervision regime which will focus on capital management. Under the new regime, China will establish state capital operating companies and state capital holding companies. The Decision does not explain the specific functions of these companies; however, our research indicates that the former could be formed to carry out restructuring of SOEs that have under-performing assets, while the latter could seek to take a page from the Singapore Temasek model, which is viewed as a successful model to manage and invest state capital.

According to the Decision, in “natural” monopoly industries, such as public utilities, minerals and railroad networks, reforms will be introduced to separate the government’s regulatory functions from business management and operations to be conducted by the state. In addition, a charter or franchise system will be implemented so that the natural monopoly sectors will be operated by franchisees independent of government agencies, but in compliance with relevant state regulations.

The Decision also announces that a portion of state-owned capital will be transferred to social security funds, and that the government is committed to improving the state-owned capital operation budget system. By 2020, the proportion of SOE profits that is allocated to public finance will be increased to 30%, up from the current 5% to 15%. These funds will be used to ensure and improve the quality of people's livelihood.

In order to enhance the operational efficiency of SOEs, the Decision requires that SOE corporate governance be improved. The introduction of long-term incentive and control mechanisms, the strengthening of investment accountability requirements, and consideration of ways to publicize important information, are all intended to strengthen corporate governance. SOEs are required to reasonably increase market-oriented recruitment and fairly determine and strictly regulate executives' income levels.

The SOE reform plan outlined in the Decision will most likely open up new investment opportunities to the private sector. Currently, there are more than 100,000 SOEs nationwide, among which 112 large state-owned corporations are under the direct supervision of the central State-owned Assets Supervision and Administration Commission (SASAC). The total assets of the central SOEs were valued at RMB44.8 trillion (approximately US$7.35 trillion) at the end of 2012. According to media reports, a senior SASAC official recently stated that private companies and investors are welcome to acquire larger shareholdings in SOEs in order to participate in decision-making at shareholder and potentially board level. According to this official, private investors could be permitted to invest in up to 15% of an SOE's equity. This begs the question as to whether SOEs are too big to be attractive to privately-held investors. The same SASAC official noted that private companies will be encouraged to join forces when investing in SOEs’ equity or specific projects.

FOREIGN INVESTMENT

The Decision highlights the need for increased transparency in order to reinforce the momentum of domestic reforms. The stated intention is for China to broaden market access for foreign investors, unify regulations and policies applicable to domestic and foreign investors, and keep foreign investment policy stable, transparent and predictable. The Decision announces that China will open up to foreign investors (in an orderly manner) the services sectors, including finance, education, culture and healthcare. Foreign investment restrictions will be eased for child-care and old-age care, architectural design, accounting and auditing, commercial logistics, e-commerce, and the general manufacturing sector. The China (Shanghai) Pilot Free Trade Zone is acknowledged as a significant step to push forward reform and opening-up, adding that the government will select a number of other eligible locations to develop free trade zones on the basis of experience.

On November 20, 2013, China’s Ministry of Commerce, the key regulator of the country’s foreign direct investment (FDI), announced that it will improve the management of China’s FDI regulatory regime to implement the Decision’s requirements in order to create more opportunities for foreign investors, including relaxing existing restrictions on registered capital requirements, equity stakes and business scopes for foreign invested companies. In addition, multinational corporations are encouraged to establish functional institutions in China, such as regional headquarters, R&D centers, procurement centers and financial management centers. They are also encouraged to invest in technology intermediaries, innovation incubators, productivity centers and technology exchange markets.

ANTI-CORRUPTION

One year ago, China’s newly inaugurated leadership announced that it would make greater efforts to build a clean government and intensify anti-corruption efforts by going after both "tigers" and "flies," referring to high-ranking and low-level corrupt officials. The Decision highlights the determination of the Party’s highest authority to institutionalize anti-corruption efforts and “restrict power within the cage of rules and regulations.” One of the key anti-corruption measures unveiled in the Decision is reform of the existing CPC discipline inspection system by strengthening the supervision of upper-level discipline inspection agencies over their lower-levels. This new “vertical” discipline inspection system, if effectively implemented, is intended to reduce undue interference in the operations of local-level discipline inspection agencies from other government bodies at the same level, which should increase the independence and effectiveness of such agencies.

Many other measures proposed in the Decision are intended to regulate and limit government power. These measures include the establishment of a unified and open market system with orderly competition to facilitate healthy market activities, and the streamlining of administrative approval and licensing procedures, which in turn should limit government control over market forces and significantly reduce government officials’ rent-seeking opportunities.

FINANCIAL REFORMS

Only a few paragraphs of the Decision are devoted to financial reforms; however, virtually all of the key expected measures are mentioned. The support provided in the Decision should help reinforce the momentum of financial liberalization processes that are already underway.

The Decision states that China will accelerate interest rate reform, allowing the market to determine interest rates. The intention is to build a government bond yield curve, which will be referenced as a benchmark to more accurately reflect capital demand and supply in the market. Earlier this year, regulators lifted strict control over bank loan interest rates, but currently, the government still mandates a ceiling on bank deposit interest rates, effectively subsidizing banks and borrowers at the expense of savers. The theory is that by completely lifting interest rate controls, capital should flow to more productive sectors and companies. A deposit insurance scheme will be established to mitigate the risks of financial instability if banks offer reckless and unsustainable interest rates in their competition for customers.

Qualified private financiers will be permitted to sponsor and establish small- to medium-sized local banks to serve local financial needs. This is intended to introduce greater diversity into a financial landscape dominated by state-owned banks. Commentators anticipate that the first small- and medium-sized private banks will most likely be established based on the recommendation of local governments and will be subject to approval by the China Banking Regulatory Commission.

The Decision additionally confirms the government’s determination to achieve more freedom in cross-border capital movement, accelerated capital account convertibility, and establishment of a foreign debt and capital movement oversight regime. As these initiatives are gradually implemented, China’s financial system will undergo significant changes and the pace of Chinese outbound investment and offshore funding-raising is likely to increase. In the short term, it is expected that investment quotas under the Qualified Foreign Institutional Investor (QFII) and RMB Qualified Foreign Institutional Investor (RQFII) programs will be further increased and foreign financial investors will be able to access more diverse investment products in China.

One of the most aggressive items in the Decision is the announcement that the government will modernize the country’s IPO share-offering system, moving away from the existing approval-based regime to a registration-based one. This reform initiative, if properly implemented, will bring fundamental changes to China’s stock market. Notably, China’s current approval-based IPO system features a low percentage of direct financing, which is expected to change. In addition, under the current approval based system, the dominant role played by regulators in reviewing and approving IPO applications has tended to have the effect that listing opportunities have been allocated to candidates taking into account political considerations. Often those candidates have not utilized the capital raised on the market in the most efficient and productive way.

The proposed systematic overhaul of listing procedures will need to be implemented gradually, however, in order to avoid a counter-productive impact on China’s immature stock market. Commentators have voiced concerns that the existing securities regulatory and capital market infrastructure in China is below the level of more mature capital markets in other jurisdictions, such as the U.S. and the U.K. A viable registration-based IPO system, similar to the one operating in the U.S., would require a high degree of professionalism and ethics among accountants, lawyers and brokers, as well as more active participation by sophisticated institutional investors and a strong court system and regulatory enforcement capability. There is a long way to go before Chinese stock markets will be able to operate in these optimum conditions.

RULE OF LAW

Since the beginning of 2013, a series of high profile legal cases involving several senior government officials and celebrities have held the public’s attention. Heated public debate over these cases has highlighted increased legal awareness among the public and underscored public comments on the rule of law. The Decision re-assures that the authority of the Chinese Constitution and the principle of the rule of law will be upheld through enhanced implementation of the Constitution. The Decision emphasizes that no organization or individual can operate outside the Constitution or any other laws, and any that all persons should be held liable for violations of law.

The Decision also calls for the establishment of a legal “in-house” counsel system within provincial and sub-provincial level governments. Currently, many local governments have engaged legal counsel, who perform ancillary roles but who have not been granted sufficient authority to guide government to operate in an improved compliance environment. With their role vindicated by the Decision, it is hoped that the status and power of government legal counsel will be significantly enhanced and that they will play more prominent roles in the governance of government bodies.

Another important practical development is that for the first time, designated intellectual property courts will be established throughout the country (in addition to the special IP courts already existing in cities such as Beijing and Shanghai). This initiative indicates the intention of the government to improve judicial enforcement of intellectual properties rights, an area frequently criticized by foreign commentators.

REFORM OF JUDICIARY

The Decision states that China will improve the independence and fairness of its judicial and prosecutorial systems. One measure to achieve this goal will be the use of centralized control over personnel, finance and property of sub-provincial courts and prosecutors’ offices at provincial level. For many years, both domestic and foreign observers have commented that Chinese courts are susceptible to local government influence. The purpose of the proposed institutional reforms is to reduce localization of judicial power and political interference with the judiciary from local administrative bodies. Currently, the appointment and removal of judges and other court personnel, and court funding are all controlled by local governments. This structure sometimes gives rise to opportunities for local protectionism.

How the new unified judicial management system will operate is currently unclear. It is probable that moving court budgets to the provincial level will be relatively straightforward, but rationalizing court personnel management is likely to be more complicated. The Chinese Constitution mandates that judges and prosecutors are appointed by People’s Congresses at the relevant government level. According to a recent article published in the People’s Court Daily, in order to comply with the Constitution the appointment and removal of judges and prosecutors must accord with existing procedures and formalities; however, nomination of and supervision rights over judicial and related appointments can be vested at the provincial level, thereby taking power away from local party organs.

In addition, the Decision announces reforms to the existing adjudication committee system. The committees, which comprise presiding judges as well as leaders of courts and prosecutors’ offices, are the highest decision-making body in any Chinese court. Members of the committees review important cases and judges’ draft opinions, and decide on sentencing and the award of damages and other compensatory measures. This model suffers from a major flaw in that court rulings could be susceptible to undue influence by the court’s internal administrative officials, who do not directly hear cases but are under the control of local politics and law committees. This practice has been criticized as it can lead to manipulation of court rulings. Under the new regime, the power of the adjudication committees will be significantly reduced and presiding judges will be given complete power to make rulings.

Overall, the Decision expresses new thinking regarding judicial independence in order to end local protectionism and to reduce the current amount of bureaucracy involved in the judicial system.

RURAL LAND REFORM

The Decision sets out an ambitious plan for reforming China’s rural land regime, based on recent experience of pilot local land reforms. Under the Chinese Constitution and the Land Administration Law, all land in urban areas is owned by the state, while all land in rural and suburban areas is collectively owned. Rural land is divided into arable land and construction land, and the latter includes both home-site land and business construction land. Under the existing Land Administration Law, rural land generally may not be assigned, transferred or leased for non-agricultural construction uses. Only the government can, for public interest purposes, appropriate rural land for other uses.

In recent years, land appropriation has been a major source of discontent across rural China. There have been cases in which farmers have been paid low compensation for their land by local government, who have sometimes been in league with property developers, in order to acquire land for urban expansion and industrial development projects. The Decision provides that rural business construction land may be assigned, leased or used for in-kind equity contribution by land owners. Such land will be treated equally with urban state-owned land in terms of access to the real estate market and such land will be accorded the same rights and be valued in the same manner as urban state land. The Decision references the establishment of a unified market for urban-rural construction land, but it is unclear whether such market will be nationwide, province wide or otherwise. Commentators also note that implementation of this initiative will require significant amendments to the existing legal and regulatory regime applicable to land administration, which is likely to take time.

The Decision treats arable land that farmers received under long-term tenancy arrangements (the so called chengbaozhi, or contracting system) and rural homesite land differently to rural business construction land. While the Decision does not propose trading of the first two types of land, it promises to provide farmers with more property rights regarding such land in the future. For example, farmers will be gradually allowed, based on pilot experiments, to mortgage or transfer their tenancy rights to arable land and their property rights to houses built on homesite land. The new land disposal options should help to expand farmers’ financial channels, facilitate capital accumulation, and enable farmers to grow their businesses. In addition, the Decision calls for the establishment of a rural property rights trading market and the promotion of openness, fairness and compliance in rural property rights transactions.

HOUSEHOLD RESIDENCY SYSTEM REFORM

According to the Decision, as part of China’s urbanization efforts, the government will revamp the existing hukou or household residency system and welcome rural migrants to settle in small- to medium-sized cities. Currently, China has about 300 million migrant workers, many of whom have left their farmland in order to work in cities without having the privileges that come with having city residency and related social security and other rights. The inequality of rights available to rural migrant workers and urban residents has prompted public outcry for hukou system reform.

Under the reforms, restrictions on hukou in towns and small cities will be fully lifted, restrictions on hukou in medium-sized cities will be gradually relaxed, “reasonable” requirements for hukou in large cities will be retained, while the size of populations in megacities, such as Beijing and Shanghai, will be strictly controlled. The government will make basic urban public services and welfare available to all permanent residents in cities and integrate all rural migrants who have been granted city hukou into the urban social security network.

PENSION SYSTEM REFORM

The Decision proposes a number of measures that will have far reaching effects on China’s social security regime. One of the measures that has attracted much public attention is the proposed progressive delay in the retirement age.

Currently, the majority of female employees in China retire at either 50 years, or 55 years of age and male employees at age 60 years, with some exceptions. In recent years, the percentage of China’s aged population has increased and this has placed stress on the China’s under-capitalized pension system. Drawing on international experience, Chinese academics generally agree that delaying the retirement age is one of the measures that China needs to take in order to prevent a pension crisis. Experts also comment that the new retirement policy will need to be based on the principle of actuarial balancing, and that it will not be possible to re-set the retirement age at one time. Therefore, it is likely that the new policy will increase the pensionable age progressively and implement payment incentives, such as pay-more- get more in order to encourage people to stay employed. It is important to note that the new retirement age policy will not affect benefits of senior workers who are retiring soon, but that going forward middle-aged and young workers will no longer be able to enjoy the current policy of paying into the state pension for fifteen years and then waiting for retirement. This change is likely to have far-reaching effects on labor force management and planning.

NEW ENVIRONMENTAL PROTECTION REGIME

The Decision stresses the importance of building an eco-civilization and commits to pursuing a green and sustainable path to balanced economic, ecological and social development. Commentators note that China’s current system for evaluating performances of government officials rewards economic growth over environmental protection and has contributed to weak enforcement of environmental regulations. According to the Decision, as part of the overall effort to build a greener economy, China will introduce a system that provides increased compensation to the public for environmental damage and includes criminal penalties. New resources taxes will gradually be assessed on the use of almost every natural resource, and special fees will be imposed on those who exploit, damage and pollute China’s natural resources.

The Decision calls for strengthened environmental monitoring and assessment capabilities. An early warning mechanism will be established to detect when land, water and marine resources are being overused and to improve the monitoring of emissions. Other proposed measures include timely disclosure of environment information and holding exit interviews for outgoing leaders to assess their environmental record.

The Decision also emphasizes using markets to combat pollution. The document references the need to develop environmental marketplaces, including “carbon emissions rights.” This suggests that the government is considering how to expand existing pilot carbon-trading schemes.

To accomplish the task of establishing a comprehensive ecological protection regime, China’s environmental legal infrastructure will need to be reinforced. Experts have noted that amendments to the Environment Law, Air Pollution Prevention Law and the drafting of the Climate Change Law will need to be accelerated and should provide for market-oriented pollution prevention mechanisms and incentives for wider public participation in environmental monitoring.

CONCLUSION

China has set itself aggressive reform targets, which are intended to begin the process of comprehensive fundamental change. However, those reforms are the "high-hanging grapes" that are likely to be increasingly difficult to pick and the road ahead will be challenging, more particularly since the Decision requires that by 2020, China should have achieved “decisive” achievements in key reform areas.

Further implementation of the Decision is being undertaken by a new government body known as the Central Reform Leadership Committee and more detailed provisions will be revealed in 2014. In the meantime, various regulators and government agencies have disclosed that they are working on new draft legislation, some of which could be promulgated as early as the end of 2013.