By Derek Scissors

The global crisis has prompted a great deal of talk about China.

Most of the talk starts from a faulty premise: the PRC is still moving toward a market economy. In fact, late 2008 marked the 30th anniversary of the beginning of market reforms -- and perhaps the third anniversary of their ending.

Since the present Communist Party leadership took power, fresh market-oriented liberalization has been minor. Such policies have been wound down and supplanted by renewed state intervention.

In privatization, prices, even foreign trade and investment, the PRC was heading away from the market well before the financial crisis erupted.

Privatization of the corporate sector was stalled at first, then explicitly reversed. Initiatives to increase corporate competition are also being rolled back. The sale of minority stakes at home or overseas does not alter state ownership and control.

Indeed, all national corporations in the sectors that make up the core of the economy are required by law to be controlled by the state.

The state exercises control over most of the rest of the economy through the financial system, especially banks. The state owns all large financial institutions, the People's Bank of China assigns banks loan quotas every year, and lending is directed according to state priorities, topped by favoritism for large state enterprises.

Beijing has also halted outstanding progress in price liberalization made during the first two decades of reform. Liberalization of the price of goods has been dealt a blow by greater state interference in energy and food. The People's Bank still sets compulsory and narrow ranges for both the price of domestic money (the interest rate) and the price of foreign money (the exchange rate).

The state is encroaching even on the relatively open external sector, sharply restricting incoming investment. Touted as "reform," for instance, the anti-monopoly law explicitly excludes the state giants and appears to apply only to foreign companies such as Coca-Cola. Chinese imports face nontariff barriers intended to shelter vital industries or maintain state prerogatives. The controlled exchange rate remains the main point of political contention in the U.S.-China economic relationship.

Market reform has died in part because, rhetoric aside, the Party has pursued GDP growth above all else.

Before the financial shock, while GDP growth was still in double digits and inflation was climbing toward double digits, Beijing was still stimulating the economy through negative real interest rates, making borrowing from banks effectively free. When inflation began to ebb due to the crisis, the central government further opened the ?scal taps. Eight percent GDP growth is now seen as weak and 25 percent investment growth inadequate. Ensuring blistering expansion requires more and more state-directed investment, which dominates economic activity.

Whether this is a good idea depends on whether a country can indefinitely spend 25 to 30 percent more every year without crippling waste and a warped, fragile economy. The housing sector in the United States is only the latest resounding yes to the question of whether all bubbles must eventually pop. Additionally, in the Chinese case, a focus on heavy industry continues to cause irreversible ecological destruction.

The growth obsession has its benefits, of course: China's remarkable economic performance over the past three decades, topped by that between 2002 and 2008, has made it a global player.

Most important, rapid GDP gains have created jobs: at the end of 2008, despite the crisis, the official unemployment rate for urban residents was 4.2 percent, beating the ambitious target of 4.5 percent. This success and struggles in the rest of the world has made the Party increasingly resistant to foreign pressure for economic reform.

The Obama administration's choice of how to engage Beijing on economic issues is thus difficult. Some stated American goals fly in the face of the true Chinese development model and very little progress should be expected, at least until the flaws of the model become apparent to the Party. Despite the obstacles, true market reform must remain America's ultimate aim. Otherwise, the PRC will continue to adopt policies unpalatable to the United States and ultimately unsustainable in the international context. In the absence of reform, serious U.S.-China economic conflict is inevitable.

Initial negotiations will be like pulling teeth but a consistent, patient stand will greatly speed the process whenever the Party is again open to market reform. Fortunately, a framework for engagement already exists: the just renamed Strategic and Economic Dialogue. In these talks the Obama administration must have realistic objectives in light of actual Chinese policy.

For example, rather than asking an unreceptive audience for sweeping privatization, the administration should seek a formal commitment that Beijing will open state-dominated companies to foreign investors, with reasonable limits. A long-term, explicit timetable -- formulated by the PRC -- for liberalizing exchange rates, interest rates, and domestic energy prices would recognize the process is necessary but will not be rapid. President Obama will need to work hard to move China back in the right direction, but the alternative is a progressively and dangerously worse economic relationship.

Derek Scissors is Asia Economics Research Fellow at the Heritage Foundation.

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