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Structural Flaws Will Limit China's Rise

Friday, Dec. 25, 2009

Editor's Note: This article was first published on Nov. 10, 2009, as part of the WPR feature "China's Once and Future Rise." It is made available here for free as part of a promotion that ends Jan. 5. To experience more of WPR"s subscription service, sign up for 30-day free trial.

On Oct. 1, the People's Republic of China celebrated the 60th anniversary of its founding, most notably with an air show and military parade along Beijing's Orwellian-sounding Avenue of Eternal Peace. The event showcased China's arsenal of indigenously made fighter aircraft, tanks and newer-generation Dongfeng missiles, capable of delivering nuclear warheads to targets over 11,000 kilometers away. This was hardly the first time an authoritarian government has used a military review to impress its citizens and outside observers. And China has used non-martial events to display its national pride, confidence and strength. In many ways, last year's Beijing Olympics served the same function.

But the parade left little doubt that China, the 2009 version, is surely very different from the one Mao Zedong left behind when he died in 1976. Since 1979, its economy has been doubling in size every 10 years, and growth in 2009 will likely surpass 8 percent -- remarkable in the context of the current global environment. Obviously, economic strength underpins political and military power, and if current linear trends continue, the Chinese economy will surpass that of the U.S. in absolute size before the middle of this century.

But does that mean that China will inevitably become a genuine economic and military superpower -- the next East Asian success story, like Japan or South Korea, but on an unprecedented historical scale? Major economic and social problems stand in the way of such a scenario of China's continued rise. But while many analysts recognize that these problems exist, most tend to represent them as Beijing's "to do" list, reflecting the assumption that the PRC's leadership simply needs to identify the appropriate policy solutions and then implement them. But such an approach ignores the ways in which China's problems are structural and becoming worse, and why solving them without the prospect of enormous turmoil will be difficult and even unlikely.

China's Two Distinct Reform Periods

China's modern reform period began under Deng Xiaoping in December 1978. Because the Chinese economy has been growing constantly for the three decades since then, it is commonly believed that China has been gradually but steadily reforming into a free market economy over the past 30 years. In fact, though, there have really been two distinct reform periods driven by two distinct reform philosophies since 1978: the pre-Tiananmen period from 1978-1989 and the post-Tiananmen period from 1991-present.

Prior to 1989, the unplanned, spontaneous explosion of private initiative in rural China -- fueled by limited land reforms -- was encouraged by officials and even supported by government policy. Yasheng Huang called this period the "entrepreneurial decade." Farmers were encouraged to make their own decisions for how they wanted to use their plot, even if the land itself was still owned by the state, and were allowed to sell their produce at market prices after having met their production quotas. A happy accident of the limited land reforms were the spontaneous rise in rural China of small-scale businesses, known as "Township and Village Enterprises," which provided meaningful employment for over 100 million Chinese peasants. Significantly, during this decade, mean wages and incomes were rising at the same rate or faster than GDP growth, leading to the emergence of an independent "middle class" in China. Indeed, 80 percent of the poverty alleviation that occurred since 1979 was achieved during this 10-year period.

After the Tiananmen protests in the spring of 1989, China deliberately and decisively changed tack. The Tiananmen protests -- which actually saw thousands of protests involving millions of people spring up in hundreds of cities across the country -- brought the Chinese Communist Party (CCP) to its knees. During the "Tiananmen Interlude" that followed the bloody crackdown in Tiananmen Square, the CCP nervously watched the fall of the Berlin Wall, followed by the implosion of the Soviet Union. It realized that authoritarian regimes become irrelevant at their great peril.

To preserve its relevance, the CCP expended extensive efforts to retake control of the major levers of economic power. This control today is at the heart of an economic structure that entrenches the role and status of Party officials and members in Chinese economy and society. The story of China's economic rise since the 1990s is mainly the story of the rise of the Chinese "corporate state" and the emergence of the "state-led" model of development -- not the flowering of China's private sector. Unfortunately, it is now the CCP's determination to hold on to political, economic and social power that is behind many of China's most serious problems. That is also why these problems are becoming worse.

Behind China's Current "Economic Miracle"

Even before the current global financial crisis, at the National People's Congress in March 2007 (the annual meeting of the state's highest political body), current Premier Wen Jiabao offered his country a warning, declaring that "the biggest problem with China's economy is that growth is unstable, unbalanced, uncoordinated and unsustainable." This was all but reiterated by President Hu Jintao at the five-yearly Congress in Beijing in October 2007, and was repeated again this year. In fact, similar warnings have been issued since the late 1990s.

Although economic growth remains robust, growth tells only a small part of the story of how China is faring. Serious flaws have been emerging in the Chinese economic growth strategy, particularly since the 1990s. Indeed, in recent times, China's high level of growth is somewhat symptomatic of the problem.

How has China achieved growth since the 1990s Most Western commentators focus on the spectacular success of China's export sector and the emergence of China as the "world's factory." But a greater contributor to Chinese growth is actually domestically funded fixed investment, which constituted over 50 percent of GDP in 2008 and over 40 percent of growth in that year. In 2009, due to the massive stimulus order by the government, between 80-90 percent of growth will be a result of capital investment. To put China's growing addiction to loans from state-owned banks in perspective, its banks lent out $150 billion in 2001, $380 billion in 2003, $750 billion in 2008, and $1.13 trillion in the first 7 months of 2009 alone. In other words, growth is largely the result of state-controlled entities pouring money into fixed investment projects.

But it is not just the high reliance on fixed investment that is striking. It is where the capital goes that is all-important. China is unusual in that bank loans -- drawn from the deposits of its citizens funneled into state-controlled banks -- constitute around 80 percent of all investment activity in the country. Even though state-controlled enterprises produce between just one-quarter and one-third of all output in the country, they receive over 75 percent of the country's capital -- and that figure is rising. State-controlled companies received well over 95 percent of the recent stimulus monies lent out in 2008-2009. The Chinese state sector owns over two-thirds of all fixed assets in the country. This is the reverse of what occurred in China during the first 10 years of reform, when private sector businesses received over 70 percent of all the country's capital.

The massive bias toward the state sector would not be so problematic if the 120,000 state-controlled enterprises and their countless subsidiaries could learn to innovate and adapt. Unfortunately, except for a handful of centrally managed state-controlled enterprises, this is not the case. According to one expert, 19 percent of state-controlled enterprises were unprofitable in 1978. That number had grown(.pdf) to 40 percent in 1997, and by 2006 had reached 51 percent. By a conservative estimate, 40 percent of bank loans to these entities are extended on a "policy" rather than a "commercial" basis, with most of those loans made at artificially low interest rates.

Banks are effectively fulfilling the political priorities of the government through their "policy lending" function: to maintain jobs for state-controlled enterprise workers who are the party's most loyal supporters, to maintain support for state-controlled enterprise managers who are core party members and supporters, and to maintain growth in "middle class" and urban areas at any cost, since the party needs the continual support of the new and emerging middle classes to survive. As Zhang Hanya, a senior researcher at Beijing's National Development and Reform Commission's Investment Research Institute, put it in 2007, a full year before the global financial crisis, China needs to keep fixed investment growth levels at around 25 percent per annum just to maintain present levels of employment.

This is all leading to a worsening "bad loans" problem, which has been manifest since the early 1990s and threatens to bring down the Chinese financial system. Worryingly, China's main banks have been technically insolvent for over a decade, weighed down by non-performing-loans (NPLs). Even back in 2006, accounting firm Ernst & Young estimated the total value of NPLs in the Chinese financial system at $911 billion -- about 40 percent of GDP. The balance sheets of these banks are superficially healthy, but they are only able to operate due to periodic bail-outs by the government, in which bad loans are transferred to "asset management companies." Meanwhile, bad loans are removed from balance sheets only due to stipulations that maturing loans be "rolled over" since they cannot be paid back. Banks remain liquid mainly due to the high savings of the population, deposited into their accounts because few other options besides state-controlled banks exist in China.

Recent instances of economic reform have been largely tactical, designed to plug obvious holes, rather than comprehensive. Despite overwhelming evidence that heavily protected state-controlled enterprises use capital poorly, they continue to receive a constantly rising share of the country's wealth. As a result, most of China's 40 million to 50 million private businesses remain small and heavily hamstrung by lack of access to capital. Importantly, these private enterprises use capital between 2-3 times more efficiently, and are twice as efficient in generating employment. Nevertheless, because the CCP refuses to dilute its economic power, support for the ongoing rise of the corporate state will continue despite the enormous cost to the country.

Even the piecemeal reform that has occurred runs into the enormous problem of poor or non-existent implementation. Western experts visiting China generally leave impressed by the competency of its senior officials. But functional authority in China is largely decentralized. Around 45 million provincial and local officials -- compared to less than 1 million central officials -- operate in a largely unaccountable environment, due to the lack of effective institutions for public accountability within the one-party system. These local officials oversee, regulate, and administer almost all economic and enforcement activity in the country. As a result, China's central leaders have consistently run into problems in terms of enforcing the central government's mandates and regulations.

This also leads to the enormous problem of corruption, which is systemic (particularly at the local levels), profound and embedded throughout every level of the Chinese economy and society. Estimates put the value of direct theft of state resources at around 2 percent of GDP each year, while the indirect economic cost of corruption is estimated by various Chinese researchers to represent up to 17 percent of GDP. Moreover, while it is true that China's well-known environmental problems are the result of rapid growth, these problems are also significantly caused and exacerbated by poor adherence to even minimal environmental standards and edicts on the part of local officials -- who are rewarded for achieving growth, no matter the cost. Given the lack of institutions and other mechanisms of accountability, standards imposed by Beijing are regularly ignored.

Next Page: China's leaders continue to support local officials . . .

Yet, China's central leaders have little choice but to continue to support local officials in order to prolong the survival of the CCP as the country's ruling party. In a vast country of 1.3 billion people, Beijing relies on the 45 million local party officials to represent its authority and preserve the CCP's interests. At the same time, local CCP leaders have a huge informational advantage over the central leadership: The latter have few alternate sources of information other than what local authorities reveal. Importantly, national law, economic policies, social order policies, and even centrally instituted fiscal policy are all necessarily executed by local officials.

These are all problems that go to the heart of whether the Chinese model of economy growth is sustainable. Beijing itself is aware of the problems, having warned that its economic model is becoming dangerously dependent on ever-increasing levels of inefficient capital investment to achieve growth. To solve that problem, greater support must be given to China's 40 million to 50 million private businesses. That would result in the much more efficient use of capital, the creation of more jobs, and a rise in private -- rather than just state -- wealth. That, in turn, would increase domestic consumption -- currently at around 30-35 percent of GDP, the lowest of any major economy in the world -- in order to re balance the economy and reorient its growth model toward a more sustainable approach.

However, such a policy would jeopardize the party's ability to concentrate its hold on power. Instead, leaders from Deng Xiaoping onwards have used "tactical reform" as a mechanism to retain power, insisting that the Chinese "corporate state" grow stronger rather than weaker. In this context, the pursuit of growth at all costs, far from alleviating the shortcomings in the Chinese economic model, is actually worsening these shortcomings. The problems are not just cyclical, nor are they only temporary hitches as China confronts the enormous task of development. They are serious, chronic, and systemic.

Rich and Strong State, Poor People and Weak Civil Society

One major problem for China is that too heavy an emphasis on state-led development tends to exacerbate inequality as the economy expands. Since the state dispenses the most valued business, career and professional opportunities, a relatively small group of well-placed and well-connected insiders benefit, while opportunities to prosper are denied to the vast majority. Unlike the pre-Tiananmen period, mean wages and income throughout the country have been rising three to four times slower than economic growth.

This is a serious problem for Chinese society. Its Gini coefficient -- a measurement of income distribution, where 0 means perfect equality and 1 means absolute inequality -- rose from around 0.25 in the 1980s to around .38 in the 1990s. It is now around 0.5, which is the highest in Asia. Worryingly for China, despite enormous GDP growth, about 400 million people have seen their incomes stagnate or decline (.pdf) during the past decade. Another study by the World Bank suggests that the income of the poorest 10 percent of China's population had declined by 2.4 percent each year at the beginning of this century. Since 2000, absolute poverty has actually increased, as has illiteracy. Combined with the absence of social safety nets, such as healthcare, it is no wonder that at 30 percent of GDP, Chinese consumption levels are the lowest of any major economy in the world.

An obvious counterargument here is that inequality is inevitable once development takes off in a backward, agrarian society. However, this is refuted by the cases of South Korea and Taiwan from the 1960s to the 1990s, as well as that of China from 1978-1988, all of whose Gini coefficients (.pdf) hovered around 0.29-0.34, even as their economies were growing rapidly.

Significantly, the CCP has deliberately used vast resources to sponsor, co-opt, and, in many respects, create the privileged middle classes. The great lesson of the 1989 Tiananmen protests for the CCP was that the party was better off tying the future of the middle classes to the future of the CCP, than it was isolating them. It is from the urban middle classes, after all, that any impetus for political reform is likely to come. So it is no surprise that the party's heavy capital investment bias is slanted toward urban China. Enormous national resources are directed toward nurturing the middle class in China's cities, making them the great beneficiaries of China's state-led development model.

This is reflected in the composition of the roughly 70 million CCP members -- of whom a third are businesspeople and entrepreneurs, a third are college students, and a quarter are professionals. Meanwhile, a massive underclass of up to 1 billion people represents the downside of this strategy. It is not surprising that while middle class support for the CCP remains robust -- so long as economic growth is strong, that is -- numerous internal party studies show that support for the CCP in the poorer rural areas is extremely poor.

A second problem facing China's continued rise is the lack of robust institutions needed by all strong economies and societies. The CCP's political imperative of retaining power severely impedes the building of the soft institutions needed for successful economies: enforceable property rights, independent courts and the rule of law, and independent financial and administrative organs. For example, while judges are appointed by the CCP, party officials are explicitly given the right to veto court decisions at all levels of the Chinese judicial system. The Property Rights Index released by the Heritage Foundation gives China a dismal score of 20 (the same rank as countries such as Bangladesh, Cambodia and Uzbekistan), while South Korea and Taiwan rate reasonably well at 70. All land in China is still owned by the state, although individuals may own and transfer long-term leases. But as the report observes, China's judicial system is weak, and even when courts try to enforce decisions regarding land rights, local officials ignore them with impunity. Over the past decade alone, an estimated 40 million households have had their land illegally seized or been offered inadequate compensation for it by local officials, usually in collusion with land developers.

The massive misallocation of China's wealth combined with the entrenched corruption of officials is having very real economic and social effects. For example, independent studies suggest that unemployment and severe underemployment is around 10-20 percent in urban areas and 20-40 percent in rural areas.

But if finding jobs is a problem now, finding enough young people to work will be a problem in the future. In 2015, more people will be leaving the workforce than entering it. An enormously critical juncture will be reached in 2030, when a quarter of the population -- around 350 million people -- will be older than 60, compared to just 10 percent today. Unlike in Western societies and countries like Japan, China will undoubtedly get old before it gets rich. To make matters worse, China's "pay as you go" pension pools -- which cover less than a quarter of its population -- are most likely bankrupt, as the funds have been misused by state-controlled banks and other financial bodies.

Furthermore, reported instances of "mass" social unrest directed against the government -- defined as involving 15 or more people -- have grown from a few thousand in the early 1990s to 90,000 instances in 2006, according to official figures. (A Hong Kong-based study believed that the figure in 2003 was closer to 300,000) Ominously, Beijing has since stopped revealing these figures annually. The vast majority of these protests are directed toward local officials for grievances over such things as illegal land seizures and taxes, mismanagement of the local environment -- either because of incompetence or collusion with well-connected industries -- and the misappropriation of public funds for personal use.


It is true that China has come a long way since Mao died in 1976. But the reform period that began when Deng Xiaoping took power is nearing the completion of its 30th year -- exactly half the age of modern China. In fact, the reform period has already exceeded Mao Zedong's 27 years of terrible rule. After ordering the crackdown on protesters in 1989, Deng presciently warned that the CCP had around 20 years to "get China right." Unfortunately, the party has not found the authoritarian version of the "silver bullet": a successful reform program that can enhance, rather than dilute, the CCP's relevance and grip on economic, social and ultimately political power. Worse still, there is a direct and deepening connection between the CCP's efforts to entrench its place in Chinese economic and civil society, and China's growing economic and social deficits.

Both U.S. President Barack Obama and U.S. Ambassador to China Jon Huntsman have called the U.S.-China relationship the most important one in the world. But the bilateral relationship is almost always spoken about discussed in the context of the challenges America will face as China grows stronger and more confident.

As China's military buildup confirms, Beijing is undoubtedly an ambitious regional and global power. But domestic political and social order in China depends on spectacular rates of economic growth to keep the urban classes satisfied, and tactical initiatives to keep the unsatisfied rural classes at bay. Worryingly, continued growth is dependent on an unsustainable economic model that is highly resistant to reform. It is time to seriously consider the contingency of what it might mean for the United States if, instead of continuing its rise, China becomes increasingly overwhelmed and distracted by its core weaknesses.

John Lee is the foreign policy fellow at the Centre for Independent Studies in Sydney and a visiting fellow at the Hudson Institute in Washington.

Photo: Industrial area at night, Beijing, China (photo by Peter Morgan, licensed under the Creative Commons Attribution 2.0 License).