The following correction was printed in the Guardian's Corrections and clarifications column, Saturday January 13 2007





The emergence of China as a $2 trillion economy from such inauspicious beginnings only 25 years ago is such a giddy accomplishment that the temptation to see its success as proof positive of your own prejudices is overwhelming. And the west's broad prejudice is that China is growing so rapidly because it has abandoned communism and embraced capitalism. China's own claim - that it is building a very particular economic model around what it describes as a socialist market economy - is dismissed as hogwash, the necessary rhetoric the Communist party must use to disguise what is actually happening. China proves conclusively that liberalisation, privatisation, market freedoms and the embrace of globalisation are the only route to prosperity. China is on its way to capitalism but will not admit it.

But the closer you get to what is happening on the ground in China, its so-called capitalism looks nothing like any form of capitalism the west has known and the transition from communism remains fundamentally problematic. The alpha and omega of China's political economy is that the Communist party remains firmly in the driving seat not just of government, but of the economy - a control that goes into the very marrow of how ownership rights are conceived and business strategies devised. The western conception of the free exercise of property rights and business autonomy that goes with it, essential to any notion of capitalism, does not exist in China.

The truth is that China is not the socialist market economy the party describes, nor moving towards capitalism as the western consensus believes. Rather it is frozen in a structure that I describe as Leninist corporatism - and which is unstable, monumentally inefficient, dependent upon the expropriation of peasant savings on a grand scale, colossally unequal and ultimately unsustainable. It is Leninist in that the party still follows Lenin's dictum of being the vanguard, monopoly political driver and controller of the economy and society. And it is corporatist because the framework for all economic activity in China is one of central management and coordination from which no economic actor, however humble, can opt out.

In this environment genuine wholesale privatisation is impossible and liberalisation has well-defined limits, as President Hu Jintao himself brutally reminds us. The party, he says, "takes a dominant role and coordinates all sectors. Party members and party organisations in government departments should be brought into full play so as to realise the party's leadership over state affairs". It may be true that party organisations in the provinces (some with populations bigger than Britain's) and in the chief cities are jealous of their autonomous local political control, but all retain the discretionary power to do what they choose and override any challenge or complaint from any non-state actor - or, indeed, from state actors if they cross the will of the party.

Absolute power corrupts, and the Chinese Communist party has become one of the most corrupt organisations the world has ever witnessed. The combination of absolute power and an ideology that palpably no longer describes reality is a virus that is morally and psychologically undermining the regime. And if the regime wobbles, then its capacity to sustain the unsustainable economic structures will wobble and Leninist corporatism will unravel. Beijing's authority could fragment and China's provinces reassert their destructive independence as they did in the 1910s and 20s, or a new and fiercely repressive regime could try to hold the country together abandoning economic openness and market reforms - and even pick some international fights (such as invading Taiwan?) to rally the country to its side. It is because this prospect is so real that the task of peacefully moving to a sustainable capitalism, and building the necessary institutions to do it, is so vital for both China and the world.

Ever since the late 1990s the party leadership, then under Hu's predecessor Jiang Zemin, has rightly become more and more preoccupied with how corruption is corroding the party. "If we do not crack down on corruption, the flesh-and-blood ties between the party and the people will suffer a lot and the party will be in danger of losing its ruling position, or possibly heading for self-destruction," Jiang declared in 2002, in his last political report to the National Congress. High-level officials had been arrested and imprisoned for embezzlement and racketeering; they included the party secretary and mayor of Beijing, Chen Xitong, a member of the Politburo. Cheng Kejie, vice-chairman of the National People's Congress, was executed for taking pounds 2.5m in kickbacks for arranging land deals and contracts for private business. In the financial system the highest-profile casualties were three of prime minister Zhu Rongji's hand-picked "can-do commanders", selected to sort out the financial crisis of the late 1990s, and one of whom, Li Fuxiang, leaped to his death from the seventh floor of Beijing's Hospital 304 while under investigation. To put this in a British context, it is as if the Mayor of London, the speaker of the House of Commons, the chief executive of HSBC, along with a deputy governor of the Bank of England and the deputy chief executive of the Financial Services Authority had all been imprisoned for fraud with one committing suicide.

For all the strengthening of the anti-corruption and Orwellian sounding "Central Discipline Inspection Committee", corruption remains deeply embedded. The number of arrests of senior cadres members above the county level quadrupled between 1992 and 2001, and since then have included a ring of officials in Gansu, one of China's poorest provinces, caught embezzling pounds 500m. Four provincial governors and one provincial party secretary have been charged recently - the top posts in China outside Beijing. And in September 2006 came the arrest of Shanghai party secretary and member of the politburo Chen Liangyu for his involvement in the misappropriation of pounds 206m of social security funds.

The Chinese economist Hu Angang, in his trailblazing book Great Transformations in China: Challenges and Opportunities, calculates that over the late 90s the cumulative annual cost of corruption was between 13.3% and 16.9% of GDP and is still around that level today. Every incident of corruption - smuggling, embezzlement, theft, swindling, bribery - arises in the first place from the unchallengeable power of communist officials and the lack of any reliable, independent system of accountability and scrutiny. Corruption has become part of the system's DNA, now threatening the integrity of the state.

To see how, look no further than the combination of one-party control and corruption and how it deforms the legal system. The judicial apparatus is politicised from top to bottom. Every president and vice-president of a court is appointed by the party; and the courts are funded by provincial governments. The court bureaucracy works on the same basis as the rest of the government, with a party committee system superintending each rung of the court hierarchy. Judges often make decisions at the instruction of the committee or government independently of the legal merits of the case.

Many judges still have no formal legal training - the majority are retired army officers, only too ready to do the party's bidding. The scale of the corruption is stunning. In 2003, 794 judges were tried for corruption (out of a national total of 200,000). In 2003 and 2004, the presidents of the provincial high courts of Guangdong and Hunan were both found guilty of corruption. When the party does not or cannot influence the judgment in a case, it can use its influence over the police to decide whether to slow down or not enforce the judgment. Enforcement rates in China are lamentable; for example, only 40% of provincial high court decisions are enforced. The lack of a clear system of property rights, with the party-state claiming particular privileges, can make debt enforcement against state organisations close to impossible.

As a potential watchdog to correct any of this, the media is crippled. China now has more than 2,000 newspapers, 2,000 television channels, 9,000 magazines and 450 radio stations, but they are all under the watchful eye of the party in Beijing or provincial propaganda departments. These authorities issue daily instructions on what may and may not be reported; journalists who digress will be suspended from working or even imprisoned. China is estimated to have 42 journalists in prison, the highest number in the world. Editors know roughly how much slack they have; but recently, under Hu Jintao, there has been a tightening of the leash. The right to travel independently and report from a non-local city had allowed more aggressive reporting of corruption; but it has been rescinded. Some prominent editors have been fired. For instance, Yang Bin, editor of China's most forceful tabloid, the Beijing News, was dismissed in 2005 for reporting village protests against unfair confiscation of land. Other journalists have been prohibited from publishing. The Committee to Protect Journalists, in its 2005 report on repression of the media, quotes the government-run People's Daily: "[During 2004] censorship agencies permanently shut down 338 publications for printing 'internal' information, closed 202 branch offices of newspapers, and punished 73 organisations for illegally 'engaging in news activities'."

In February 2006, three of China's most distinguished elders - Li Rui, a former aide to Mao Zedong, Hu Jiwei, former editor of the People's Daily, and Zhu Houze, a former party propaganda chief - published a letter condemning the approach: "History demonstrates that only a totalitarian system needs news censorship, out of the delusion that it can keep the public locked in ignorance," they wrote. Far from ensuring stability, they continued, such media repression would "sow the seeds of disaster".

All this is obvious to western eyes; what is less obvious is the way the same system of control undermines the economy. Successful businesses have to be successful in business terms - with managers freely exploiting opportunities, developing products and brands and promoting on ability. No such autonomy is possible within Leninist corporatism; party needs come before those of business, enforced by a national system of party committees in every enterprise, finance from state-owned banks and a complex system of accounting and ownership rights that leaves majority ownership of most enterprises with the state. Private shareholders have very limited ownership rights; companies' fixed assets are separated out in company accounts and can still only be legally owned by state and public bodies. And as MIT economist Yasheng Huang argues, government shareholders interfere, especially if a firm is successful. Countless Chinese firms, he says, have been driven to bankruptcy or thwarted in their growth ambitions because the government has exercised its ownership privileges to meet party objectives.

In short, the party state is at the centre of a spiderweb of control of the economy, radiating out from the tight ownership and direction of the 57 sectors the party considers the economy's strategic heart like steel and energy to a more relaxed stance the less important the party considers an enterprise's activity - such as packaging or hairdressing. Even they can be controlled if need be. The general rule is that the more politicised and controlled a Chinese enterprise, the lower its productivity and performance. Thus the performance of China's State Owned Enterprises (SOEs), which control two-thirds of industrial assets, has hardly improved during 20 years of reform. One in three of their employees is estimated to be structurally idle. SOEs are on a financial edge and barely profitable. According to one influential estimate, even the tiniest upward movement in interest rates or the slightest decline in sales would mean that 40%-60% of their enormous bank debts would not be serviced, rendering the entire Chinese banking system bankrupt. They are commercial and business disaster areas.

Even large private companies, although better performing, are still affected. Davin Mackenzie, managing director of iVentures, which is based in Beijing, says that almost no private company, however well run, wants to leave the opaque, informal world of guanxi personal relationships in which the main aim is to hide revenue, cash, and profits from potential political direction. The vast majority, he says, run themselves out of the "cash box in the back of the Mercedes". Most private Chinese companies have three sets of accounts - one for the banks, one for the tax authorities, and one for management. Most do not last long; the average duration is three years. The law of the jungle prevails: you do what you can get away with. China is the counterfeiters' paradise, where intellectual property rights are neither respected nor enforced. Between 15% and 20% of all well-known brands in China are fake; two-thirds of the imports confiscated by US Customs as fakes were made in China. Counterfeiting is estimated to represent 8% of GDP - eloquent testimony to Chinese business strategies and the ineffectiveness of the legal system.

The cumulative result of all this is economic weakness, despite the eye-catching growth figures. Innovation is poor; half of China's patents come from foreign companies. Its growth depends on huge investment, representing an unsustainable 40% or more of GDP financed by peasant savings. But China now needs $5.4 of extra investment to produce an extra $1 of output, a proportion vastly higher than that in economies such as Britain or the US. But 20 years ago, China needed just $4 to deliver the same result. In other words, an already gravely inefficient economy has become even more inefficient. China's national accounts tell the same story. Hu Angang calculates that China is now back to the Mao years in term of the inefficiency with which it uses capital to generate growth.

Behind all these problems lie Leninist corporatism. Capitalism, I contend, is much more than the profit motive and the freedom to set prices which China's reforms have permitted. It is a system in which many different actors freely take different decisions according to their best judgment; some are right and some are wrong, but the system never has to bet on any one being right for everyone - as in an authoritarian system of centralised economic control. But this economic pluralism is closely intertwined and dependent upon the wider political capacity of different citizens to be able to be part of a public space in which they can debate options and choices. It is because democracies possess such public spaces that, over decades, even the weakest tend to manage themselves better than authoritarian states. There is less likelihood of group-think, conformism and top-down plans that militate against good decisions - or of the quick reversal of poor decisions.

This public sphere is a whole network of "soft" independent processes of scrutiny, justification, transparency and accountability that range from a free media to independent justice. Representative government in which the people regularly vote for their governors is but the coping stone of this structure. And the processes of scrutiny and deliberation do not stop just with the state - the same processes are extended to capitalism and the market economy, and through having to justify themselves, makes them more honest and better performing.

But none of this can happen if individuals are not free and capable of being involved - and having the capacity, through the independence that property ownership, education, trade union membership and citizenship confers, freely to challenge and change individual policies, whether they are those of the government or the company they work for. These social processes work best the less social distance there is between people. The more inequality and the more social distance, the less well these processes of pluralism, capabilities and accountability can function. And the less well capitalism then functions. So China leads to an unexpected insight. Capitalism works best the more inequality is capped - and the more and better developed its democratic institutions.

The west is unforgivably ignorant about China's shortcomings and weaknesses, which leads it vastly to exaggerate the extent of the Chinese "threat". China is certainly emerging as a leading exporter, but essentially it is a sub-contractor to the west. It has not bucked the way globalisation is heavily skewed in favour of the rich developed nations. Its productivity is poor; it lacks international champions; its innovation record is lamentable; it relies far too much on exports and investment to propel its economy. To characterise China as an unstoppable force whose economic model is unbeatable and set to swamp us - the stuff of almost every ministerial and business lobby speech - is to make a first-order mistake.

Rather, the west needs to understand the depth of China's problems and the possibility, if not probability, of an economic and political convulsion as China seeks their resolution. What the west must avoid is a position where it forces the Chinese leaders' hand and China retreats towards economic isolation and freezing the reform process. The challenge to the global trading and financial system would be profound; not only would an important source of global demand be scaled back, a key source of financing the US trade deficit would be removed. China's progress would be shaken to its core.

The interest of the west is to help China avoid this fate and encourage a peaceful transition to a pluralist China within a legitimate system of accountability; a country that is comfortable with liberal globalisation and the international rule of law. To describe the goal of policy in this way is demanding enough; more demanding still is to execute it. The simple extrapolations of China's growth, predicting that it will eventually become a one-party, economic colossus, lead to an alarmist climate in which it is easier to justify trade protection or, in the United States, potential military activism. Such responses are naive. We have to play it long, encourage and help to co-manage the change that must come. Only thus will the world be a safer and still prosperous place.



· Will Hutton's The Writing on the Wall is published on January 18 at pounds 20. To pre-order a copy for pounds 18 with free uk p&p go to theguardian.com/bookshop or call 0870 836 0875