The Dark Side of China’s Rise

The only thing rising faster than China is the hype about China. In January, the People’s Republic’s gross domestic product (GDP) exceeded that of Britain and France, making China the world’s fourth-largest economy. In December, it was announced that China replaced the United States as the world’s largest exporter of technology goods. Many experts predict that the Chinese economy will be second only to the United States by 2020, and possibly surpass it by 2050.

Western investors hail China’s strong economic fundamentals — notably a high savings rate, huge labor pool, and powerful work ethic — and willingly gloss over its imperfections. Businesspeople talk about China’s being simultaneously the world’s greatest manufacturer and its greatest market. Private equity firms are scouring the Middle Kingdom for acquisitions. Chinese Internet companies are fetching dot-com-era prices on the NASDAQ. Some of the world’s leading financial institutions, including Bank of America, Citibank, and HSBC, have bet billions on the country’s financial future by acquiring minority stakes in China’s state-controlled banks, even though many of them are technically insolvent. Not to be left out, every global automobile giant has built or is planning new facilities in China, despite a flooded market and plunging profit margins.

And why shouldn’t they believe the hype? The record of China’s growth over the past two decades has proved pessimists wrong and optimists not optimistic enough. But before we all start learning Chinese and marveling at the accomplishments of the Chinese Communist Party, we might want to pause for a moment. Upon close examination, China’s record loses some of its luster. China’s economic performance since 1979, for example, is actually less impressive than that of its East Asian neighbors, such as Japan, South Korea, and Taiwan, during comparable periods of growth. Its banking system, which costs Beijing about 30 percent of annual GDP in bailouts, is saddled with nonperforming loans and is probably the most fragile in Asia. The comparison with India is especially striking. In six major industrial sectors (ranging from autos to telecom), from 1999 to 2003, Indian companies delivered rates of return on investment that were 80 to 200 percent higher than their Chinese counterparts. The often breathless conventional wisdom on China’s economic reform overlooks major flaws that render many predictions about China’s trajectory misleading, if not downright hazardous.

Behind the glowing headlines are fundamental frailties rooted in the Chinese neo-Leninist state. Unlike Maoism, neo-Leninism blends one-party rule and state control of key sectors of the economy with partial market reforms and an end to self-imposed isolation from the world economy. The Maoist state preached egalitarianism and relied on the loyalty of workers and peasants. The neo-Leninist state practices elitism, draws its support from technocrats, the military, and the police, and co-opts new social elites (professionals and private entrepreneurs) and foreign capital — all vilified under Maoism. Neo-Leninism has rendered the ruling Chinese Communist Party more resilient but has also generated self-destructive forces.

To most Western observers, China’s economic success obscures the predatory characteristics of its neo-Leninist state. But Beijing’s brand of authoritarian politics is spawning a dangerous mix of crony capitalism, rampant corruption, and widening inequality. Dreams that the country’s economic liberalization will someday lead to political reform remain distant. Indeed, if current trends continue, China’s political system is more likely to experience decay than democracy. It’s true that China’s recent economic achievements have given the party a new vibrancy. Yet the very policies that the party adopted to generate high economic growth are compounding the political and social ills that threaten its long-term survival.

COMMAND AND CONTROL

After a quarter century of gradual economic reform, has China succeeded in transforming its old command economy into a genuine market economy? Not nearly as well as most people would guess. Although China was one of the earliest socialist economies to begin serious reform, recent data on the country’s regulation, international trade, fiscal policy, and legal structure place China in the bottom third of 127 countries surveyed for economic freedom, below most Eastern European countries, India and Mexico, and all of its East Asian neighbors, save Burma and Vietnam.

The Chinese state remains deeply entrenched in the economy. According to official data for 2003, the state directly accounted for 38 percent of the country’s GDP and employed 85 million people (about one third of the urban workforce). For its part, the formal private sector in urban areas employed only 67 million people. A research report by the financial firm UBS argues that the private sector in China accounts for no more than 30 percent of the economy. These figures are startling even for Asia, where there is a tradition of heavy state involvement in the economy. State-owned enterprises in most Asian countries contribute about 5 percent of GDP. In India, traditionally considered a socialist economy, state-owned firms generate less than 7 percent of GDP.

But China’s tentacles are even more securely wrapped around the economy than these figures suggest. First, Beijing continues to own the bulk of capital. In 2003, the state controlled $1.2 trillion worth of capital stock, or 56 percent of the country’s fixed industrial assets. Second, the state remains, as befits a quintessentially Leninist regime, securely in control of the "commanding heights" of the economy: It is either a monopolist or a dominant player in the most important sectors, including financial services, banking, telecommunications, energy, steel, automobiles, natural resources, and transportation. It protects its monopoly profits in these sectors by blocking private domestic firms and foreign companies from entering the market (although in a few sectors, such as steel, telecom, and automobiles, there is competition among state firms). Third, the government maintains tight control over most investment projects through the power to issue long-term bank credit and grant land-use rights.

China’s business cycle is therefore driven by Beijing. Private-sector firms have very limited access to finance or new markets. The state even dominates many ostensibly deregulated sectors, such as the brewing industry, the retail sector, and textiles. Of the 66 publicly traded retailers in the country, only one is private. There are only 40 private firms among the 1,520 Chinese companies listed on domestic and foreign exchanges.

THE PARASITIC STATE

To many observers, Beijing’s tight grip on the Chinese economy means only that its reform process is incomplete. As China continues to open itself, they predict, state control will ease and market forces will clear away inefficient industries and clean up state institutions. The strong belief in gradual but inexorable economic liberalization often has a political corollary: that market forces will eventually produce civil liberties and political pluralism.

It’s a comforting thought. Yet these optimistic visions tend to ignore the neo-Leninist regime’s desperate need for unfettered access to economic spoils. Few authoritarian regimes can maintain power through coercion alone. Most mix coercion with patronage to secure support from key constituencies, such as the bureaucracy, the military, and business interests. In other words, an authoritarian regime imperils its capacity for political control if it embraces full economic liberalization. Most authoritarian regimes know that much, and none better than Beijing.

Today, Beijing oversees a vast patronage system that secures the loyalty of supporters and allocates privileges to favored groups. The party appoints 81 percent of the chief executives of state-owned enterprises and 56 percent of all senior corporate executives. The corporate reforms implemented since the late 1990s — designed to turn wholly state-owned firms into shareholding companies — haven’t made a dent in patronage. In large- and medium-sized state enterprises (ostensibly converted into shareholding companies, some of which are even traded on overseas stock markets), the Communist Party secretaries and the chairmen of the board were the same person about half the time. In 70 percent of the 6,275 large- and medium-sized state enterprises classified as "corporatized" as of 2001, the members of the party committee were members of the board of directors. All told, 5.3 million party officials — about 8 percent of its total membership and 16 percent of its urban members — held executive positions in state enterprises in 2003, the last year for which figures were available.

An incestuous relationship between the state and major industries can doom developing countries, and China is more susceptible than most. The combination of authoritarian rule and the state’s economic dominance has bred a virulent form of crony capitalism, as the ruling elites convert their political power into economic wealth and privilege at the expense of equity and efficiency. The state’s economic dominance preserves systemic economic inefficiency as scarce resources are funneled to local elites and bureaucratic constituencies. The World Bank estimates that, between 1991 and 2000, almost a third of investment decisions in China were misguided. The Chinese central bank’s research shows that politically directed lending was responsible for 60 percent of bad bank loans in 2001–02. The problem persists today. Chinese economic planners revealed in early 2006 that 11 major capital-intensive manufacturing industries were overproducing. For example, the country’s steel industry, the world’s largest, has 116 million tons (or about 30 percent) of excess capacity.

State enterprises are also miserably unprofitable. In 2003, a boom year, their median rate of return on assets was a measly 1.5 percent. More than 35 percent of state enterprises lose money and 1 in 6 has more debts than assets. China is the only country in history to have simultaneously achieved record economic growth and a record number of nonperforming bank loans.

Party membership and business acumen do not often go together. Because of the party’s fixation with high growth, government officials are rewarded for delivering, or appearing to deliver, precisely that. This incentive structure fuels a massive misallocation of capital to "image projects" (such as new factories, luxury shopping malls, recreational facilities, and unnecessary infrastructure) that burnish local officials’ records and strengthen their chances of promotion. The results of these mistakes — gleaming office complexes, industrial parks, landscaped highways, and public squares — tend to impress Western visitors, who view them as further proof of China’s economic prowess.

The Chinese economy is not merely inefficient; it has also fallen victim to crony capitalism with Chinese characteristics — the marriage between unchecked power and illicit wealth. And corruption is worst where the hand of the state is strongest. The most corrupt sectors in China, such as power generation, tobacco, banking, financial services, and infrastructure, are all state-controlled monopolies. None of that is unprecedented, of course. Tycoons in Russia, after all, have looted the state’s natural resources. China, at least, boasts genuine private entrepreneurs who have built prosperous companies. But China’s politically connected tycoons have cashed in on China’s real estate boom; nearly half of Forbes’ list of the 100 richest individuals in China in 2004 were real estate developers.

Various indicators, pieced together from official sources, suggest endemic graft within the state. The number of "large-sum cases" (those involving monetary amounts greater than $6,000) nearly doubled between 1992 and 2002, indicating that more wealth is being looted by corrupt officials. The rot appears to be spreading up the ranks, as more and more senior officials have been ensnared. The number of officials at the county level and above prosecuted by the government rose from 1,386 in 1992 to 2,925 in 2002.

An optimist might believe that these figures reveal stronger enforcement rather than metastasizing corruption, but the evidence suggests otherwise. Dishonest officials today face little risk of serious punishment. On average, 140,000 party officials and members were caught in corruption scandals each year in the 1990s, and 5.6 percent of these were criminally prosecuted. In 2004, 170,850 party officials and members were implicated, but only 4,915 (or 2.9 percent) were subject to criminal prosecution. The culture of official impunity is thriving in China.

What’s worse, corruption is now assuming forms normally associated with regime decay. Corruption involving large numbers of officials used to be rare. Now it’s rampant. Regional data suggest that large-scale corruption rings account for 30 to 60 percent of all the cases of graft uncovered by authorities. In some of the worst instances, entire provincial, municipal, and county governments were found to be tainted. In Heilongjiang Province, a corruption scandal involved more than 400 local officials, including the former governor, the former organizational chief of the party’s provincial committee, a vice governor, the chief prosecutor, the president of the provincial high court, and eight of the province’s 13 party bosses. According to official reports, in Shenyang (the capital of Liaoning Province), Fuzhou (the capital of Fujian Province), and more than 30 other counties and prefectures, groups of senior local officials, including party chiefs and mayors, have been on the payroll of organized gangs involved in murder, extortion, gambling, and prostitution.

As ominous as the corruption itself is what these scandals are beginning to reveal about the government’s legitimacy. In their confessions, corrupt officials often blame their misdeeds on a loss of faith in communism. There is anecdotal evidence that senior party officials have taken to consulting fortune-tellers about their political careers. The ruling elite in China, it appears, is drifting and insecure. Fearful about what the future may hold, some officials do not want to wait even a few years to turn their power into wealth. In 2002, almost 20 percent of the officials prosecuted for bribery and nearly 30 percent of those punished for abuse of power were younger than 35. In Henan Province in 2003, 43 percent of local party bosses caught up in corruption were between 40 and 50 years old (as compared with 32 percent older than 50). China has seen its future leaders, and a disproportionate number of them are on the take.

THE TWO CHINAS



With elites cashing in quickly, ordinary Chinese are falling behind. Estimates from various sources, including the World Bank and the Chinese government, suggest that income inequality has increased at least 50 percent since the late 1970s, making China one of the most unequal societies in Asia. A recent study reports that less than 1 percent of Chinese households control more than 60 percent of the country’s wealth (by comparison, 5 percent of the households in the United States own 60 percent of the wealth). Rising inequality, to be sure, is not unusual in countries moving toward a market economy, but China’s neo-Leninist system, warped incentives, and elitist policies have amplified the trend.

A generation ago, the offspring of the ruling elite took up positions in the government or military; today, they go into business. The social ramifications of their self-dealing are particularly evident in real estate, where peasants regularly earn less than 5 percent of the value of their land while developers pocket 60 percent, with the remainder going into local government coffers. Privatization, too, offers insiders a chance to hit it rich by gobbling up state assets on the cheap. A recent study showed that 60 percent of privatized state enterprises were sold to their managers. As a result, 30 percent of all private-firm owners are now party members.

Meanwhile, basic services and good governance for ordinary Chinese are falling further behind. According to the World Bank, China’s governance ranks in the bottom half of all the countries in the world. China underinvests in crucial social services, especially education and public health. Government expenditures on education fell nearly 20 percent as a share of total education spending in the 1990s. In rural areas, home of China’s poorest citizens, 78 percent of the education budget must be raised from peasants through local taxation and fees, while Beijing provides only 1 percent of the funding for rural education.

In public health, the consequences of misspending are even more severe. Government money, which accounted for 36 percent of all health expenditures in the 1980s, plunged to less than 15 percent by 2000. China has hospitals and equipment, and its per capita spending is higher than comparable developing countries. But these resources are among the most unequally distributed in the world. The World Health Organization rated the fairness of the Chinese healthcare system below all countries except Brazil and Burma. According to China’s own Ministry of Health, two thirds of the population lacks any type of health insurance, and about half of the sick do not seek professional medical treatment at all.

DEMOCRACY DELAYED

Rapid economic growth has not yet produced China’s much-anticipated political pluralism. Perhaps, some observers speculate, China is still too poor to afford democracy. But with a per capita income of nearly $1,500 ($4,500 if you consider people’s purchasing power), China is richer than many poor democracies. It’s not poverty that is holding up democracy; it’s a neo-Leninist state and the crony capitalism it fosters.

In part, democracy itself has been a victim of the country’s economic expansion. However flawed and mismanaged, the country’s rapid growth has bolstered Beijing’s legitimacy and reduced pressure on its ruling elites to liberalize. Democratic transitions in developing countries are often triggered by economic crises blamed on the incompetence and mismanagement of the ancien régime. China hasn’t experienced that crisis yet. Meanwhile, the riches available to the ruling class tend to drown any movement for democratic reform from within the elite. Political power has become more valuable because it can be converted into wealth and privilege unimaginable in the past. At the moment, China’s economic growth is having a perverse effect on democratization: It makes the ruling elite even more reluctant to part with power.

Lavish government spending on law and order helps to ensure that power-sharing won’t be necessary in the near future. Since the Tiananmen Square tragedy, the party has invested billions in beefing up the paramilitary police force (the People’s Armed Police) that has been deployed in suppressing internal unrest. To counter the threat posed by the information revolution, and especially the Internet, the Chinese government has blended technological savvy with regulatory might. The Chinese "Internet police," officially known as the Ministry of Public Security’s Internet and Security Supervision Bureau, is reportedly more than 30,000 strong. Its Beijing branch proudly claimed that, in 2002, it participated in a multi-agency exercise to see whether the government could rid the Internet of "harmful content" within 48 hours of the onset of an emergency. (During the exercise, all "harmful content" was removed in 19 hours.) The party’s refined strategy of "selective repression" targets only those who openly challenge its authority while leaving the general public alone. China is one of the few authoritarian states where homosexuality and cross-dressing are permitted, but political dissent is not. Domestic opposition groups and individuals who might challenge the party’s authority are left isolated and powerless.

The emerging social elite, by contrast, is co-opted and coddled. The party showers the urban intelligentsia, professionals, and private entrepreneurs with economic perks, professional honors, and political access. For example, nationwide, 145,000 designated experts, or about 8 percent of senior professionals, received "special government stipends" (monthly salary supplements) in 2004; tens of thousands of former college professors have been recruited into the party and promoted to senior government positions. At least for now, the party’s charm campaign is working: The social groups that are normally the forces of democratization have been politically neutralized.

China’s neo-Leninist regime has formidable resources—but much more serious defects. State-directed investment, made to secure the political loyalty of key constituencies and advance personal careers, will prevent China from realizing its economic potential. The corruption of the state will likely deepen. The deterioration of the public health infrastructure and education systems will generate social tensions and mass alienation, thus eroding the party’s base of support and increasing its vulnerability to the economic or political shocks that will inevitably come.

China has already paid a heavy price for the flaws of its political system and the corruption it has spawned. Its new leaders, though aware of the depth of the decay, are taking only modest steps to correct it. For the moment, China’s strong economic fundamentals and the boundless energy of its people have concealed and offset its poor governance, but they will carry China only so far. Someday soon, we will know whether such a flawed system can pass a stress test: a severe economic shock, political upheaval, a public health crisis, or an ecological catastrophe. China may be rising, but no one really knows whether it can fly.