China’s Economic Slow Down Will Have Political Consequences – Critics Argue That The Vast System Of State Owned Enterprises Is Wasteful – Reforms Ahead?

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By Paolo von Schirach

October 20, 2012

WASHINGTON – China is facing a major economic problem wrapped in a political problem. The emerging evidence is that the reformed, Deng Xiaoping vintage, economic model is not working so well anymore. The impressive impetus towards economic liberalization that began in the 1980s unleashed the creativity and ingenuity of tens of millions of entrepreneurial Chinese. Once it was established that making money was not inconsistent with a still dominant Communist political structure, China was on a roll.

China’s model

For decades China did extremely well because of the optimized combination of several factors: massive public investments in infrastructure that allowed manufacturer to deliver goods to foreign customers in record time, cheap labor, an under valued currency that favored exports and an almost perennial construction boom that enriched local officials and developers, while employing tens of millions. The entire growth strategy was financed through cheap capital provided by a state banking monopoly that could attract all private savings at almost zero cost.

As the economy grew at a fantastic rate of 10%, year after year, the Chinese Communist Party re-legitimized its political monopoly by transforming itself into a supercharged Chamber of Commerce, relentlessly pursuing economic growth.

The Chinese are masters at changing content while leaving the old labels intact. Mao is still on all the Chinese bank notes, even though this is no longer Mao’s China. Likewise, it does not matter that the Communist Party is no longer pursuing Marxist orthodoxy. What matters is that the Communist Party is still in power, retaining just as before an absolute political monopoly.

That said, there are signs that this ideal union between an ever growing economy and political control may not work any more. Let’s see why.

Not working so well now

First of all, China’s construction boom cannot continue at the same pace. There is just too much unneeded stuff. Too many empty office towers and even empty planned cities (such as Ordos, in inner Mongolia). There is brand new but underutilized infrastructure that creates no value. You cannot just keep adding more to it, simply to show higher GDP numbers.

Secondly, the vast price advantage provided by China’s cheap labor has been eroded. Chinese labor costs are growing, and so its exports can no longer be super cheap. Going forward, one can expect that they will reach parity with the West. At that point China will have to compete on quality rather than price. How many consumers in the West buy a product because of the superior quality of Chinese brands? They buy it because it is cheap.

Chinese economist argue against SOEs

Less construction and slower exports translate into slower growth. As all this is unfolding, some Chinese economist question the Keynesian model of more stimulus to be provided by more public spending. (See AP story: China’ New Leaders Face Tough Economic Choices, October 21, 2012). They argue, quite correctly, that in the long run this is terribly inefficient and wasteful. They point out that the still vast system of China’s State Owned Enterprises (SOEs) consumes wealth, while providing in the aggregate negative returns. (Some have estimated an average return on equity of minus 6%). The World Bank, working in conjunction with a Chinese think tank, recommended in March that China would undertake a major reform of its SOEs in order to regain economic efficiency.

Other Chinese intellectuals, (see many articles published in the magazine Caixin), have squarely accused the SOEs sector of being mostly a series of wasteful monopolies controlled by the politically connected to further their own power interests, as opposed to being wealth producing entities.

Politics and economics

That said, the very notion of reforming half or more of the Chinese economy, the half that is controlled by the state, is an almost impossible task from a political standpoint. And this is because the SOEs system is totally intertwined with the power structure. And the Chinese power structure, now determined by a system based on cooptation that favors continuity, is singularly unsuited to launch bold reforms.

The leaders who rise to the top in China are not reformers; they are skilled survivors who managed to avoid major problems on their way up. On top of that, the huge number of people who run the SOEs and benefit from them, whatever the inefficiencies of the system, have no interest whatsoever in any reform. In fact they will oppose any effort in this direction because for them this is a matter of personal political and econ0mic survival.

Unsustainable model?

Taking all this into account, without serious pro-market reforms, it is most likely that China’s incredible economic rise will end soon. This does not mean economic disaster, of course, only going back to “normal” growth. Still, much slower economic growth will allow Chinese critics of the current, inefficient set up to voice their discontent. (On October 13-14, the WSJ published an interesting interview with one of them, Zhan Wiying of Peking University). And since in China economic policy criticism implies some degree of political dissent, we may very well be on the verge of something quite dramatic.

Market economies and autocracy

In the end, what China did was incredible and unprecedented: several decades of sustained economic growth successfully managed by an autocratic regime.

Still, history shows that we can have sustained economic growth and we can have autocracy. However, in the long run the two are mutually exclusive. Post-Stalinist Russia failed. Semi-reformed China has done a lot better, but it may be close to running out of steam.

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