Chinas Troubled TransitionAnyone who goes to visit China today sees the progress that has made headlines.
Officials who take you on a tour will be happy to show you the sparkling new office complexes and industrial parks that line the impeccably landscaped highways.
But the sprawling new factories and luxury shopping malls add up to only part of the picture.
According to a recent report from the Carnegie Endowment for International Peace, if you dig beneath this glittering surface, you find a nation that is being run from on high by an elite cadre of politicians who are ignoring the needs of most of its citizens.
In fact, according to a report in the latest issue of The McKinsey Quarterly,1 China suffers from a stagnant rural economy, widespread poverty, unemployment, an unstable financial system, social disorder, and rampant corruption.
But it’s easy to overlook the reality when the country’s economy seems to be booming.
Earlier this year, China’s gross domestic product topped that of Great Britain and France, putting China in fourth place among the world’s largest economies.
Late last year, China became the largest exporter of technology in the world. In the process, the Chinese economy is gaining on the U.S., and some believe China will actually be the world’s largest economy by mid-century.2
For this and other reasons, China has become a magnet for investors from all over the world who see that nation as both the world’s greatest manufacturer and the world’s greatest potential market.
Investors have been snapping up Chinese investments and, thereby, driving up the prices of Chinese companies.
For example, the largest banking institutions in the world are buying into Chinese banks, ignoring the fact that they are sitting on billions in bad loans.
Among the players are Bank of America and Citibank.
In addition, every big auto company has either built or is in the process of building factories in China, even as the car market appears over-saturated.
To justify such moves, businesspeople point to China’s amazing record of advancement and growth.
But, just how good is that record?
Not nearly as good as some would lead you to believe!
If you examine the cold, hard numbers, you find that Japan, South Korea, and Taiwan have actually achieved much more impressive growth than China since 1979.
For example, China has had to spend 30 percent of its gross domestic product on bailing out failed state-run banks during the past few decades.
Nevertheless, its banking system remains perpetually on the brink of collapse.
By comparison, India saw a return on investment that was between 80 percent and 200 percent higher than in China, depending on the industry sector you choose to measure.
According to a recent report from the global intelligence firm Stratfor, even though China’s numbers show some astonishing growth, it is the wrong kind of growth for creating the long-term success needed for a sustainable economy.3
For example, more than 16 percent of all of China’s loans go to housing.
But even while the country suffers through a housing shortage, 700,000 new apartments stand vacant.
The problem is that the Chinese system produces the wrong kind of housing in the wrong places.
That kind of mindless growth does not lead to a healthy economy.
And it’s this misallocation of resources that is part of the reason China has become the world’s largest consumer of many raw materials, even as it earns less than 5 percent of the world’s GDP.
And, despite all the hype about reform, China remains near the bottom of the list of nations in terms of its economic freedom, well below most of Eastern Europe, as well as numerous other Third World countries, such as India and Mexico.
One reason for this is the heavy hand of the state in the economy.
As we have pointed out before, the only way to grow a truly robust economy is by allowing free agents to interact and create it from the bottom up.
Top-down economies never work in the long run.
China is no exception.
According to the latest figures available, the Chinese government employed a third of the population in cities and created 38 percent of the GDP.
A survey by UBS shows that less than one-third of the economy is in private hands.
By comparison, 95 percent of the economies of most other Asian countries are privately held.
For example, in India, the government controls only 7 percent of the economy.
Making matters worse in China, the government directly owns most of the money and most of the production capacity.
From this position, it wields virtually monopolistic powers over such industries as banking, financial services, telecommunications, energy, automobile manufacturing, transportation, steel, and natural resources.
To maintain that position, it simply forbids competition from within China or from abroad.
The government controls the land and the loans, so it can dictate who can ? and who cannot ? enter a market.
Not surprisingly, those who can enter a given market are the party members with the best political connections.
Since those in power cannot hold onto power solely through oppression and threats, they must also provide incentives for the vast bureaucracies, the military, and the businesspeople.
So it must tread a fine line between totalitarianism and handing out perks and patronage to sweeten the deal to ensure the loyalty of privileged party members and special interest groups.
As a consequence, the party appoints 81 percent of the CEOs of state-owned companies.
The fact is, the corporate reforms of the last few years are largely for show, and even those companies that are publicly traded are still under Communist Party control.
This has led to a system in which those in authority can essentially loot the Chinese economy to increase their personal wealth.
Such a system doesn’t need to be efficient, because money is essentially free.
For example, if one of the higher-ups in the party wishes to ensure the loyalty of a particular region of the country, all he needs to do is give the local bureaucrats a new car factory.
Those officials will get rich from the construction, and the local population will be happily employed and less likely to complain.
Meanwhile, the money will be flowing from government coffers in a steady stream, even as no one demands that the factory make a profit or raise productivity.
According to a study by the World Bank, a third of the decisions about such investments by China were wrong between 1991 and 2000.
Such patronage also resulted in 60 percent of failed bank loans in 2001 and 2002.
Even China itself admits this, reporting that almost a dozen major manufacturing industries were producing goods for which there was no demand or market.
The steel industry alone suffers from 30 percent over-capacity.
And of course, in a commodity business like steel, over-capacity means the collapse of prices.4
This in turn has meant that Chinese companies are not profitable, running at a median ROI of only 1.5 percent, with more than a third of companies losing money.
But the demand from on high for growth has pushed lower-level party officials and local bureaucrats to create the appearance of growth at any cost.
And that has resulted in the apparent veneer of success that you see when you visit China: office towers, factories, and malls lining the landscaped highways that serve up the attractive impression of prosperity.
Unfortunately, the death knell of an economy is delivered by organized and systematized graft and corruption.
And that is now the norm developing in China ? especially in state monopolies such as banking, infrastructure, financial services, and tobacco.
Even larger is the real estate market, where party officials have an open opportunity to profit.
Meanwhile, ordinary citizens in China are suffering in poverty.
Income inequality has increased by more than 50 percent in the past few decades, while a fraction of 1 percent of the Chinese control more than 60 percent of the country’s wealth.
As a result, education and public health are at all-time lows.
According to the World Health Organization, Chinese healthcare is worse than in all countries except Brazil and Burma, despite its supposedly booming economy.
Worst of all, fully two-thirds of the population has no access to healthcare at all.
The result is that, every year, China experiences more and more confrontations between police and citizens objecting to what they see as corruption and incompetence.
In light of these facts, we offer six forecasts for your consideration:
First, China will struggle to transform itself from a low-margin contract manufacturer into a high-margin hub of innovation.
China will spend billions to build labs and train Ph.D. researchers.
Its mantra is “innovate rather than imitate.”
But, without entrepreneurial incentives including the rule of law, China’s commercial results will resemble those generated by the million-plus Ph.D. researchers working in Russia.
Russia has been stuck at the level of affluence we see in China today for 50 years and it’s had a nominally capitalist system for about 15 years.
It has even generated income through its oil and gas industries.
But capital and education are not enough: Almost all of Russia’s growth has been in de facto organized crime.
China will have to work hard to escape a similar fate.
Second, the Chinese government is now stretched to the breaking point between its desire to hold onto totalitarian power and its need to make sweeping economic reforms that will bring market forces into its way of doing business.
The pressures to change are building, and with a population of 1.3 billion people, it’s difficult to say whether the greatest pressure will come from within or from without.
What’s certain is that change is inevitable.
Third, by 2050, China will become either a democratic state like Taiwan or South Korea, or a “kleptocracy” analogous to modern Russia.
Despite vast segments of the Chinese population who live in poverty, the mean average person in China is not as poor as the mean average person in many Third World democracies like the Philippines or India.
In fact, the average purchasing power of a Chinese citizen is $4,500 on a Purchasing Power Parity basis.
So, it’s not poverty that keeps China from becoming a sustainable democratic state with a free market economy, private property rights, and guaranteed human rights.
The only force standing in the way right now is the corruption and crony capitalism that result from having a neo-Leninist government.
Aside from Hong Kong and Taiwan, the Chinese lack models for operating in a non-authoritarian mode.
As in Russia, eliminating the iron fist of the state will cause more problems than opportunities unless the people are ready to replace it with Adam Smith’s “invisible hand.”5
Fourth, in either case, the situation in China will have to get worse before it gets any better.
The fact is, as much of a mess as the Chinese economy is in, it has grown; and even unhealthy growth can serve to keep a regime in power.
As long as those in power have money flowing through their hands, change won’t come from within the Communist Party.
Those government officials will bolster law enforcement and the military to ensure that a democratic movement doesn’t arise from within the vast disenfranchised population.
Meanwhile, the upper classes of professionals, entrepreneurs, and intelligentsia are made complacent by access to the luxuries of Western lifestyles.
In this way, the government neutralizes almost everyone who would move for reform.
Only when the civil unrest becomes unmanageable will the change be forced upon those in power.
Fifth, Chinese efforts at neutralizing the forces of democracy will be unsustainable.
Sooner or later, the flaws in the economic structure will grow into great fissures, and the privileges China lavishes on its upper classes will disappear.
Buying political loyalty lasts only as long as the money is flowing, and without change, China’s economy is headed for a crash.
In this fragile condition, any political shock from without or within could cause the scheme to come unraveled.
At that point, the country will be ripe for change, pushed by both the elite and the poor.
This is likely to lead to more repression and a potentially unhappy period of painful change.
China may still generate some reasonable short-term returns, but theTrends editors believe it’s way too early for the long-term investor to get involved.
Sixth, in the coming decade, expect more decay rather than a rapid transformation to a democratic state.
As recently observed by Roderick MacFarquhar, a professor of history and political science at Harvard University, China’s Communist one-party state is unsustainable and will have to change.6
But inertia will carry it on for some time to come.
Then, when the transition comes and China’s 2,000 - year history of totalitarianism ends ? which it inevitably must in the modern world ? it is an open question whether it will move with relative ease to become a democratic state like Indonesia, Mexico, or the Philippines, or will instead deteriorate into the kind of corruption and authoritarianism Russia found itself in after communism fell.
References List :
1. To access the report “Putting China’s Capital to Work,” visit the McKinsey & Company website at: www.mckinsey.com
2. Foreign Policy, March/April 2006, “The Dark Side of China’s Rise,” by Minxin Pei. ⓒ Copyright 2006 by the Carnegie Endowment for International Peace. All rights reserved.
3. Stratfor.com, June 6, 2006, “An Inflection Point in China’s Banking Problem,” by George Friedman. ⓒ Copyright 2006 by Strategic Forecasting, Inc. All rights reserved.
4. Foreign Policy, March/April 2006, “The Dark Side of China’s Rise,” by Minxin Pei. ⓒ Copyright 2006 by the Carnegie Endowment for International Peace. All rights reserved.
5. An Inquiry into the Nature and Causes of the Wealth of Nations (Fifth Edition) by Adam Smith is published by Methuen and Co., Ltd. ⓒ Copyright 2000 by Liberty Fund, Inc. All rights reserved. 6.
6. Foreign Policy, March/April 2006, “Rotting from the Inside Out,” by Roderick MacFarquhar. Copyright 2006 by the Carnegie Endowment for International Peace. All rights reserved.
