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 . . .