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China is headed for breaking point – unless its institutions can change


Nick Henderson

By

October 20th, 2017


Nick Henderson considers the impact of China’s political institutions on its future, and argues that Chinese growth in its current form is unsustainable.


It’s hardly up for debate – China is a cornerstone of the 21st century world economy, and for good reason. Since 1978, China’s economy has grown with breakneck speed, with an average annual GDP growth rate of around 10 percent, coupled with exponential increases in per capita household income, and a dramatic reduction in the number of individuals living in absolute poverty.[1]

However, past performance is not necessarily an indicator of future outcomes, and issues China’s political landscape remains a huge roadblock for the nation’s future prosperity. In their 2013 book Why Nations Fail, Daron Acemoglu and James A. Robinson postulate that a nation’s long-term success is defined by the inclusiveness of its economic and political institutions.[2] While China’s economic institutions have developed greatly since 1978, its political institutions remain ‘extractive’, controlled by an all-powerful Communist Party.

This is an enormous restriction on future growth potential, but more importantly it prevents the broader Chinese population from gaining any political traction. No political traction means poor political representation, which can lead to large segments of the Chinese population being disenfranchised. History has shown that these extractive systems will not allow for broad prosperity in the long-term.

Explaining China’s growth miracle

China’s rapid growth post-Mao Zedong cannot be credited to the still-absolutist Communist Party. Rather, it has occurred despite the Party’s enormous reach, similar to previous growth in the Soviet Union, which also occurred despite extractive institutions and authoritarian rule. Income per capita in China remains low compared to that of developed nations, and its post-1978 growth was a result of the need to play catch-up with the developed world.[3]

In the wake of the economic and humanitarian catastrophes that were Mao’s Great Leap Forward and subsequent Cultural revolution, Deng Xiaoping maneuvered his way into power, and in 1978 established sweeping market reforms. These changes allowed China to adopt global innovations that occurred during Mao’s time as leader.[4] The reforms retained highly extractive political institutions, but allowed the State to compete on the international market. This provided an influx of foreign investment and an expansion of China’s production capacity, who were now positioned to utilise their enormous labour surplus and introduce low-cost exports to the rest of the world.[5]

Despite the lack of political freedoms held by China’s people, this unique set of circumstances allowed large room for economic growth. The need to catch-up stimulated growth despite the absence of creative destruction– where innovation allows products to be created that supercede old, less efficient ones (think how Uber has taken business away from 13CABS). This form of economic development was not necessary in the period following Mao’s death, as China’s economic growth relied heavily on industrialisation that echoed preceding developments in the Western world.[6]

But this form of growth isn’t sustainable

Since we now know of the Soviet Union’s ultimate fate, the substantial decline in China’s growth rate since 2010 should be sounding alarm bells.[7] In the past three decades, China’s private sector has been responsible for 95% of growth in the urban workforce, despite being heavily regulated, censored and influenced by the Party.[8] While this growth had previously been stimulated by a surplus of cheap labour, the growth of China’s middle class has reduced this availability.[9]

The increased industrialisation and prosperity of the Chinese population means they will need to innovate in areas less associated with wage labour. This, according to Acemoglu and Robinson’s hypothesis, is problematic, due to the incentives that remain blocked by Communist Party policy. While there remains enormous untapped potential for future prosperity in China’s private sector, Party elites have thus far been unwilling to relinquish their hold on the market. The societal constrains of the all-powerful Communist Party do not allow for this sort of market-based growth, as it may only occur through a direct cessation of power from the Party elites to political outsiders, such as businessmen and entrepreneurs.

One vehicle the Communist Party has utilised to prop up its growth rate is currency intervention. In order to make its products more appealing to the international market, China has been buying foreign reserves with home currency since 1994.[10] This increases the supply of yuan on the foreign exchange market, and simultaneously decreases the supply of foreign currency. The result is an artificially undervalued yuan, which increases China’s export competitiveness.

Yet currency intervention is another impermanent solution to China’s long-run growth problem. There has been substantial recent capital flight from China, in no small part due to uncertainty surrounding the yuan.[11] The prospect of flying too close to the sun is inherent when undertaking any form of currency intervention, and dependence on this technique to maintain a high growth rate is as dangerous as strangling private enterprise.

Securing future prosperity

The long-term cooling of China’s economy may be avoided if China’s ruling elites make a conscious effort to improve the inclusiveness of China’s institutions. There has been a degree of recognition within the Party of the dangers ahead, with former Premier Wen Jiabao advocating further free-market reforms to avert a ‘historical tragedy’ like the Cultural Revolution.[12] A lone voice, however, is not enough to instil meaningful change. More political figures must advocate institutional change, and the clock is ticking.

This a tough ask, since the empowerment of a broader cross-section of society will directly diminish the political elites’ own power. The quick suppression of the 1989 protests at Tiananmen Square painted a bleak picture, and the continued media censorship of global sites such as Google, Facebook and Youtube leave room for state-controlled alternatives such as WeChat, which censors any messages containing sensitive words or phrases.[13] The push to empower China’s broader society must overcome this stranglehold on critical discussion output and individual thought, and it must come from a continued and constant criticism of absolutist rule. This criticism must be broad, loud, and it must incentivise China’s elites to cede their power to the broader public. In other words, it must give them no better options.

China has nearly exhausted its capacity to grow under the extractive institutions of the Communist Party. The similarly extractive Soviet Union was able to achieve growth by forcibly allocating resources toward industry, but as with China, it was playing catch-up with the developed world. Once per capita income rose, the growth stopped, as the incentives for innovation and productivity dried up under a restrictive, authoritarian reign. China’s growth miracle is coming to an end, illustrated by the recent decline in GDP growth. If it wants to prevent its economy from running out of steam Soviet Union-style, China must shed its restrictive political institutions, and allow more room for innovation and empowerment.

References:

[1] Lindbeck, A. (2006). An Essay on Economic Reforms and Social Change in China. (Working Paper 4057). Stockholm, Sweden: Stockholm University, Institute for International Economic Studies.

[2] Acemoglu, D., & Robinson, J.A. (2012). Why Nations Fail: The Origins of Power, Prosperity and Poverty. London, United Kingdom: Profile Books Ltd.

[3] Ibid, p 150.

[4] Tisdell, C. (2008). Thirty Years of Economic Reform and Openness in China: Retrospect and Prospect. (Working Paper No. 51). Brisbane, Australia: University of Queensland, School of Economics, p 8.

[5] Wildau, G. (2015, May 8). China’s surplus rural labour vanishes as it passes the Lewis turning point. The Australian Financial Review. Retrieved from http://www.afr.com/

[6] Friedman, T. L. (2012, March 21). Why Nations Fail. The New York Times. Retrieved from http://www.nytimes.com/

[7] Zhai, F., & Morgan, P. (2016). Impact of the People’s Republic of China’s Growth Slowdown on Emerging Asia: A General Equilibrium Analysis (Working Paper 560). Tokyo, Japan: Asian Development Bank Institute.

[8] Ryan, D. (2014, January 21). How private is private in China? The Australian. Retrieved from http://www.theaustralian.com.au/

[9] Wildau, G. (2015, May 8). China’s surplus rural labour vanishes as it passes the Lewis turning point. The Australian Financial Review. Retrieved from http://www.afr.com/

[10] Morrison, W.M., & Labonte, M. (2013). China’s Currency Policy: An Analysis of the Economic Issues. Congressional Research Service. Retrieved from https://fas.org/sgp/crs/row/

[11] Taylor, S. (2012, September 18). China’s balance of payments: current and capital accounts now pulling in different directions. Simon Taylor’s Blog. Retrieved from http://www.simontaylorsblog.com/

[12] Branigan, T. (2012). China needs political reform to avert ‘historical tragedy’, says Wen Jiabao. The Guardian. Retrieved from https://www.theguardian.com/

[13] Sonnad, N. (2017, April 17). What happens when you try to send politically sensitive messages on WeChat. Quartz. Retrieved from https://qz.com/

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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