China's Authoritarian Capitalism

China’s phenomenal rise has led many to view the country as an indomitable juggernaut. Why then does Premier Wen Jiabao describe the country’s economic model as “unstable, unbalanced, uncoordinated and unsustainable?”

Because it is.

The much-vaunted China Model has morphed in the past decade into a one-of-a-kind system of authoritarian capitalism that is in danger of terminating itself – and taking the world down with it. It is also proving incompatible with global trade and business governance, and threatening multinationals that fear losing technology and business secrets to China’s mammoth state-owned enterprises they are forced to partner with.

The Chinese Communist Party has two unwavering objectives: make China rich and powerful and to guarantee the party’s political monopoly. Some top party leaders are pushing far-reaching reforms that expand the private sector and empower entrepreneurs. They believe that the party must cede its smothering hold on economic power to foster growth and social stability. But such plans face determined opposition from others enriched by the status quo.

Describing the dilemma, a senior economic planner cited a line from a Tang Dynasty poem, “No ancient wisdom, no followers,” referring to new endeavors during tumultuous times. “Policy formulators in China often have a sense of venturing out alone,” Liu He, deputy director of the Development Research Center of the State Council wrote in an essay advocating reforms, “with no ancient wisdom to guide them and nobody appearing to follow them.”

Deng Xiaoping started down this path in the 1980s by allowing farmers to market a portion of their crops. Rural entrepreneurs quickly invested their earnings in local enterprises. By 1996, these enterprises accounted for 36 percent of industrial output and 135 million jobs. Meanwhile, the country’s Soviet-designed SOEs stagnated.

As the private sector rocketed ahead, the party concluded in the mid-2000s that a dominant state sector was necessary. To avoid the rise of Russian-style oligarchs, China opted for a party-led oligarchy. Control is exercised through the party’s Central Organization Department, which appoints all key leaders of the huge, monopolistic, centrally controlled SOEs. Most of these positions carry ministerial or vice-ministerial rank in the party, so they outrank their government overseers. As a result, the SOEs are more beholden to the party than the government.

This system was cemented in place with a 2006 directive designating two categories of industries for state involvement: “Strategic” industries – armaments, power generation, oil, telecommunications, aerospace and more – were to have sole state ownership or absolute state control. “Pillar” industries – including automobiles, electronic communications, architecture, steel, nonferrous metals, and chemicals – were to stay largely in state hands, meaning majority state control or ownership.

Also in 2006, China launched the infamous Indigenous Innovation campaign with the goal of transforming China into a technology powerhouse. The plans directed SOEs to obtain technology from multinational partners through “co-innovation and re-innovation based on the assimilation of imported technologies.” Not surprisingly, multinationals and their governments saw this as a blueprint for technology theft.

Neither the World Trade Organization nor the array of bilateral trade dialogues and dispute resolution bodies has ever dealt with anything like China’s authoritarian capitalism. Given the country’s size and economic clout, it threatens to push existing systems to a breaking point. But China is also the biggest beneficiary of current configurations. Contradictions abound.

Statistics in support of reform are compelling. Though blocked from many sectors, and largely unable to get bank financing, Chinese private enterprise accounts for 90 percent of new jobs, 65 percent of patented inventions and 80 percent of technological innovation. Meanwhile, Chinese consumption is 35 percent of GDP versus 63 percent in Brazil and 54 percent in India. China is also facing what economists call “the middle-income trap,” a stage when low-cost labor and easy technology adoption max out as competitive advantages.

Without domestic consumers to offset export decline and drive growth – typically through innovation – the emerging economy will languish. The World Bank says that that in 1960 there were 101 middle-income economies. By 2008, only 13 of them had reached high-income status. The reason is that those enriched during the developing state are often entrenched and able to block change.

China’s first decade of WTO membership and simultaneous return to favoring SOEs has been lucrative for the SOEs. A June 2011 study by the Unirule Institute of Economics, an independent Chinese policy research center, detailed how SOEs are eating the fruit of reform. Unirule estimated that SOEs had accumulated some RMB 5.8 trillion in profits from 2001 to 2009. But if the discounted land, cheap utilities, lowball interest rates and other subsidies unveiled by Unirule are deducted from SOE profits, the real average return on equity for the period is negative 6.29 percent. As of 2010, only 2.2 percent of SOE profits were turned over to the state.

The past decade has been China’s version of America’s Robber Baron Era and Gilded Age – compressed, compounded and intensified. Previously, the party seemed to operate under an unspoken “don’t ask, don’t tell” adage. The party aristocracy could use influence to accumulate family assets, but they were supposed to keep it low-key. According to a Bloomberg study, the wealthiest 70 members of the National People’s Congress now have a combined worth of $90 billion.

A window into the use of SOEs to harvest wealth and undergird party power was cracked open by the March detention of Politburo member Bo Xilai for “serious discipline violations” and the arrest and later conviction of his wife, Gu Kailai, for killing a British businessman. After Bo’s detention, reporters dug up public records showing that his brother under an assumed name was vice chairman and the holder of US$18 million in stock options of a Hong Kong-traded SOE. Bo’s sister-in-law was found to be serving on the board of more than 20 companies.

Less than three months after Vice Premier Zhang Dejiang was dispatched from Beijing to replace Bo as Chongqing city party secretary, the government announced RMB 350 billion worth of contracts involving several dozen central SOEs to boost the Chongqing economy and revitalize support for the party – investments worth nearly $12,000 per Chongqing resident.

The most challenging reforms will be fixing the hukou, or housing registration, system enacted in the 1950s to prevent peasants from flooding into the cities. The government estimates that more than a quarter of urban residents in major cities lack an urban hukou. This population includes some 160 million migrant workers who lose access to health care, education and other social services once they leave their countryside homes. Just over 50 percent of the Chinese population now lives in cities. With 13 to 15 million migrating to the cities annually, this is expected to reach two-thirds by 2030.

The good news is that hukou reform could transform 10 million migrant workers annually into the next wave of urban consumers, forming a “potential new global market of unprecedented size” that would boost the world economy, according to DRC economic planner Liu He.

The Party mouthpiece People’s Daily was bellicose after President Barack Obama criticized China in November 2011 for “gaming the system” of international trade. The paper responded that the US should realize that “Smart people move with the times, conceited people are eliminated by history.”

That’s solid advice for China.

(James McGregor is author of the new book No Ancient Wisdom, No Followers: The Challenges of Chinese Authoritarian Capitalism. He is a journalist turned businessman who has lived in Beijing for more than two decades. This is printed with permission from the Yale Center for the Study of Globalization)