For prior posts in this series, see Whither Xi? Whither CCP? Whither China?


Whither China post #7 – Question 5 – Whither China's economic development with no democracy?


contrapositive modernization theory – if not q, then not p – if no democracy, then no future growth

Many observers make not only the first phase of the modernization argument – that with economic growth comes demand for democracy – but also the second phase, the contrapositive argument – if no democracy evolves, then growth will slow or stop. Despite the successes to date, the argument goes, there is a looming disaster, as modern economic growth, or demands of a service economy, or post-industrial growth, or the era of IT, or AI, is incompatible with CCP authoritarian governance. 

Quite honestly, it is tough to maintain this skeptical view with the extraordinary Chinese growth in the last few decades.  The growth miracle is not smoke and mirrors and excess investment and debt.  There is substance –  the China superstar projects like the high speed train system, the Three Gorges Dam, the South-North water transfer projects, the space program, the moon landing, the Mars exploration, even the OBOR projects.  For all of the instances of corruption and fraud and poor quality in Chinese construction, there is ability to build very tall buildings and very impressive train stations and first class hotels without them falling down or showing structural cracks before completion. There is ability to build the high speed train cars and the space rockets and the moon lander.  Huawei and Tencent and Alibaba are ahead of Apple and Google and Amazon in services.  Where is the slowdown from lack of democracy?  Tesla has nothing on Chinese electric car manufacturers.  At least some pharmaceutical researchers are the equal of those in the US – a colorectal cancer drug, developed in China, has been approved for use in China.  Major western pharma companies have been doing research in China for more than a decade.   Somehow, I don’t think creating more democracy in the US will help American science and technology close gaps with China.

Modernization theory seems to have run its course, but the contrapositive story hangs around.  The reality is that growth came, demand for democracy did not, and democracy has no prospects.  Now the argument is, unless there are democratic reforms, economic growth will slow or stop.  Perhaps some promoting this view are remembering the development of Japan post World War II.  Japan embraced democracy, surprisingly, in 1946, and economic development flourished.   The reasoning is that there had to be a connection, though the connection between economic and political reform is never quite made clear. The argument centers around changes to Chinese economic institutions – rules about banking, finance, and greater openness, to be sure, but also intellectual property and equal treatment of foreign companies, equal treatment of Chinese people, and ultimately, rule of law. Chinese leaders do see change in current economic institutions as necessary to continued growth. Further opening of finance, banking, capital flows, service businesses, are all on the table – with Chinese characteristics, of course, but on the table.  Perhaps if these institutions can change sufficiently, democracy will not be necessary.  In 2012,  Wen Jiabao himself made the entreaty at the press conference of the National People’s Congress –

“As the economy developed, it has caused unfair distribution, the loss of credibility, corruption and other issues. I know that to solve these problems, it’s necessary to not only enter into economic reform but also political reform, especially reform of the Party and the state’s leadership system.”

“Reform has reached a critical stage. Without the success of political reform, economic reforms cannot be carried out. The results that we have achieved may be lost. A historical tragedy like the Cultural Revolution may occur again. Each party member and cadre should feel a sense of urgency.”

Wen was tying economic reform to political reform.  A contrary view comes from Wang Dan, one of the leaders of the Tian’anmen protests in 1989.  Wang commented at a May 31, 2009, press conference in Toronto on the so-called "Beijing Doctrine": "For the sake of economic improvement, everything can be done, even killing people ... [such a doctrine shows that] the Tiananmen Massacre is still going on, only in different ways: it was the students' lives being taken physically in 1989, but it is the mind of the world being poisoned spiritually today."  Wang is suggesting that economic improvement is the bottom line, but the future path must be through political reform. That is a step too far for CCP.  Some few people may realize the human cost without freedom, without democracy, but they can and will be – harmonized, is the popular term.   Consumption has proved sufficient to satisfy the vast majority of Chinese, as would be the case anywhere.  Those few for whom the ability to speak and write freely – journalists, academics, some lawyers, rights activists, a few malcontents – what per cent of the population can they be?  2%  5%?  Small enough to be controlled. 

There is no doubt that substantial reforms are necessary to address an economy which remains inordinately tied to government funded debt to support GDP.  The debt overhang is one thing – it may be possible to grind out deleveraging of both good debt and bad debt – but the Chinese private economy, as energetic as it looks to us, still does not generate enough new growth on its own.  One can make the argument that democracy would help solve that problem, but one needs to explain just how that would occur.

Kellee Tsai looked at Chinese entrepreneurs in Capitalists without a Class and subsequently in Capitalism Without Democracy.  She questioned whether they could form a “class” that would press for political change.  She found no basis for thinking that businesspeople will agitate for democracy; nor do entrepreneurs think that without democracy, their welfare will decline.  Tsai’s key point –

Counterfactually, this means that if capitalists are not excluded from the current authoritarian regime and their material interests are not under threat, then it is unlikely that an elite corps of business owners would press for democratic change – even if certain political leaders or other well-organized groups advocated democratization (Capitalists without a Class,)

Business people use guanxi and bribes and other forms of corruption to maintain close relations with government, particularly local government.  In this way, the interests of business people are incorporated into government policy, stability is maintained, and there is no need for protest or mass campaigns against the government.   As long as business interests can be heard – and no one would say that citizen interests are held above those of business in China – business owners see no hindrance from lack of democracy.  The system works, just as it does for American businesses in any authoritarian country. 


Impediments to growth

There are constraints operating in China that hinder growth.  The hukou – the place registration system – is one.  The hukou operates like apartheid in South Africa – restricting wages and benefits for a large segment of the population.  For at least a decade, central and provincial governments have pledged to get rid of hukou distinctions, without effect.  Middle class Chinese do not want their kids going to school with farmer’s kids, and local governments are correctly afraid of the social welfare costs – education and health care – in taking care of tens of thousands of “immigrants” to cities.   City residents and city governments are strongly opposed to relaxation of the hukou status for peasants.  Another vow to eliminate the hukou restrictions in small cities has just come from the central government in the last couple of weeks (April, 2019).  This may work.  But peasants will still be facing a wall in becoming legal residents in Beijing, Shanghai, Hangzhou, and the other big, and most desirable, cities.


An economic impediment to growth

Observers in and out of China have pointed to continued growth in debt finance, faster than growth in GDP.  In macroeconomic terms, this means that overall debt is growing faster than the economy's ability to repay it. This is considered dangerous when too much debt has accumulated.  Deleveraging - paying off debt - is a necessary step.  But the problem is more than just paying off the debt - it is changing the growth model for the economy.

Michael Pettis, professor of finance at Guanghua School of Management at Peking University, does not see any examples of a country that has either been able to grow its way out of high levels of debt to GDP or institute reforms sufficient to eliminate dominance of the “growth = debt, debt = growth” model.  In economic terms, total factor productivity (TFP) the “missing link” in GDP calculations (since it is a residual, the secret sauce left over after labor and capital inputs are added and the total then subtracted from GDP) is not the source of growth in China. This, despite what we hear all the time about Alibaba and Tencent and Huawei and Xiaomi and ZTE and innovation in China.  China is big, and those "national champion" companies still comprise a small share of overall GDP.   TFP is the source of most long term growth in the advanced economies, since labor and capital inputs do not vary much in total over a span of a few years.  So where can growth in the Chinese economy come from?  Not exports any more.  Not manufacturing any more.  Not infrastructure investment any more.  What is left?  Consumption.  But people can only consume beyond basics if they have disposable income to spend.

Pettis makes the point that household income as a share of GDP must rise significantly if China is to continue growing.  I agree.  But that requires transfers from vested interests, including the government, to households – provide shares of big SOE to citizens, break up SOE, let wages rise, eliminate the hukou, dramatically increase social spending on health care and pensions and education.  Therein lies the source of China’s middle income trap – not a crisis, just an inability to grow GDP per person very much.  Those transfers will not take place on a large scale.  But those economic and financial and legal reforms are what Mr. Xi should be working on. 


How could China remove impediments to growth?

Let me give you two examples of supply side reforms that would assist China in increasing household income and reducing inequality at the same time.  Both are applicable anywhere in China, and both would require a change from the accepted regulations.  Both would transfer income and wealth to households rather than to existing state entities.  Neither is likely to be implemented. 

1 – the Hangzhou peasant residential development – as you know, the government in China owns all the land – except for farmer land, which was collective land.  That land is owned by the farmers, in some manner not quite well defined legally but nevertheless, not the government.   My school in Hangzhou is in a development zone with several other schools.  Several hundred acres of farm land was purchased by the government for the development zone, the farmers relocated to nearby highrise and low rise buildings.  Farmers became small business owners and drivers and maintenance people.  The schools and infrastructure and some shopping areas were built by state owned developers and contractors.

At least one small patch of farmer land was not purchased.  The tract faced Liu He Lu, now a major arterial street feeding into downtown Hangzhou and the east side and the north side.  All around this tract there is new development.  From 2008, when I began visiting the area, one could smell the ripeness for new development – the zone, the widened streets, the huge new developments a couple of miles to the north and east.  Anyone, particularly farmers who knew the area, could make money by simply buying land and holding it, if that were legal.  The farmers in this community did still own this plot of land, big enough to put up four or five high rise buildings and some first floor retail.  The city of Hangzhou wanted to control all development in Hangzhou but could not determine the future for this plot because it was farmer land.  The farmers erected the highrises, and rented the stores, and Hangzhou was denied the tax money that would otherwise have come.  By all accounts, the units are well-built.  The farmers got the money instead.  The city of Hangzhou was not pleased.  But that is how income inequality is reduced. 

2 - Restrictions on who can profit from real estate development – in the US, anyone –but anyone – can be a real estate developer.  No experience necessary.   Not so in China, which has rankings based on experience and assets for different levels and kinds of development.  In the socialist mindset of bigger is better, Chinese urban planning designs the enormous developments that we have seen going up everywhere for the last twenty years.   There is a single developer for the twenty or fifty highrise buildings, including the primary school and community center and perhaps some adjacent retail.  In order just to bid on the land, the developer must put up huge amounts of cash, and if successful in the bid, then buy the land upfront.  Land costs in China tend to be about 70% of total project costs, compared with 25% or 30% in the US.  As a consequence, real estate developers in China tend to be very big companies.  Usually state owned, but private as well.  The private developers must of course be very well connected politically. 

Of course, developers and their contractors should be qualified to do the work they propose.  But residential developers in particular do not require high levels of sophistication in design or engineering.  In any case, those functions are performed by outside contractors.  And further, the real work on most construction sites is done by farmers or construction workers who come from farms.  As the system is designed, all profits from sale of apartments or stores go to the state owned developers or their equally large private counterparts who have been pre-qualified for the work.

Why not break the single development parcel into ten pieces, or twenty?  Let smaller contractors bid on the profitable work of development, and get those profits into the hands of workers, rather than enormous SOE or private developers?  This is an easy solution to implement – would only require the government to put ten or twenty parcels out for bid, instead of just one.  A bit more paperwork, but transfer profits to more people.  As a byproduct of the sharing of the wealth on development, one could get variations in design, helping to eliminate the numbing sameness of high rise and lowrise residential construction that one sees everywhere. 

I did suggest changing - allowing farmers to do small scale development and reap the profits.  In Hangzhou and Wuhan and Shaoxing, I asked cadres from the Land Bureau and urban planning departments if they thought such a change would be beneficial.  All looked at me as if I was from Mars.


Rebalance to stay on course

China must rebalance its economy for its own economic survival.  Debt accumulation cannot keep growing faster than GDP.  Increasing household consumption is the only way for GDP to continue to grow well.  There is no world precedent for a country with household income shares as low as they have been in China, and now ageing and middle class concerns will demand more social services.  China has built far more than it needs to build, and attention must change from investment in things to investment in people. The rebalancing will be difficult in China – vested interests are very powerful, and rebalancing necessarily means taking income and wealth from the powerful and giving it to households.  It would be possible to keep ignoring the debt warning signs and for China to not deleverage meaningfully.  Debt as a share of GDP can stay about where it is, household incomes as a share of GDP can stay about where they are.  At some point, though – an unexpected bankruptcy, big failures in wealth management products, a substantial increase in the value of the RMB that reduces exports to a trickle, bank deposit interest rates in the US that get back to 4 or 5 or 6 per cent while Chinese rates are 2 or 3% – Chinese could lose confidence in the value of the yuan, in the ability of the government to manage, and then legitimacy is lost.  At that point, capital flight would become enormous, middle class Chinese would flee, and survivability for CCP would truly be in question.  In this case, not rebalancing would be the spark for political change.  But rebalancing might be the spark for political change as well, if Mr. Xi were to push too hard and vested interests pushed back harder.  China can rebalance systematically or not, but it must needs come. The China that emerges from the economic rebalancing will be a different looking China – institutions will be different.  But democratic institutions will not be part of the mix.

Pettis describes the dilemma –

China’s unsustainable rise in debt is part of a self-reinforcing dynamic involving the consumption imbalance, and the important point is that because imbalances necessarily must reverse themselves eventually, any useful reform must be consistent with China’s economic rebalancing. In fact it should have been obvious years ago that Chinese policymakers only ever had two choices. They could proactively implement the reforms aimed at reversing the imbalances, however costly these reforms might be (and the longer they were postponed, the more costly they would become), or they could try to postpone the necessary reforms indefinitely – as many if not most countries in similar circumstances had done unsuccessfully in their attempts to sidestep the costs of rebalancing.

In the latter case, however, they would have almost certainly discovered, as their predecessors always discovered, that as the debt burden increased, the increasing impact of the distortions caused by the imbalances – and it is important to remember that the two are self-reinforcing – would eventually break through the institutional constraints that had prevented adjustment earlier. Rising balance sheet fragility makes an economy more sensitive to imbalances and to disruptive shocks, by which I mean that and balance sheets become increasingly fragile, their disruptive unraveling can be caused by progressively weaker random shocks – i.e. “triggers” – so that in very extreme cases it takes deceptively minor shocks to trigger major disruptions.  The risk in that case is that the imbalances would reverse themselves disruptively and force an unwanted resolution of the excessively high debt burden – of which the most obvious, but not only or even most likely, way would be in the form of a financial crisis of some sort.

Banking and finance are not in a good position.  Exports are not in a good position.  Young Chinese are not in a good position.  Local governments are not in a good position.  Mr. Xi is not in a good position.  CCP is not in a good position.  But no Chinese, save for a very few intellectuals, are pushing for democracy.  And growth seems to continue without it.  As I have heard for more than fifteen years, welcome to China. 


Next: Whither China? post #8 - Question 6 – But how about innovation. Can you have that without democracy?