The Third Pillar

by Raghuram Rajan

  Reforms had also raised expectations, but the market taketh even as it giveth. Instead of obtaining the good jobs that students in elite universities like Beijing University believed they were destined for, many experienced unemployment as the now profit-conscious, overstaffed, state-owned firms cut back on hiring. Moreover, students were aware of the growing protests against socialist governments in Eastern Europe, and the cracks that were emerging in the Soviet empire. Somewhat optimistically, they believed that China’s reformers, who seemed so open to economic change, might also support more broad-based political liberalization. The death of Hu Yaobang, a leading reformer who had been forced to resign for being too liberal, was the trigger for protests in Tiananmen Square in Beijing in the spring of 1989, where unhappy workers joined students.

  For a while, it seemed that the protesters might force the party to back down. Students of the Central Academy of Fine Arts erected a statue of the Goddess of Democracy in the square, facing the huge official poster of Mao Zedong. Yet, when Deng was faced with a choice between political liberalization and continued Communist Party control, the man who had been purged twice chose the party. The army was called in, and on a bloody June 4, 1989, cleared out the square. Many students, workers, and their supporters died in and around the square. A tank pushed over the Goddess of Democracy, and it was soon reduced to rubble. Key protest leaders were arrested, the worker leaders were tried and some executed, while the better-connected student leaders got jail terms. The liberals in the party such as the general secretary, Zhao Ziyang, were purged and hardliners gained influence. There was no longer any question of distancing the party from the government. The party would govern.

  Deng was faced with terrible choices, though there was a cold-blooded logic to his decision. China had suffered enormously from internal chaos in the past when the center had been weak. The turmoil in the Soviet Union, where Gorbachev’s Perestroika encouraged fissiparous forces without energizing economic growth, suggested what not to do. Deng rejected radical political liberalization so that he could orchestrate gradual economic reforms. The government would create the market in China, instead of allowing it to emerge spontaneously and unpredictably from the embers of a socialist economy. Perhaps his choice was right for the growth of the Chinese economy, but it postponed political freedom for the Chinese well into the future. By skewing the balance, it probably made it harder to move China away from the possibility of autocratic rule, one of Deng’s aims. It was probably one of the most consequential decisions in recent world history.

  For a while, further economic reform was put on the back burner. However, in 1992, Deng went on a tour of southern China, using the trip to reaffirm the necessity of continued liberalization. He is rumored to have said, “To get rich is glorious,” and to have complained that the conservative elements of Chinese society were more dangerous than the liberalizing elements. Reforms took off once more, but they were profoundly different in character, as MIT economist Yasheng Huang argues. In the next decade, under the leadership of President Jiang Zemin, who had been the Communist Party boss in Shanghai, the epicenter of economic activity as well as government attention shifted to the large towns and cities in the coastal areas, to state-owned enterprises, and to encouraging foreign direct investment.5

  At the same time, the small village communities, which had seen a whiff of political liberalization and democracy in the 1980s, had their powers, including budgeting, taken away by party bosses in townships in the 1990s.6 The party bosses were appointed, not elected, so this was effectively a centralization of power away from the hard-to-control and numerous village communities.

  FROM ENTREPRENEURIAL TO STATE CAPITALISM

  So from the uncontrolled, near-spontaneous emergence of entrepreneurial activity in poorer, rural, and interior areas, China moved toward more state-led capitalism in the richer towns and cities and coastal areas. State-owned firms, especially the larger ones, were obviously easier for the party to control, but they were overstaffed and inefficient. Over the decade of the 1990s, China took three important steps to improve their functioning.

  First, it adopted the policy of “grasping the large, letting go of the small.” This meant selling or closing smaller state-owned firms across the country, many of which were unprofitable. Some of these were sitting on valuable assets like real estate. City or provincial party bosses captured the illegal gains as they sold these to cronies at bargain basement prices.7

  As the government’s ownership was pruned, it could focus its attention on the large, and significantly more important, state-owned enterprises. In 1990, the State Council enacted a policy of “two guarantees,” which assured the large state-owned enterprises of access to cheap credit and underpriced inputs like commodities. The enterprises also obtained cheap power and land. Some of the inefficiencies of these overstaffed firms were offset as they invested in more modern capital stock, and other inefficiencies were masked by the lower costs of their inputs. Many of these companies were also allowed to list on domestic or foreign stock markets, which gave them access to equity capital and also brought on board large investors who could exercise some corporate oversight and improve productive efficiency.

  Second, the state-owned enterprises were allowed to sack their surplus staff. Workers in China believed they would always have the “iron rice bowl”—the promise of lifelong employment with a guaranteed pension and other benefits such as housing. The Communist Party abandoned this implicit promise. The unemployment generated by the state-owned firms laying off nearly fifty million employees in the decade after Deng’s southern tour was a tremendous shock, as traumatic as one any capitalist system would impose. It was made more brutal by it being unexpected.

  Third, state-owned firms were consolidated where possible under common holding companies so that operations could be rationalized and they would get pricing power. For example, the Baosteel Group took control of six large steel manufacturers—three wholly owned by the group and three publicly traded.8 The effect of all this was to increase output per worker and the profitability of the state-owned enterprises. Much of this improvement typically came from overinvestment of cheap capital, which was used very unproductively.9

  The surplus workers fired from state-owned enterprises, as well as the migrants from rural areas who had been let go from increasingly mechanized agriculture, had to be employed somewhere, for the party could not ignore worker distress indefinitely. This reflects a paradox in China, and more generally with authoritarian regimes. Since they do not have legitimacy from the polls, they need legitimacy from policy choices that indicate they have the greater good of the people in mind, else the cost of maintaining the authoritarian regime against the wishes of the people would increase exponentially. Democratic leaders can admit to mistakes saying, “We messed up,” and move on. In many cases, they can blame the previous administration. Authoritarian regimes, at least those that want to retain the consent of the ruled, cannot, since sound policy is the basis of their legitimacy. Nor do they have the luxury of blaming the previous regime—even if the decisions were made by different leaders, current leaders have to defend them, else it would suggest the regime is fallible and the people should have the choice of dispensing with it. We will return to this paradox of legitimacy-seeking authoritarianism shortly.

  One solution was foreign direct investment, which was especially attractive to the Chinese authorities because it brought know-how, but very little political threat—any foreign firm that dared to interfere politically could be summarily expelled. Cheap and well-trained labor was an important attraction for foreign firms intending to manufacture and export from China to world markets. So was the ability to locate in the coastal areas, with easy access to ports. It was not easy, though, for foreigners with few local connections to comply with the myriad regulations that a reforming socialist economy imposed on business—even today, as economist Chang-Tai Hsieh emphasizes, China is only seventy-second on the
World Bank’s Ease of Doing Business ranking. This is where the city mayor or regional party boss came in.

  An Indian businessman told me how he had expressed an interest in investing in a middle-sized Chinese city in the early 2000s. When he went to visit the city, he was met at the airport by the deputy mayor on a Sunday, taken to visit a possible site that very day, then taken to the mayoral office where all the necessary permissions had already been prepared. Every difficulty could be dealt with; all he needed to do was to sign on the various dotted lines and bring in his money to start the project. The party eased the way for its favored businesspeople.

  There were two other important motivations for foreign investors. One was a lower income tax rate relative to domestic firms. Second, starting in the 1990s, China worked to keep its exchange rate from appreciating even as its exports and trade surpluses increased. The undervalued exchange rate was effectively a subsidy to exporters, because dollar revenues were higher when translated back to renminbi. Many foreign firms set up production in China to take advantage of its abundant educated labor, its improving infrastructure, the willingness of suppliers to promise and deliver the impossible, and to a lesser extent, its undervalued exchange rate.

  What worked for foreign direct investment also worked for local private investment, especially construction and real estate, which employed many unskilled workers and had the collateral benefit of creating infrastructure. The key input here was cheap credit, land, and permissions, all of which the mayor could secure. Land, especially farmland, could simply be expropriated from the current occupier for little compensation, especially since all land technically belonged to the state. The expropriated land could then be turned over to the real-estate developer, sometimes at a significant markup that added to the coffers of the city government. Such actions became increasingly necessary as the central government started retaining most of the tax revenues in the early 1990s, forcing city and provincial governments to become entrepreneurial in raising money. Invariably, some of the funds generated from such legally murky actions also went to bolster the personal income of the party officials as compensation for their “entrepreneurship.”10

  Corruption was not the only motivator. Many party bosses showed keen interest in such investment because economic growth in their region was an important consideration for their promotion up the party hierarchy. Others did so because the local government obtained shares in the start-up, which gave it a continuing stake in the company’s growth. At any rate, the onerous rules and regulations as well as the relatively murky property rights were an important obstacle to any ordinary person setting up business, but were not a problem for those with party connections. The party thus fostered private enterprise while keeping control over who was allowed to open businesses or expand.

  When the irrepressible ordinary citizen ignored these implicit norms and struck out on their own, they did so at their peril. For example, the Xiushui Market in Beijing was a thriving outdoor market, specializing in brand-name fakes (especially popular with foreign tourists).11 The district government closed the market on grounds that it was a fire hazard and that it was selling fakes, and proceeded to evict the shopkeepers and demolish the market. A private entrepreneur was then given the rights to build and operate the new indoor Xiushui Market, and he proceeded to auction the more limited space there, with the highest bid for a stall reaching $480,000. The merchants who had built the name and reputation of the earlier market (no matter that it was built on fakes) had their own brand name expropriated from them, and only a third could afford stalls in the new market. Poetic justice some would say but not surprisingly, many of the stalls in the new market also sold fakes!

  THE REPRESSED HOUSEHOLD

  The subsidized inputs to corporations had to be paid for by someone—that was the ordinary householder. Given her productivity, not only were her wages lower than they would have been in a more developed economy (as in many developing countries, they were held down by massive surplus labor in agriculture), her taxes paid for the other subsidies granted to the corporate sector, she paid the high prices charged by local monopolists, and she received low interest rates on her deposits (the government capped the rates payable on deposits at a low level, in order to allow banks to profitably make cheap loans to corporations and developers).

  Even while the household received miserable returns on its deposited savings, the government had taken away its promise of a safe job and guaranteed pension. Chinese labor unions did not really fight for worker wages or rights, except when signaled to do so by the government—they were essentially there to control and channel worker dissatisfaction. Furthermore, in 1979, China’s one-child policy effectively mandated a maximum of one child per couple. It resulted in six adults—four grandparents and two parents—depending on that one child for support in their old age, if they did not have savings of their own.

  The household had further challenges. Its most important property—the house and the land it stood on—was insecure, as we have already seen. Also, industrial growth, as well as the blind eye that was turned to violations of regulations, polluted the air people breathed, the water they drank, and the food they ate. China was becoming the workshop to the world, but its people were paying for it with a deteriorating quality of life as the country drew in the dirty factories and power plants that were closing everywhere else.

  China therefore followed a unique growth path. Ordinary households bore a burden that would not have been possible in a more democratic environment. There were important compensations. Because the system generated very modern infrastructure and investment rapidly, the economy grew fast. Many new jobs were created, and the productivity of existing jobs increased quickly. So average wages grew fast, even though they were lower than the additional value each worker created. China was growing rich quickly, so it was easy to ignore the distortions.

  Nevertheless, a large share of the income generated in the country ended up as savings rather than final consumption by the households—partly because it was locked up as corporate profits of state-owned corporations that were not paid out but reinvested and partly because households saved more, worried about the removal of the safety net and the insecurity of property. Chinese private consumption to GDP fell from about 50 percent in 1990 to about 47 percent in 2000. In the next decade, when China grew very fast, consumption fell further to a meager 35.5 percent of income in 2010. The Chinese household paid a price for the jobs that growth generated, but the growth was spectacular. Hundreds of millions of Chinese have been lifted from poverty into relatively comfortable middle-class lives since the reforms started.

  PARTY CONTROL AND CRONY COMPETITION

  The party therefore facilitated growth, not by opening access to all but by using its good offices to clear the path for select business. At the same time, it tightened its political control. A 2005 white paper by the party defined democratic government as “the Chinese Communist Party governing on behalf of the people.”12 This meant more than single-party rule, it meant extending the party’s tentacles more directly into business.

  Every large state-owned enterprise had a party cell, with the party boss often a more powerful figure than the company CEO.13 The party decided overall strategy and senior appointments in the company. This ensured the party had firm control of the state-owned enterprises, and their enormous funds. Of course, this also enabled party members to do favors for one another, including appointing one another’s children to cozy jobs.

  Membership in the party was increasingly the route to success in China. Private-sector firms soon read the writing on the wall and created their own cells. In the internationally known consumer electronics and home appliances product company Haier, its CEO also served as the secretary of the company’s Communist Party committee.14 The party made it clear that it wanted both information and the ability to intervene in every organization that might be a possible threat to its political monopoly. The private secto
r complied.15

  Such strong political control over business, without a vocal public community that can enforce separation between the state and business, raises concerns about inefficient crony capitalism and possible authoritarianism that we have discussed earlier in the book. Has China been special in avoiding these ills? In a sense it has . . . thus far . . .

  As political scientist Daniel Bell argues, the Chinese Communist Party is in many ways a meritocracy, which trains and tests its members in the practice of governance.16 Each of the nine members of the Standing Committee of the Politburo, the apex body of the party, has come up the hierarchy after proving themselves in regional or city governments. With an important element of their performance appraisal being how much they grew the local economy, local party bosses were ferocious in attracting potential investors to their locality, facilitating the set-up and growth of local firms, and protecting them against authorities elsewhere including at the center. Chang-Tai Hsieh points out that many of the big cities in China have taxis of only one make—the make produced by the automobile joint venture of the city government. By forcing local taxi owners to buy the favored brand, the local authorities support their local champion.