The Third Pillar

by Raghuram Rajan

  So there is extensive cronyism within a locality. Moreover, the subsidies to firms in a locality can keep them alive even if they destroy economic value. Also, the party has favorites at the national level, including some very large state-owned firms that monopolize the national market. Therefore, it is hard to call China a fully competitive market. Ferocious business competition is, however, sustained between the champions of the myriad localities. Competitive cronyism is probably a more appropriate term for Chinese practice. It has worked thus far. Does China have the right system for continued growth, though? To answer that, we have to understand the post–financial crisis change in China’s model of growth.

  THE NEED FOR CHANGE

  What China has managed in the last few decades is truly unprecedented in the history of mankind. Never have so many been brought out of poverty so quickly. Furthermore, China has some of the world’s most technologically capable companies, its most competitive universities, its speediest transport and logistics networks, and its most vibrant cities. Chinese development has been near miraculous, growing at 8.7 percent a year between 1980 and 2015. However, China can no longer grow as it used to.

  The model of growth that China followed in the 1990s and early 2000s, of lowering input prices for corporations while making households bear the costs, has its limits. For one, it relies on export growth as well as investment growth providing a significant portion of the demand for the goods it manufactures, since consumption, by design, has been relatively low. The Global Financial Crisis severely constrained developed-country spending, especially on imports, many of which come from China. Furthermore, as populist parties have gained strength across the developed world, it has also become clear that some governments will turn protectionist. As I write this, the United States and China are engaged in a tariff war. Finally, foreign firms that invested in China with the intent of exporting to the world now see the growing Chinese domestic market as very attractive. They used to defend Chinese exports (which often were from their own Chinese operations) into their countries. Now, they support protectionist threats from their governments, hoping this will force the Chinese government to lower tariffs and other barriers, and open the Chinese market to their goods. From China’s perspective, the political environment in developed countries makes it risky for China to rely further on exports. That means China has to generate more demand for its production domestically.

  Credit-supported domestic investment expansion was one way China goosed up domestic demand, but it is yielding diminishing returns. Debt has been mounting in the system, with a huge jump after the financial crisis. Moreover, continuing investment in infrastructure and housing is getting harder to justify. The premise behind Chinese infrastructure investment was “build it and they will come”—that once built, utilization of the infrastructure would pick up quickly. In the early years of investment, this proved true, given the enormous pent-up demand. There was little need to keep track of whether China needed the investment; it generally did. Now, almost every moderately sized city has a swanky airport and a shiny new metro. The absence of a market test of whether the investment is justified and the enormous subsidies that are given to every investment are leading to excessive investment. The costs of keeping new infrastructure running, given the modest local utilization, eats into local government budgets. Local governments have been permitted to borrow from the public markets in recent years, but their finances now look precarious, given their enormous debt loads and the mounting losses on their public investments. Similar concerns pertain to investment by state-owned firms, where subsidies allow firms to expand when they should instead be closed down.

  That leaves the option of boosting consumption. The removal of the distortions that generated easy growth, such as unduly low interest rates on household bank deposits, will give households more income from which to consume. Moreover, households are growing more resistant to bearing the costs of growth. Even in the first decade of the century, indiscriminate and unfair land acquisition from households prompted thousands of protests across the country.

  China also has a problem with inequality. Many households in rural communities have not benefited from development since employment growth has been unevenly distributed, with the best and most numerous jobs in cities, especially in the coastal areas. China has to address growing income inequality by creating good jobs in rural areas and in the internal provinces, a problem we have seen that developed countries also grapple with.

  Finally, as a result of its one-child policy, and because it allows very little immigration, China is one emerging market that is aging rapidly. As labor-force growth has slowed, wages are rising rapidly, forcing some industries to shift to cheaper countries. Even though the one-child policy has been relaxed in recent years, the Chinese are increasingly reluctant to have multiple children. China, therefore, may grow old before it grows rich—which is why it has to plan for a future society where the resources it will have to support its elderly are far lower than what Western populations have.

  In sum, China, having reached middle income and caught up with advanced economies in a variety of industries, has to move toward a more normal economy, repressing consumption less and subsidizing investment less. It must protect household property rights better. It has to move away from relying on the rest of the world to consume its additional production to consuming more of it domestically. It must move away from dirty manufacturing to cleaner high-tech manufacturing and to services. Finally, given the enormous increase in complexity of the Chinese economy, it ought to let market forces play a greater role, with the government retreating from guiding the economy at every turn. Indeed, all these objectives are part of the intended Chinese policy reset.

  Yet it requires an enormous change in the Chinese way of doing business. Chinese firms will have to become efficient on their own steam, and win market share, without subsidized inputs or local government protection. Financial markets and competition, not the party, will guide who gets resources. Such a future China looks very different from the China of the past. Can China manage the change? Its greatest weakness may be its greatest strength so far, the Communist Party and its desire for continued control.

  WHAT CHANGE ENTAILS

  The Communist Party has obtained its legitimacy from its superb management of the economy, and its ability to create growth and jobs. It has lost legitimacy from the visible corruption of some of its members, both locally and at the center. The key elements of President Xi Jinping’s agenda, when his term started in 2013, were to create growth that relied more on household consumption. He also wanted to improve the party’s image by reducing corruption. Let us see what this implies.

  Fighting corruption is popular, and the public has joined in. For instance, Chinese social media has brought down a number of officials who have been photographed wearing watches that are many times their annual salary (their defense, naturally, is that these are cheap fakes). Yet the anti-corruption campaign hits at a core element of the earlier growth success. By spreading fear and shutting down local sweet deals, it prevents local officials from helping business navigate the thicket of rules successfully. The solution is obvious. Lighter, clearer, transparent regulations will permit freer business entry, dispensing with the need for “door-opening” by powerful local party officials.

  With innovative new entrants, and the adoption of new technology and efficient management practices by incumbents, China will be able to grow without weighing on households. Some Chinese firms such as Baidu, Alibaba, and Tencent are pushing the frontiers of what is possible on online platforms and payment systems, catering to Chinese youth who are much more willing to consume and take on debt than their parents. China, given its enormous access to data, is probably much further along in some aspects of artificial intelligence and machine learning than developed countries.

  The bulk of employment is not in high-tech sectors, though, but in older legacy manufacturing such as automob
iles and steel. This is where China needs new technologies—such as electric and driverless cars and battery storage. It could acquire them by requiring foreign companies to enter into joint ventures if they want to sell in China—and the enormous size of the domestic Chinese economy now makes it a very attractive carrot—or it could buy companies abroad. Yet companies and countries are growing increasingly wary of China’s ambitions, realizing that the Chinese will improve upon any technology shared today to outcompete them tomorrow. Equally, Chinese firms are finding it harder to replicate or otherwise expropriate foreign technology, as developed country firms become more aware of the threat and protect their technology better.

  China therefore has to innovate, using its increasingly well-trained students, many of whom receive advanced degrees abroad, as well as its diaspora, who can be attracted back with the promise of well-funded laboratories and comfortable lifestyles. Chinese research and development has been progressing fast, but it will take time to make a difference.17 In the meantime, if China does give market forces more play, significant parts of its manufacturing sector will be uncompetitive without the explicit and implicit subsidies they have grown used to. When parts of the economy become uncompetitive, modern economies rely on the financial sector to identify troubled firms, shut them down, and reallocate resources from them to healthier ones. Thus markets, rather than the state, allocate resources, and they do so based on who can use the resources better in the future rather than on the basis of who has the best connections.

  In sum then, China has to open up entry, remove subsidies for incumbents, allow free competition, and let the market close down underperformers. All this has to be done while the party retains control, which means it cannot allow the private sector to become too independent. What might it do?

  THE CHALLENGE OF CHANGING PARTY BEHAVIOR AND RETAINING PARTY CONTROL

  Freer business entry means local party bosses will have to shift from selecting which new firms will enter and opening doors for them, to leaving all doors open to anyone who may wish to enter. This requires an enormous change in mind-set, especially since it requires the officials to allow their incumbent local champions—the source of some of their revenues and even personal incomes—to be subject to competition. If local party bosses are unwilling to lower local entry barriers, and at the same time unwilling to go back to the old corrupt ways fearing a vigilant central leadership, there will be little entry and slow growth.

  Suppose local party bosses do acquiesce to command from the center and free business entry. The party then has to ensure that those firms that grow can be trusted, since the new entry process does not filter the politically unreliable out. The party already has a method of doing this—to place its cells in each large firm, whether private or public, to govern the political direction of the firm. Presumably, if entry is freed, party cells will have to go into firms at an earlier stage than currently the case, to compensate for the lack of initial vetting.

  Given the party’s power, party representatives will be tempted to influence the course of the business, if nothing else to improve local growth and employment outcomes. That will make ostensibly private firms, which are typically focused on efficiency and profitability, into softer state-linked firms. It will require enormous discipline for party appointees to avoid the allure of influencing business decisions, when they have the power and position to do so.

  Even if they do not interfere, the existence of such powerful cells will tie the firms to the party in the minds of the people. That leads to yet another problem. In a growing and changing economy, some firms will have the wrong business model. The right business decision would be to let such a distressed firm go into bankruptcy, and even shut down. Given that every significant firm is believed to be under some party direction, the party’s reputation for infallibility will be at some risk. The party’s reputation can absorb the occasional corporate failure, not a cluster of them. An intrusive party will suffer from the classic soft-budget constraint that János Kornai postulated for socialist economies: It will not be able to shut down failing firms, especially if failures are bunched. Instead, it will rescue them and waste resources.18 Control is not free, it comes with the people assigning responsibility to the party.

  Can the financial market help ease the party’s problem? Probably not—it will tend to make it worse. That the party-controlled state will intervene if there are a number of failures creates the classic moral hazard problem of “too many to fail.” If markets know that the state will bail out firms or investments so long as there are a sufficient number of them, it has an incentive to create that number and more, and stop worrying about risk. The party’s desire for political control could, therefore, undermine the market’s pricing of risk.

  The investment behavior of Chinese households, which needs to augment savings for retirement, does not help. The household is ever alert for opportunities to make higher returns domestically, given that there are significant restrictions on investing abroad. Every time the government alters its policies a little, allowing households new investment opportunities or signaling a more relaxed attitude to credit, huge quantities of savings move to take advantage of the return differentials that might briefly be available. This flow pushes up the prices of financial assets, creating asset price bubbles. The government, wary of antagonizing the many households who invest their precious savings, is then tempted to intervene to support financial asset prices if they fall. If it does intervene, households come to rely on the government to bail them out, thus ensuring the financial market underprices risks. If the government does not intervene, it will have many unhappy households, and undermine its reputation for economic management and thus its legitimacy. Invariably, it chooses to intervene, ensuring the Chinese financial markets remain an unreliable allocator of funds.

  In sum, the party will be tempted periodically to substitute its wisdom for the wisdom of the market. If so, the market will never be able to mature to guide resource allocation and risk management. Real change will occur only when Chinese financial markets are weaned off the state’s protection. China needs its investors to absorb the lesson that financial markets do not just go up but they also go down. That is a painful lesson that the state finds difficult to impart, for financial busts do raise questions about the competence of an all-seeing and all-powerful party. For a party that is unelected, and has little ability to blame previous administrations, these questions are better not asked.

  As China moves to the frontier of innovation, its businesses will have to make more mistakes. It will also have to close more of its old smokestack industries. The strength of markets is their ability to deal with mistakes and failure. The desire of the party to stay in control could undermine that strength.

  THE STATE, MARKETS, AND DEMOCRACY IN CHINA

  Democracy, as we will see in India’s case, makes it harder for the state to act in some cases. However, it also makes inaction easier. The party in power does not have to take responsibility for everything, and it does not have to maintain a pretense of infallibility since it derives its legitimacy from elections, not perfection. That allows it to deal better with market ups and downs. Certainly, democratic governments also intervene in markets, but every market crash is not a referendum on the government. Democracy therefore creates a separation between the state and markets in yet another way than the one we saw in the Populist and Progressive movements. It allows the state to be more decoupled from markets, and allows each, then, to function better without any cross-linkages undermining their functions.

  All this assumes that China will continue to have enlightened meritocratic leadership that enjoys the broad support of its people. In the absence of elections, the people have to rely on the internal processes within the party to produce the right candidates. There are important reasons to worry that the internal processes are being undermined.19

  The anti-corruption campaign has had the collateral effect of centralizing
power within the party, with those who have the ability to levy corruption charges. Since so many party officials and existing businesspeople are compromised by corrupt acts in the past, the anti-corruption campaign can be used selectively to quiet opposition within the party and among the private sector. Indeed, my Chinese friends refer to the “original sin,” a term used to describe the legal compromises that almost every private Chinese firm of any size (and their relevant local regulators) made in its early days when rules essentially prohibited all business. The original sin then gives the anti-corruption authorities a handle with which to beat everyone involved if they step out of line. The absence of any uncompromised opposition clears the way for an authoritarian faction to assume control of the party, if it so chooses.

  Furthermore, party procedures, including those that ensured a regular change in leadership, are being overridden. Deng was worried about the reemergence of one-person rule. The evaluation of party candidates for promotion based on objective measures of performance, as well as competition between them, injected a certain amount of dynamism in the party. Deng also attempted to instill traditions that would prevent a Mao-like dictator from taking over. Apart from structures that promoted collective leadership, one tradition was a limit of two five-year terms for the national president. A second was that the current president’s successor would be determined in the middle of his term so that the succession would be smooth. Both traditions have been abandoned recently, corroborating the point that without sources of power in the country that are independent of the state, such norms are unlikely to constrain a determined leader.

  The party seems to be moving toward more control and centralization. A Communist Party memo in 2013 entitled Document No. 9 warns about the perils from Western constitutional democracy, a free press, and other “universal values” as ideas meant to undermine and even break up China.20 In a related vein, China’s “Great Firewall” prevents radical ideas from the internet from seeping into the country, while China’s large internet platforms have to share their data with the government. China’s proposed “social credit system” intends to combine all the data on a person through artificial intelligence to produce a score for each Chinese citizen, which will determine their access to private and social services. Whether political and social activity will be taken into account remains a source of worry. With facial recognition software, and ubiquitous cameras, there may indeed be no privacy for the citizen from the state, as well as no freedom from it.