18 September 2019

China’s economy runs on corruption – and the state is scared

By Leo Austin

Foreigners can float in and out of China without ever understanding the world around them. They sit at the dinner table, happy that the mayor’s brother has stayed for the meal and that they’re just one nod and one wink away from a deal.

Yet they may have little idea who he works for, nor why the waiters are all from one village, nor why the restaurant is where it is or why the special this week always seems to be beef. Everything that happens does so for a reason and it is seldom just a matter of price.

Small-scale corruption is endemic in China. Every time a company wins a tender, or an agency is retained, or a salesman selects a distributor, a deeper relationship is revealed than that which is shown in the contract.

The impact of corruption on China’s economy is much larger than its cost in cash. These choices distort the market. They make it hard for new entrants to get a first break. They lead to bad choices on government investments, to the sustained use of the wrong technology, to the wrong manager getting the job. They add costs to every single part of the economy.

Where does this corruption come from? Part of it is driven by the unfairness of incomes and a lack of opportunity. The state system was designed to keep people in their place and the Chinese people have raged against it for decades.

China has had a ‘hukou’ (or similar) household registration system for a thousand years now, which identifies and determines the rightful home of each individual, the place where they enjoy state education and medical services. If you are very lucky this is Beijing, Shanghai, Guangzhou or Shenzhen. These days, any provincial city is a reasonable outcome. But for most people it is a rural county.

In the 1980s and 1990s it was difficult even to get a job outside your registered home area. Today, the system is more marketized but it is still discriminatory. It is very difficult for the children of rural migrants to graduate from an urban school and almost impossible for outsiders to access subsidised government housing.

The hukou system has led to a long history of wage suppression in China. Compared to its Asian neighbours, wages in China have historically been much lower than they should be at the same level of GDP.

People weren’t free to move to where the best jobs were. The huge state enterprises in their hometowns provided free education and free medical services, but they didn’t have to compete for workers and they didn’t have to pay the best wages. Rural incomes are generally 40% of urban incomes across most of China.

Wage suppression was a boon to the growing Chinese economy since it created a major source of investable funds. That extra investment was paid for with low consumption. If you look at consumption as a share of GDP and compare China to the other Asian Tigers, by 2016 China was consuming 20% less than Japan and 30% less than Korea did at the same level of development.

As China struggles with excess capacity in steel and construction and finds that fixed-asset investments can no longer drive GDP, it is trying to move towards a consumption-based economy. That requires incomes to rise.

Demographic change has already started to make that happen. In 2011, as a new shortage of younger workers started to bite, the share of wages in GDP began to rise again and is now close to US levels. Consumption has turned up in parallel but is skewed by inequality. According to the IMF, China’s 2015 GINI Coefficient for income inequality was, at 50 points, one of the highest in the world and 30 points higher than the OECD average.

In an unfair society, people look hard for opportunity. Resources are controlled by the bureaucrats, as they always have been in the Mandarin system. The world of ‘Guanxi’ emerges: covert networks that open doors for new business; the chance to be considered an insider by a leader; the opportunity to get something you need with the unspoken promise that you will give back to the group. This gives rise to the culture of factions that drives China.

Officials are not well paid – in 2015, President Xi’s annual salary was only 22,000 USD a year and that was a 60% increase on the previous year –  but with power comes the chance to seek rents. A clever official must hand out their deals to those who will pay them back. Tight factions are formed. They dine together nightly, holiday together yearly. Some enjoy bonds of blood. Others a shared history of mutual entanglements, first small and then large, all complex and often troubled. They each know enough to ensure mutually assured destruction should one of them step out of line.

Resources go to the wrong people. State owned enterprises represent maybe a third of GDP in China today, but they still received around 82% of all the corporate bank loans in 2018, at least in the legal banking system. The money is not invested wisely.

According to the Nikkei Asian Review, for the nearly 300 non-financial state owned enterprises (SOE) listed in China, returns on equity fell by half in the loose-money boom years between 2007 and 2017. Over the same period, the return on equity for comparable US and European companies rose – ending more than double the level of Chinese SOEs.

All this has a serious impact on productivity – as Conference Board research shows, China’s Total Factor Productivity for the period 2013 to 2018 was negative.  In most economies, productivity improvements drive GDP growth every year in the absence of population or capital growth. In China, productivity was a drag on growth for the period when the money supply – the amount of capital available – was growing the fastest.

Only part of that weakness is a question of operational efficiency. In Silicon Valley, capital is used to raise the company’s valuation – to grow revenues, profits or the customer base. In state-run China it is used too often to produce an image of investment, a picture of a successful project that can be used for promotion and a shell from which benefits can be drawn.

The credit growth was astonishing. In the five years to 2017, the wide measure of money M3 nearly doubled in China. In the eight years to 2017 it nearly tripled. So much of the money went into buying property that it distorted the entire Chinese economy; maybe even Chinese culture.

House prices in Beijing and Shanghai rose seven-fold from 2003 to 2019. The incredible rise in housing prices has made living conditions much worse than suppressed incomes alone could have done. In Beijing and Shanghai, young educated migrants pack themselves into shared rental flats to survive, termed ‘the ant groups’, unable to pay rents on their own and maybe unable this lifetime to buy an urban house. The average price of a house in Shanghai is nearly 50 times the average total annual income.

It’s often these bright, white collar migrant workers who bring the highest risk of major corruption for a multinational company. Their desperation to do well, to raise enough cash for a deposit on a house can lead to very bad decisions.

The Communist Party itself struggles to manage the challenge of corruption and factions within its realm. In a system where position begets resources, the competition for position is the greatest competition of all; and every time someone receives a helping hand, it must be paid for.

Officials and party cadres are supposed to be promoted based on a detailed system of key performance initiatives (KPIs), reviews and recommendations. Yet for Chinese regional officials, the KPI section represents only one of nine components for the annual review – the remainder of which are political and prone to personal judgement.

There is a rule in the Communist party against the forming of factions. Yet they obviously exist. They form a core of party culture; and they form a core of Chinese culture. More than anything else – more than America, more than the internet – the Communist Party fears corruption. In the words of Xi Jinping, “corruption could lead to the collapse of the Party and the downfall of the State.” The only thing – the party believes – that can beat the party, is the party itself.

It’s hard to believe that the government’s efforts to re-centralise China can succeed if success means prosperity and the Chinese Dream. Since Xi Jinping came to power, there has been a perceptible growth of the state. People talk of ‘Guo Jin, Min Tui’ – the state’s advance and the people’s retreat.

It has happened. Part of it was driven by Xi’s need to take control of the party and all its arms, corporate and political, as the great fight on corruption began. Part of it was driven, perhaps, by the feeling that China – its land so huge and its people so disparate – was unwieldy and ungovernable.

Yet people can’t escape the feeling that it is also driven in large part by the Party’s innate lack of sympathy for private business. As the weak economic data of late 2018 became clear, Xi Jinping issued a public letter to private entrepreneurs, telling them that he would continue to value and protect them. He followed that with a high-level symposium on private business.

President Xi spoke of giving the private sector confidence and offering tax cuts and support. He instructed local governments to spend more time with private business. Soon after, the banking sector was directed to increase lending to private companies. Yet all this happened because the instinct of the party is to increase state power and not to allow the true freedom that a market economy requires. Getting the best return on investment will always be secondary to getting the best result for a faction.

Many in Washington fear that China is already eating America’s lunch. Yet China cannot be a true competitor to the US until it allows merit and innovation to allocate capital and rewards. An economy built on wage suppression and state investment can be large, but it cannot be competitive in the long-term.

Imagine if 80% of the bank loans in America went to politicians. Putting resources into the hands of officials reduces returns. The more the Chinese state spends, the lower returns are and the higher the debt burden rises. The rule of the factions continues. Unless the state retreats, it may yet bankrupt the country.

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Leo Austin is Senior Advisor to The Conference Board China Center for Economics and Business