China: Quo Vadis?

China today is at a crossroads. There are many forces at play, both internally and externally. In both the economic and geopolitical realms, China is a country of dual  identities. Economically, China is in transition from a relationship-based system, exemplified by its large number of State-Owned Enterprises (SOEs), to a market-based system, as seen in the massive growth of private companies. Although China has made notable strides in moving from relationship-based to market-based approaches and institutions, its economy today remains a hybrid, with growing market-oriented sectors co-existing with a shrinking, yet still powerful, state sector.

In the geopolitical realm, China also has two identities. On the one hand, it is a world power with the potential to be a catalyst for global growth and integration, backed up by a track record of record-breaking development and a powerful cultural history. On the other hand, China has the potential to assert itself as an authoritarian force, backed up by a substantial military.

These dual identities are interacting in different ways — they are merging in some places and are at odds in other places. This is influencing how China is interacting with the rest of the world. Alternatively, it is also influencing how the world interacts with and views China.

Economic Duality and Transformation

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A replica of Wall Street’s charging bull on the Bund in Shanghai.  AGENCE FRANCE-PRESSE/GETTY IMAGES

In 1998, one year after the Asian Financial Crisis led to regional contagion of currency and stock market declines, reduced import revenues and government upheaval throughout South Asia, University of Chicago professors Raghuram Rajan and Luigi Zingales wrote on the implosion of relationship-based financial systems in the crisis and the limitations that would be overcome through completing the transition to an arms-length system.6

Relationship-based systems are commonly seen in developing countries. In this system, return is ensured for the lender by “granting power over the firm being financed, e.g., through ownership or through retaining a role such as main lender, supplier or customer.”6 The lender ensures return by retaining some form of monopoly over the firm being financed. “As with every monopoly, this requires some barriers to entry”6 that substantially raise cost of entry to potential competitors, e.g. due to regulation or lack of transparency. In an arms-length system, the lender is protected by explicit contracts. Contracts and associated prices determine transactions that are undertaken. “As a result, institutional relationships matter less and the market becomes a more important medium for directing/governing terms of transactions.”6

In China today, both systems are functioning in parallel as it continues to develop and integrate with its global markets. The role of the market and private business in China’s rapid ascent has been profound. Private companies now account for more than two-thirds of China’s economic output, up from zero when reform began in 1978, in an economy that has expanded 25 times in real terms. Private companies also account for almost all jobs growth in the same period and are leading contributors to export growth.3

In addition, China has endeavored in recent years to promote positive, business-driven relationships with free-market economies, further reflecting China’s own internal development towards a market economy and its desire to be at the forefront of international trade. Specifically, China is continuing to integrate with the global financial markets. In November 2014, China launched the Hong Kong – Shanghai share link, providing global investors direct access to China’s capital markets. Also in November, plans to build a Canadian Renmimbi hub were announced, making currency transactions simpler and cheaper.

In addition to the rise of the market, relationship-based systems can still be seen clearly in China. The largest examples of this are China’s State-Owned Enterprises (SOEs). SOEs fall into three groups: industrial SOEs, of which there are about 145,000, virtually all of which report to provincial and local governments; banking and financial companies; and media and entertainment companies. Thirty years ago, SOEs were owned and controlled entirely by the government. The government determined what and how much to produce, where to invest, who to sell to, how to price and where to get financing SOEs had no right to hire and fire, and profits were handed over to the government. SOEs acted like mini-societies, providing life-time employment and basic social services, such as clinics and schools. SOEs also benefited from cheaper financing from state-owned banks, favoritism from local governments in land sales and fewer demands from regulators.

By the early to mid-1990s, SOEs were in financial crisis. They were hampered by rigid internal management structures and uncompetitive compared with more nimble, market-oriented, non-state firms. The government began an incremental, protracted, privatization program, which is still underway. This program included modernization of SOE governance, management and legal structures, all of which increased their “contractibility”5 quotient significantly, a key prerequisite for a market-based system. The low productivity and low returns of SOEs (less than half that of private companies in China) are a drag on the economy that cannot be afforded, especially in the face of a structural slowdown associated with a declining working-age population and the fading benefits of past economic reforms. China’s leaders agree that growth must increasingly come from productivity gains driven by improved resource allocation, rather than through simply agglomerating large amounts of capital and labor.5 Jian Chang of Barclays says that improving SOEs is “the most critical reform area for China in the coming decade.”

Geo-Political Hegemony Duality: Leadership through Growth and Influence or Control through Military Intervention?

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Chinese President Xi Jinping, right, is seen toasting with Macau Chief Executive Fernando Chui Sai-On in this handout photo in Macau to celebrate the 15th anniversary of its handover in December.2

In addition to its two economic identities, China has two geopolitical identities. It is a world power with the potential to be an important catalyst for global growth, integration and peace, as well as an authoritarian state with the potential to assert itself through force.

As a catalyst for growth, China is working vigorously to expand its international markets and trade, key elements of its future economic performance and, therefore, its internal stability. Over the past two years, China’s President Xi Jinping and Premier Li Keqiang have embarked on a frenetic diplomatic offensive, making at least 17 visits to 50+ countries on five continents and racking up close to 500 meetings with foreign heads of state and government.2 Wang Yi, the foreign minister, said proudly that Messrs. Xi and Li have created “a ‘Chinese whirlwind’ in the world.”

Recognizing that its regional and global growth rests on well-developed infrastructure, China is also continuing its decades-long efforts to develop what Beijing has coined as “comprehensive connectivity,” the end result of which is a networked Asia with China at its heart. Since 1978, Chinese national investment has been targeted toward regional container ports, industrial parks, high-speed railways, and highways that crisscross the Asian mainland, energy pipelines, and other infrastructure. China is now bringing economic development further west and south, creating additional trade and markets. At the November 2014 Asia-Pacific Economic Conference (APEC), China announced the establishment of an Asian Infrastructure Bank and a Silk Road Fund to finance regional development projects.4 This includes $40 billion in loans to help create a 21st-century version of the ancient Silk Road in the South China Sea region.4 It remains an open question as to whether this will result in an ASEAN block with closer economic ties to China or if China will ultimately use its economic and military weight to repress and control the region.

As a global geopolitical leader, China is engaging in activities to promote regional stability. During 2014, China has engaged with Afghanistan as the US prepared to leave the region. China shares a small but strategic border with Afghanistan from Xinjiang province and has an interest in the stability of the region. China has pledged $325 million and has promised to help train 3,000 Afghan professionals and to assist in training and equipping the Afghan National Security Forces.3 The Central Asia region has great possibilities for economic development, but also contains the potential for conflict among nuclear-armed neighbors. China has an opportunity and a difficult task to help ensure that the region becomes an engine for growth, not for conflict.7

China has built global credibility for its economic transformations and accomplishments, which have lifted 500 million people out of poverty. It is now in a position to leverage these successes to further benefit both itself and all of Asia through trade and economic development. At the same time, it has the potential to incite regional instability over territorial disputes and military brinksmanship. Recent territorial incidents include the dispute over the Senkaku (Diaoyu) Islands with Japan, the South China Sea with the Philippines, and unilaterally placing an oil-drilling rig in waters 120 miles from Vietnam’s coast. China is also in danger of smothering some of the key contributors to its success in Hong Kong and Taiwan, rather than recognizing and promoting them, as Deng Xiaoping did with successes such as the Household Responsibility System.9 Any or all of these possibilities risk its economic and geopolitical future. Will China dominate the region through force or will it help lead the region to increased profitability and peace?

Conclusion

China’s current economic diversity can be traced to two incomplete transitions: first, the development away from bureaucratic socialism towards a market economy; and second, China’s ongoing industrialization and its evolution from a rural to an urban society. These two transitions affect every aspect of the economy, society and culture, and are both far from complete. China has made notable strides in moving from relationship-based to market-based approaches and institutions, but its economy today remains a hybrid.

China’s economic and political aggressiveness is occurring at a time when its current economy faces notable risks of a significant downturn. Its leaders are working vigorously and globally to promote economic growth. While this aggressiveness could be beneficial to both China and the Asian region, it can also be threatening, given its demonstrated propensity for using force to impose its will. Going forward, China’s standard of living and the rights of its citizens will be influenced by how it reconciles these systems and approaches. China today carries with it a complex mix of the traditional, the socialist, the modern, and the market, bundled in a pragmatic mindset to solve problems with any and all tools and opportunities at its disposal. It is too early to know with reasonable certainty how these forces will ultimately play out. Quo vadis – where are you going – is an especially apt question for China. China’s evolution and accomplishments since 1978 are awe-inspiring and unprecedented. Will its people and its leaders continue to build mutually beneficial relationships and systems domestically and with the rest of the world? If yes, this well could define the 21st century as a golden era of peace, prosperity and civilization.

References

1. “Quo Vadis.” (Where are you going?) http://en.wikipedia.org/wiki/Quo_vadis%3F
2. Browne, Andrew. Wall Street Journal. “Expect No Easing of ‘Chinese Whirlwind’. Beijing Softens its Bluster, but Ambition Remains Unchanged.” January 6, 2015. http://www.wsj.com/articles/expect-no-easing-of-chinese-whirlwind-1420531486.
3. Lardy, Nicholas. Peterson Institute for International Economics. “China’s Rise Is a Credit to Private Enterprise Not State Control.” Op-ed in the Financial Times. September 15, 2014. http://www.iie.com/publications/opeds/oped.cfm?ResearchID=2670.
4. Economist Intelligence Unit – Country Report – China. 12-14-14. http://www.eui.com
5. Zhang, Dong and Freestone, Owen. “China’s Unfinished State-Owned Enterprise Reforms.” http://www.treasury.gov.au/PublicationsAndMedia/Publications/2013/Economic-Roundup-Issue-2/Economic-Roundup/Chinas-unfinished-SOE-reforms.
6. Rajan, Raghuram and Zingales, Luigi. University of Chicago “Which Capitalism? Lessons from the East Asian Crisis.” Journal of Applied Corporate Finance, Vol. 11, No. 3, Fall 1998.
7. Cotter, Michael W., US Ambassador (ret). http://www.unc.edu/depts/diplomat/item/2008/0406/comm/cotter_newface.html.
8. Naughton, Barry J.. The Chinese Economy: Transitions and Growth. Cambridge, MA: MIT Press, 2007. Kindle Edition.
9. Kennedy, Robert E. and Marquis, Katherine. “China: To Get Rich is Glorious.” 2006 (revised 2013). HBS case no. 9-707-022.

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