China's State Capitalism on Trial: Urgent need to escape from the "Transition Economy Trap"

Chi Hung KWAN
Consulting Fellow, RIETI

Developed nations such as Japan, the United States, and European countries are increasingly concerned about the state capitalism observed in China and other emerging countries in which the government aims to develop the economy by actively intervening in the market through state-owned enterprises. For example, Nihon Keizai Shimbun argued in an editorial on April 8 that "we have to limit the spread of state capitalism and strengthen the trend of emphasizing fair market competition."

Even in China, momentum is building to review the division of roles between the government and the market. This comes against a backdrop of the spreading recognition that high growth cannot be sustained as long as the vigorous development of private-sector companies is impaired, and consumption cannot gather steam under state capitalism because wealth is concentrated in the state (including state-owned enterprises).

Since the late 1970s when China shifted to reform and a policy of opening up to the world, it has sought to transform itself from a planned to a market economy. With administrative reform lagging behind economic reform, however, the government is still intervening in areas where it should not ("overstretching"), while at the same time, it is not playing a role in areas where it properly should ("negligence").

Examples of overstretching include the facts that the government still controls important resources such as land and that state-owned enterprises continue to monopolize key industries. Also, government officials have considerable discretionary authority and frequently intervene directly in the economic activities of companies. In effect, the government, which should be the referee, is at the same time also a player, so the economic game cannot be fair.

Examples of governmental negligence, on the other hand, include China's inadequate provision of public goods and services such as environmental protection, social welfare, medical services, and education. Also, economic regulations have not been put fully in place, and their implementation lacks transparency. Moreover, there is a need to develop the market infrastructure supporting financial and other transactions and to strengthen the government's macro control capability.

Because of the distorted relationship between the government and the market, various problems—including the corruption of government officials, widening income gaps, resource depletion, environmental destruction, and a lack of domestic demand—are becoming more and more serious. As a result, there is a risk that a conflict between the state and the private sectors will emerge and destabilize society.

To solve these problems, hereafter, the government has to recast its role to meet the needs of a market economy. Above all, the reform of state-owned enterprises including privatization is urgently needed.

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From the start of the reform and opening up policy, the Chinese government began to encourage the development of non-state-owned enterprises, including private businesses. In addition, in the second half of the 1990s, the government started to promote the privatization of state-owned enterprises in the name of the "strategic restructuring of the state-owned economy" and "ownership reform."

In recent years, however, the share of state-owned enterprises in some areas has been increasing while that of private businesses has been decreasing. In particular, the economic stimulus packages totaling four trillion yuan that were implemented after the collapse of Lehman Brothers in September 2008 aggravated this trend, because the stimulus funds were concentrated on infrastructure investments such as railways, roads, and airports, which are mostly monopolized by state-owned companies.

The tilt toward the state sector at the expense of the private sector could curtail the growth of the Chinese economy in the medium and long term. First, in order to protect their monopoly position, large state-owned enterprises tend to pressure authorities and increase barriers to market entry. This behavior stymies the introduction of competition and the further opening up of markets for non-state-owned enterprises. A typical example of this situation is the concentration of bank lending in state-owned enterprises which makes it difficult for private businesses to obtain financing.

Moreover, because monopolistic enterprises can easily make profits, they have little incentive to improve efficiency. Consequently, state-owned enterprises remain uncompetitive in international markets.

Indeed, despite the fact that China has come to be called the "workshop of the world," the country's major exporters are mostly foreign-affiliated companies. Those Chinese state-owned enterprises that are ranked in Fortune magazine's annual Global 500 scarcely contribute to China's export total.

In addition, the profits of state-owned enterprises, which are mostly retained internally and not paid out, suppress consumption by reducing labor's share of the national income on one hand, and encouraging wasteful investment on the other.

Reflecting this, China's investment ratio (the ratio of capital formation to GDP) has been higher than seen in Japan, South Korea, or Taiwan during their high-growth periods, and its investment efficiency—measured by the marginal capital coefficient (which is calculated by dividing the investment ratio by the GDP growth rate)—has been poorer. This trend has become more pronounced since the Lehman Brothers collapse (see table).

Table: Investment Efficiency of China
- Comparison with Japan, South Korea, and Taiwan during their high-growth periods
Table: Investment Efficiency of China
Note: A higher marginal capital coefficient indicates lower investment efficiency.

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Based on such adverse effects of state capitalism, voices calling for accelerating reforms centered on the realization of a market economy are now being heard not only overseas but also inside China. However, while there is general agreement on the need for such reforms, they have yet to be put in place because of the difficulty of agreeing on the details.

Acknowledging that the objections and resistance by vested interest groups are the major causes behind the slow pace of reform, a group of sociologists at Tsinghua University put forward in a recently released report the concept of a "transition economy trap" and proposed strategies for China to escape from it.

The transition economy trap refers to a situation whereby vested interest groups that emerged in the process of shifting from a planned to a market economy, such as state-owned enterprises, hamper further reform and try to maintain the "mixed system" created during the transitional phase. The consequence is distorted economic and social development and worsening associated problems such as income gaps and environmental destruction.

According to the report, in China, which has fallen into the transition economy trap, vested interest groups seek quick profits by pursuing high growth without regard for wasting resources. Promoting large-scale construction projects and holding large events have become important tools to boost economic growth. With institutional reform stagnating, institutions that were supposed to be transitional have actually taken root. Monopolization of the markets by state-owned enterprises is a typical example. Moreover, social mobility is low, and the social structure is solidifying. As a result, not only is the dynamism of the overall society ebbing away, but also class conflict has become more pronounced.

Based on this analysis, the report offers the following strategy for China to break out of the transition economy trap.

First, China must move into the mainstream of global society based on universal values such as a market economy, democracy, and the rule of law. Rejection of the mainstream is the main reason why China fell into this transition economy trap, as well as the excuse for vested interest groups to maintain the status quo.

Next, China must accelerate political reform. The corruption of power is weakening the government's authority and its ability to execute policies. Political reform has to be embarked upon by creating a mechanism to constrain power, such as increasing the transparency of the government.

Finally, instead of delegating the power to make decisions on reforms to local governments and ministries as in the past, the decision-making system has to be changed so that reforms are based on a grand design drawn up at the top echelon of the central government. When promoting these reforms, the government has to listen to the opinions of the people to gain their support and, at the same time, place a basic value on fairness and justice.

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The 18th National Congress of the Communist Party of China will be held this fall, and a major reshuffle of the top leadership is on the agenda. An unavoidable issue for the new leadership will be escaping the transition economy trap by speeding up reforms. In that regard, the extent to which the Tsinghua University research group's strategy is put into practice should be closely watched.

>> Original text in Japanese

* Translated by RIETI.

May 24, 2012 Nihon Keizai Shimbun

June 25, 2012