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Communist Party Needs to Loosen Its Grip

John Lee

Over the weekend, Premier Wen Jiabao told the National People’s Congress (NPC) that China will pursue more ‘balanced’ and ‘sustainable’ growth of around 7-8 percent over the next five years. When it comes to hitting designated targets, the common assumption is that China’s state-controlled model gives Beijing a decisive advantage in economic management. But its state-led approach—and the role of the Chinese Communist Party (CCP) in its political-economy—is precisely the reason behind the country’s structural problems.

Despite the applause for his ‘new approach’ announced over the weekend, the Premier has been giving the same speech for some time. But he is correct. China is much too reliant on unsustainably high levels of inefficient fixed-asset investment to produce growth. Increasing by between 20-40 percent per year over the past decade, fixed-asset investment levels cannot simply be accounted for by the rate of urbanisation in China which is growing at 1-1.5 percent annually. Such investment now constitutes around 55 percent of GDP which is way above the 25-30 percent levels that occurred in East Asian countries such as Japan and South Korea when they were rapidly industrialising in the 1960s and 1970s.

Bank lending, which funds the bulk of domestic fixed-asset investment, expanded from US$750 billion in 2008 to US$1.4 trillion in 2009 and US$1.2 trillion in 2010. The 2011 target is US$1.1 trillion. Over the past fourteen months, Beijing has raised the reserve requirement ratio of banks ten times. Interest rates have been raised three times since October 2010 and almost weekly directives have been issues to bank branches to curb lending. Despite all these measures, Chinese banks lent an estimated US$220 billion in January alone.

Three quarters of the capital go to state-owned-enterprises (SOEs). Overseen by the thousands of local bank branches, the vast majority of domestic capital is destined for the 120,000 locally owned SOEs and their countless subsidiaries. This creates two obstacles against slowing and ‘rebalancing’ the drivers of Chinese growth.

First, local governments are prohibited from borrowing from banks or issuing bonds. To get around these restrictions, they create state-owned commercial entities. These entities plough capital into the local property market through the process of (often illegally) acquiring land, re-classifying the land as commercial, building on it, and then selling the buildings. Indeed, about 50 percent of local government revenues come from property. This means that the tax revenue function for local governments in China is largely based on the perpetuation of a property bubble. For this reason alone, local officials and bank branches can pay only lip service to central directives to curb lending.

Second, local officials who exercise formidable control over local bank branches rely on an endless and ever-increasing flow of capital to local SOEs. The favouring of SOEs (and suppression of the domestic private sector through capital deprivation) is a key pillar of how the CCP maintains its economic dominance and relevance at the grassroots levels, allowing it to dispense the most valued business and career opportunities. It is no coincidence that economic and social elites are the Party’s strongest supporters. Significantly slowing the flow of capital to these local SOEs, even if half of the investment undertaken by these entities offer zero or negative returns, is not an option. This is despite Chinese economists believing that hidden non-performing-loans in the books of local branches could amount to 40-70 percent of GDP.

The extensive state-led bias favouring the 120,000 SOEs over 5 million private companies (and the 45 million informal private businesses) have resulted in a structural imbalance: while SOE revenues have been growing at 15-20 percent annually, mean household incomes have been expanding at a paltry 1-3 percent over the past decade. It is no wonder that domestic consumption is languishing at around 30 percent of GDP—the smallest percentage for any major economy in the world. Until the CCP releases its grip on the levers of economic power—unlikely in an age where economic irrelevance can rapidly lead to popular demand for political reform—China cannot have high growth and reform its dangerously ‘unbalanced and unsustainable’ economic model.

Over the weekend, and referring to the last 5 years of 11.2 percent growth per annum, Premier Wen boasted that ‘These brilliant achievements clearly show the advantages of socialism with Chinese characteristics.’ The fact that he has been issuing the same warnings for most of the decade—with little actual progress—should temper the growing international admiration for China’s authoritarian model.

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