Is China Really an ‘East Asian success story’?

State-controlled investment in China provides poor financial returns, explains John Lee

When the Nobel Prize-winning economist Kenneth Arrow was asked which countries had the best managed economies for a 2004 Wall Street Journal article, he nominated China, Taiwan and South Korea.(1) Arrow’s point of view is consistent with the widely shared belief that China is the latest successful instalment of the ‘East Asian model’ of authoritarian development (the ‘model’). As David Dollar, the head of the China desk for the World Bank, consistently argues, China is pragmatically replicating many elements of the model. According to Dollar, China’s approach ‘is not that different from what other successful East Asian countries have done before.’(2)

Despite the absence of an actual generic ‘East Asian model’ of economic development, Dollar is correct to point out that there are many similarities. An authoritarian government deploying a state-led development approach is the most striking commonality between South Korea and Taiwan in the 1960s and 1970s, and China since 1978. But most commentators also fail to appreciate important differences. Despite the tendency for China watchers to do so, Beijing has never explicitly characterised its economic developmental approach as an ‘East Asian’ one. This article argues that we should resist viewing China’s rise as simply the next winning installment of the broad East Asian authoritarian model. In fact, the differences are potentially significant enough to call into question whether China will follow the pattern of successful modernisation that Taiwan and South Korea enjoyed.

‘East Asian model’ of authoritarian transition—South Korea & Taiwan
The similarities in performance of China, Taiwan and South Korea as their economies industrialised are considerable. From 1960–95, South Korea grew at an annualised pace of 8.1% and Taiwan at 8.6%. Likewise, since the onset of reforms from 1979 onwards, China has grown at an annualised pace of between 8–10%.

However, more interesting are similarities in the overall political-economic approach. The problem for backward economies trying to grow and develop quickly is that social and economic institutions are similarly undeveloped, individual expertise is poor, and the possibility of chaos resulting from rapid liberalisation is high. To avoid a descent into disorder, Samuel Huntington laid the intellectual groundwork 50 years ago for the development strategy of ‘authoritarian transition’ whereby existing authoritarian systems could initially provide political order, rule of law, and the stability needed for successful development.(3)

Only after the development of institutions necessary for sustainable development could governments in developing countries take a lesser role.

The prescience of Huntington’s work is powerfully demonstrated by the recent histories of countries such as Taiwan and South Korea but with an added twist—government intervention and supervision of the economy to provide the conditions for rapid industrialisation and economic activity. Both benefited from a significantly depreciated currency and low labour costs to pursue an export-orientated strategy as a major driver of growth. Both also relied heavily on state-led fixed investment to underpin GDP growth. This was made possible by government control of the financial sector and, in particular, the nationalisation of banks. In Taiwan, high levels of savings meant that the source of capital was largely domestic. In South Korea, there was heavy reliance on foreign borrowing until 1980. Furthermore, both invested heavily in education to ensure the building of ‘human capital’ and the adaptability of the labour force as the countries industrialised.

Although economists will undoubtedly point out the differences between the approaches adopted by Taiwan and South Korea,(4) they had one critical thing in common: the government took early responsibility for the promotion of economic growth, macroeconomic stability, and institution building. Both the Kuomintang in Taiwan and the dictatorship led by General Park Chung-Hee entrenched autocratic rule in their respective countries through various repressive measures in the 1960s and 1970s. As Helen Hughes points out, in the mid 1950s, Taiwan and South Korea were generally regarded as basket case economies.(5) But at a vulnerable stage of nationhood, these states avoided chaos. Ultimately, the economic record of these two East Asian autocracies when viewed over several decades is an inspiring one. Per capita GDP rose more than six-fold in South Korea and Taiwan during this period.

To be sure, there were important differences between the South Korean and Taiwanese approaches and each had countless failed policies along the way directly associated with an extensive governmental role in the economy. For example, a chain of problems and imbalances resulted from the protectionist and mercantilist trade policies that South Korea in particular deployed in the earlier years.(6) It was only after these countries gradually abandoned import-substitution policies and shifted towards open trade systems that exports and employment grew, resulting in increased savings and investment—one of the main pillars of the so-called East Asian model. But even though governmental intervention produced an army of bureaucratic and private rent seekers in the system, state intervention and supervision of the economy was nevertheless designed to nurture and protect fledgling domestic private firms, buy them time, and ultimately establish the foundations of a modern economy in which a vibrant, dynamic private sector could ‘take off’ and ultimately drive economic development.

China—duplication or forgery?
There are clearly manifold similarities between China and its East Asian neighbours. For example, like its successful neighbours, China pursues an export driven growth strategy that is aided by an artificially low currency and competitive labour costs. It also relies on a domestic led fixed investment strategy in which the state sector plays a dominant role. State-owned industries in about a dozen key areas are given many forms of protection to give them opportunity to develop.

Yet, the many apparent similarities are only surface deep. The key to success in Taiwan and South Korea was to create the conditions needed for vibrant organisations, competition, and private enterprise to eventually take off. Even though it was within a context of state-guided capitalism (and mistakes were made), the government ultimately offered a ‘helping hand’ to lay the foundations for future private enterprise and capitalist activity—in particular, rule of law, property rights, and social and political stability. Rent-seeking by the state occurred but the state never became predatory. As Joseph Stiglitz remarks, commenting on the East Asian miracle a decade ago (in which he included Taiwan and South Korea but not yet China), rather than replacing markets, ‘these governments promoted and used them.’(7) Despite superficial similarities, China is pursuing a different approach. Stiglitz complimented the governments of these East Asian pioneers for directing and supporting private industry rather than crowding it out and replacing it. But in the case of China, the nature, purpose and extent of the role of the state in Chinese economy and society sets it apart from its successful East Asian neighbours.

The return of the Chinese state
In July 2001, then President Jiang Zemin gave a widely reported speech that many believed finally offered ideological legitimacy to the private sector and confirmed that China was treading bravely on the East Asian pathway to success:

Since reforms and opening, the social structure of our country has changed substantially. There are now non-governmental high-tech entrepreneurs and technicians, managers and technicians employed by FIEs (foreign investment enterprises), individual households, private entrepreneurs … so on and so forth. They are also contributors to the socialism with Chinese characteristics.(8)

The following year in November 2002, the 16th National Congress adopted a new constitution that opened Party membership to ‘Any Chinese worker, farmer, member of the armed forces, intellectual or any advanced element of other social strata’ (Chapter One, Article 1). Entrepreneurs once ‘outcasts’ were now ‘honored guests.’(9) Many saw this as a concession by the leadership that a new, capitalist China had finally emerged, albeit one with ‘Chinese characteristics.’

Looks can be deceiving. Most Western commentators focus on the spectacular success of China’s export sector and the emergence of China as the world’s factory. But the greater contributor to Chinese growth is actually domestically funded fixed investment, which constituted over 50% of GDP in 2008 and over 40% of growth in that year. China is way off the charts in this regard. Taiwan, for example, which had an unparalleled growth rate of 8% each year over 50 years never had capital investment spending of more than 30% of GDP.(10) South Korea had a one-off spike in the fixed-investment rate of 40% of GDP in 1990 but averaged around 30% during its growth periods in the 1970s and 1980s. Even Japan only averaged around 30% of GDP in the 1970s. But it is not just the high reliance on fixed investment that is striking. It is where the capital goes that is all important.

China is unusual in that bank loans constitute around 80% of all investment activity in the country—a disproportionately high level. Even though state-controlled enterprises produce between one-quarter and one-third of all output in the country, they receive over 70% of the country’s capital, and the figure is rising. This is the reverse of what occurred in Taiwan where the private sector received more than three-quarters of all capital during the 1970s—the primary Taiwanese growth period.(11) In South Korea, the private sector received between 50% and 60% of all capital from 1963–79.(12) Likewise in Japan where the private sector received around 70% of all investment in the 1970s and over 80% in the 1980s. This Chinese bias towards the state sector is further demonstrated by looking at the proportion of fixed assets in the country owned by the state. In China, the figure stands above 60% and it is rising. In Taiwan, the average in the 1970 and 1980s was around 30%. In South Korea, the figure averaged around 20% during the same period.

The move towards an unbalanced state-led model did not occur by accident but was the result of deliberate policy. The Chinese reform experience can be divided broadly into two periods with the Tiananmen protests in 1989 constituting the dividing line. Prior to 1989, the spontaneous explosion of private initiative in rural China—fuelled by limited land reforms and unobstructed by officials—certainly propelled China closer towards a free-market model. Significantly, 80% of the poverty alleviation that occurred since 1979 was achieved during this period. But a top-down change away from nurturing the growth of the private sector is obvious when examining fixed asset investment measures before and after the ‘Tiananmen Interlude.’ From 1981–89, fixed asset investment by the private sector was growing at 20% per annum. During the ‘Tiananmen Interlude,’ it dropped to 2.6% and from 1993–2001 only rose 12.4% per annum. Private investment in rural China, which had been growing at above 19% prior to 1989, dropped to 1.1% during the ‘Tiananmen Interlude’ and averaged only 7.5% from 1993–2001.(13)

Domestic short-term loans to domestic private businesses tell a similarly oppressive story, comprising only 2.5% of all short-term loans extended by all financial institutions in 2005.(14) A World Bank survey in 2000 covering 10,000 mainly private firms across 81 countries showed that two-thirds of Chinese private firms surveyed nominated formal credit constraints as a ‘major constraint’ on the operation and growth of the business. Only Moldova ranked worse according to this survey.(15)

The explosion in the number of officials is further indication of the rise of the Chinese ‘corporate state.’ In the 1980s, China had fewer than 20 million officials on the payroll. In the early 1990s, the number grew to more than 20 million, and by 2004 there were more than 46 million. This equates to around one official for every 28 people.(16) This is backed up in a further report that indicated the doubling of officials during the 1990s. In the 1980s, a small township had around 10 to 20 officials and a large one had around 20 to 30 officials. By 2004, an average township had more than 100 officials.(17)

Another case in point is that more than 30 of the largest 35 listed companies on the Shanghai Stock Exchange are majority owned by the state and state-controlled entities. Between 1990 and 2003, less than 7% of the initial public offerings on the Shanghai and Shenzhen stock exchanges were from private-sector companies.(18) The Chinese state owns about 50% of all the shares of listed companies.(19) When state-controlled entities are included in the calculation, it is likely to be around 70–80% of all listed shares. In terms of assets, employment, national output, and control of the most important sectors, the state’s role in the Chinese economy is far more profound, extensive, and entrenched than at any time in East Asian countries such as Taiwan and South Korea.

The political motivations behind these developments are clear. The Tiananmen protests brought the Party to its knees. Authoritarian regimes become irrelevant at their peril. To preserve its relevance, the Party has gone to extensive lengths to retake control of the major levers of economic power. This control is at the heart of an economic structure that entrenches, for the moment, the role and status of Party officials and members in the Chinese economy and society.

The predatory state
The massive bias towards the state sector would be acceptable if the state-controlled enterprises could learn to innovate and adapt. Unfortunately, except for a handful of centrally managed state-controlled enterprises, this is not the case. For example, in a recent report released by the IMF, and authored by World Bank China Director David Dollar and IMF Assistant Director Shang-Jin Wei, a survey of 12,400 firms in 120 cities in China was taken for the period 2002–04. The study found that despite a quarter century of reforms, capital use by state-controlled firms produced returns that were up to 54% poorer than returns from capital use by domestic private and foreign owned firms.(20) A recent report by consultants McKinsey & Co suggested that the average Total Factor Productivity of large state-owned and state-controlled industrial firms was half that of privately owned firms.(21) Bear in mind that the 152 centrally managed state-owned-enterprises or SOEs (as well as the thousands that are subsidiaries of these large centrally managed firms) are the most efficient of the state-owned and state-controlled entities. Even then, 80% of profits from all centrally managed SOEs come from fewer than a dozen firms such as China Mobile, Sinopec, and China National Petroleum Corporation—all operating in virtual monopoly environments.(22) In other words, the vast majority of even the centrally managed SOEs, despite easy credit and protected environments, are poor performers. Most of the approximately 120,000 provincial state-owned or state-controlled enterprises and collectives perform even worse.

To put the situation in perspective, China’s overall use of capital is twice as inefficient as India’s when measured in terms of capital inputs used to produce additional output. In fact, World Bank findings indicated that about one-third of recent investments made generated zero or negative returns.(23) Given the regime’s need to continually stimulate the economy for political ends, it is no wonder loans keep on increasing at an incredible pace despite economic rationality demanding that it should not. This might further the end of maintaining loyalty to the ruling Party and entrenching its power, but it is at enormous cost to the country.

There are further problems with China’s political-economy model that could take it in a different direction to what unfolded in Taiwan and South Korea.

John Stuart Mill famously said that political economy is about the ‘aggregate’ increase in wealth and prosperity. A developing system that leads to the concentration of wealth in the hands of a few creates an unsound and unstable political economy. One problem for China is that too heavy an emphasis on state-led development tends to exacerbate inequality as the economy expands. Since the state dispenses the most valued business, career, and professional opportunities, a relatively small group of well-placed and well-connected insiders benefit while opportunities to prosper are denied to the vast majority. This is certainly a serious problem for China. Its Gini coefficient, a measurement of income inequality,(24) rose from around 0.25 in the 1980s to around 0.38 in the 1990s.(25) It is now around 0.5,(26) which is the highest in Asia. In contrast, the Gini coefficients of South Korea and Taiwan from the 1960s to the 1990s hovered around 0.34 and 0.29 even as the economies of these countries were growing rapidly.(27) Worryingly for China, despite enormous GDP growth, about 400 million people have seen their incomes stagnate or decline during the past decade.(28) Another study by the World Bank suggests that the income of the poorest 10% was declining by 2.4% each year at the beginning of this century.(29) Since 2000, absolute poverty has actually increased, as has illiteracy.

A second problem is the lack of robust institutions needed by all strong economies. The political imperative of retaining power severely impedes the building of the soft institutions needed for successful capitalism: enforceable property rights, independent courts and rule of law, independent financial and administrative organs. For example, the Property Rights Index released by the Heritage Foundation gives China a dismal score of 20 (which is the same rank as countries such as Bangladesh, Cambodia and Uzbekistan), while South Korea and Taiwan rate reasonably well at 70.(30) All land is still owned by the state although individuals may own and transfer long-term leases. But as the report observes, China’s judicial system is weak and even when courts try to enforce decisions regarding land rights, local officials ignore them with impunity.

China’s future …
The absolute size of China means that even if its economy falters, China will continue to be a major presence in the region. However, given the weaknesses in its economic strategy and civil society, we need to consider the possibility that China is becoming more like an unbalanced South American giant such as Brazil than an East Asian success story such as Taiwan and South Korea.

John Lee is a Visiting Fellow at the Centre for Independent Studies. A fully updated second edition of his book Will China Fail? will be released in June 2009. Jen-Wei (John) Liu provided research assistance in writing this article.

Endnotes

(1) David Wessel and Marcus Walker, ‘Nobel winners in economics are upbeat about the future as China and India surge,’ The Wall Street Journal, 3 September 2004.
(2) ‘Interview with David Dollar and Louis Kuijs,’ World Bank Quarterly Update, 1 July 2008.
(3) Samuel Huntington, Political Order in Changing Societies (New Haven: Yale University Press, 1958).
(4) Perhaps the most notable difference is that South Korea nurtured huge industrial giants known as chaebols, while Taiwan avoided capital concentration in just a few large firms.
(5) Helen Hughes, ‘Why have East Asian countries led economic development,’ The Economic Record, 71:212 (1995), 88–104.
(6) As above.
(7) Joseph Stiglitz, ‘Some lessons from the East Asian miracle,’ World Bank Research Observer 11:2 (1996), 156.
(8) Speech by President Jiang Zemin, 1 July 2001.
(9) Deng Peng, ‘From outcasts to honoured guests: The changing fortunes of private entrepreneurs in China and the struggle for CCP legitimacy,’ Journal of Third World Studies, Spring 2006.
(10) Council for Economic Planning & Development, 1997, Taiwan Statistical Data Book 1997 (Taipei 1998).
(11) Shirley WY Kuo, Gustav Ranis, and John CH Fei, The Taiwan Success Story—Rapid Growth with Improved Distribution in the Republic of China (Boulder, Colorado: Westview Press, 1981), 80–81. 
(12) Major Economic Statistics and Economic Planning Boards from various years.
(13) Based on National Bureau of Statistics analyses, cited in Yasheng Huang, Capitalism with Chinese Characteristics, 21.
(14) People’s Bank of China, Quarterly Statistics Bulletin (Beijing: People’s Bank of China, 2006).
(15) World Bank, The World Business Environment Survey 2000 (Washington, DC: The World Bank Group, 200).
(16) Zhao Shukai, ‘Reforms of townships,’ State Council Investigation and Research Report 168, 2004.
(17) Zhao Shukai, Changing Township Organisations,’ State Council Investigation and Research Report 119, 2004.
(18) Yasheng Huang, Capitalism with Chinese Characteristics (New York: Cambridge University Press, 2008), 171.
(19) James V Feinerman, ‘New hope for corporate governance in China?’ The China Quarterly 191 (2007), 593.
(20) David Dollar and Shang-Hin Wei, Das (Wasted) Kapital: Firm Ownership and Investment Efficiency in China (Washington, DC: IMF, January 2007).
(21) Diana Farrell, ‘The value of financial system reform in China and India,’ McKinsey Global Institute Report, 2007.
(22) Minxin Pei and Jonathan Anderson, ‘The color of China,’ The National Interest, March/April 2009, www.nationalinterest.org/Article.aspx?id=20952, 13.
(23) See Minxin Pei, ‘How rotten politics feeds a bad loan crunch in China,’ The Financial Times, 7 May 2006, 9.
(24) A coefficient of zero means perfect income inequality and a coefficient of 1 means perfect income inequality.
(25) Jiandong Chen, Wenxuan Hou, and Shenwu Jin, ‘A review of the Chinese Gini coefficient from 1978–2005,’ Social Science Research Network Working Paper Series, 16 January 2008.
(26) ‘China suffers widening income gap,’ China Daily, 1 July 2007.
(27) Kui-Wai Li, Capitalist Development and Economism in East Asia (London: Routledge, 2002), 55.
(28) See statement by Joshua Muldavin, Major Internal Challenges Facing the Chinese Leadership, U.S.-China Economic and Security Review Commission, 2–3 February 2006.
(29) Richard McGregor, ‘China’s poorest worse off after boom,’ The Financial Times, 27 August 2006.
(30) www.heritage.org/index/Country/China.