What Glue Holds Communist Capitalism Together in China? Cronyism

With a few cronyist tweaks, China’s communist leaders made capitalism safe for Party rule. But will cronyism become China’s next booming export?

 

 

The Chinese economy is a puzzle that fascinates Chicago Booth professor Chang-Tai Hsieh. Ask an economist what it takes to create a successful business environment and she’s likely to tick off a predictable list of liberal institutions: strong property rights, rule of law, enforceable contracts, a strong and independent judiciary, etc.—the kinds of items that appear on the World Bank’s famed Doing Business Report, for example.

 

But then there’s the People’s Republic of China. Last year it clocked growth of 6.9 percent and over the past three decades has achieved a stunning reduction in poverty: from nearly 756 million living at the international poverty line in 1990 down to around 25 million by 2013. But “you look at the details of China and you ask the question, ‘What is the judiciary system? What kind of rule of law is there in China?’” Hsieh says. The 2013 Doing Business Report ranked China at 151 (out of 180) for overall ease of starting a business, according to Hsieh, in the near vicinity on the list of Haiti and Congo. “All of you should see that there’s something missing about this,” Hsieh told an audience in a Becker Friedman Initiative talk at Chicago Booth in February, “because we don’t talk about China in the same way that we talk about Congo.”

 

A week or so after Hsieh’s talk, the Economist was doing rather a lot of puzzling over the Chinese economy as well. In the wake of president Xi Jinping’s recent decision to remove term limits on himself, the newspaper dedicated its cover story to examining how the West managed to delude itself for decades into assuming that the internal contradictions of the communist behemoth’s turn to capitalism would inevitably foster liberalization of its institutions. The dichotomy between the predictions of those who thought China would become the “next great capitalist tiger” and those who saw it as “the world’s last great communist dragon” appears to have been a false one—China today is both. But how?

 

Hsieh’s talk—entitled “Crony Capitalism with Chinese Characteristics” and based on the eponymous working paper he and coauthors Chong-En Bai and Michael Song put together in 2014 following a tête-à-tête with local apparatchiks in a small (by Chinese standards) city of two million in southern China—offers some insight. On the Venn diagram of economic systems, there is at least one sliver where capitalism and communism can overlap without much logical contradiction: cronyism. In building its state capitalist machine, China’s Communist Party has avidly embraced patronage and cronyism whilst simultaneously deploying the arms-length institutions that liberal economists see as essential to market operation as a weapon to stall the proliferation of unfavored firms.

 

Institutions that aren’t what they seem

 

“Let me just give you a summary of what I think the story is,” Hsieh recapped at the start of his talk. “The way I want you to think about it is formal versus informal institutions.”

 

“What the World Bank Ease of Business indicator measures is what I’m going to call the ‘formal institutions,’ what the rules on the books say. What you quickly figure out in China is that if you try to go by the book, you’re dead.”

 

He recounts the story of a mom-and-pop shoe manufacturer in a small city in China who had to pay 95 different taxes and seek 192 official signatures to expand his small business in a process that took him two years. This, Hsieh says—those 95 taxes and 192 signatures—this is what the Doing Business indicators are capturing.

 

But the real key to opening a business in China, Hsieh says, is to go in through the back door and sidle up to a Party dealmaker. Chinese apparatchiks can in fact be much friendlier to capitalists than one might think: “I hate to venture into amateur psychology,” he jokes to his audience of business school students, “but I’ve met about 20 of these bosses and the thing that really strikes me about their personality is that they remind me a lot of you guys. They’re basically businessmen. They’re basically about making deals.”

 

“What you quickly figure out in China is that if you try to go by the book, you’re dead.”

In the small city Hsieh visited in 2014, he was introduced to a vice-mayor—one of nine in that city (this one ostensibly responsible for education). But as Hsieh quickly discovered, “the vice mayor for education is not spending any of his time running the public schools.” Instead that vice mayor’s office was responsible for “soliciting business and making sure the businesses that he solicits get everything that they need in order to make their businesses evolve.” By Hsieh’s count—with nine vice-mayors each responsible for about 20 projects and the local Party head and mayor handling the most important companies—about 250 local firms, employing about a third of the local labor force, were the private-sector darlings of the local Party.

 

In their 2014 working paper, Hsieh and coauthors generalized the insights from that experience to China more broadly. They argue that China’s multitudinous municipal administrations, each controlled by a Party apparatus, court private firms (which often partner with G7 multinationals that bring extensive tech knowhow and intellectual property), pick cronies, and then grant them local monopolies or near-monopolies in exchange for a partial ownership stake for the municipality itself.

 

These favored firms enjoy extraordinary privileges, monopoly rents, and access to the local Party’s patronage networks while the municipalities use China’s labyrinthine formal rules to seal out those firms’ potential competitors. In return, the Party gets its share of monopoly profits while retaining enormous formal and informal control over the private economy.

 

“I want to illustrate this by talking about one specific aspect of Chinese policy,” Hsieh explains:

 

The main element of Chinese industrial policy in the 1990s and the 2000 was what they call their Policy to Support the Strategic Industries. The policy was the following. They picked about 20 sectors which they called “the strategic sectors,” and they basically put in place a set of rules, laws and said that, “In these sectors, only these firms are allowed to operate.” In the aluminum industry, only one company was allowed to produce aluminum. In the steel industry, they only allowed seven firms. In the car industry, they only allowed six.

 

When you look at it as an economist, this is like a total disaster. If you only allow these six firms to operate then there’s basically no competition. But it didn’t quite work out that way.

 

Hsieh gives an example: Shanghai GM, China’s largest car company, is a joint venture between General Motors and the Shanghai Automobile Industry Corporation (SAIC), itself owned by the City of Shanghai, and one of six favored car producers in the city. (“This is important,” Hsieh notes. “It’s a stateowned firm, but it’s owned by the city, not by the central government.”)

 

SAIC also holds a stake in Shanghai Volkswagen (which supplies Shanghai with its entire fleet of taxis, all VW Passats—exactly as Hyundai has done for Beijing, and Toyota for Guangzhou, through their JVs with the local municipal governments) and runs the state-owned firm SAIC, which manufactures own-brand cars.

 

What do all these partners get out of this array of ventures? For SAIC, the upside of partnering with GM and Volkwagen is clear: they get access to G7 tech savvy that they can then transfer to their state-owned enterprise. The case is trickier for their MNC partners: they get juicy monopoly profits, but also risk having their cutting-edge technology nicked. (“Then, later on, when you figure out that they’ve stolen all your intellectual property, which court do you go to, to sue?” Hsieh laughs. “You are going to sue SAIC in the courts of the city of Shanghai? Good luck.”) The MNCs get around this by only sharing their most inferior intellectual property—the first car GM sold through its Chinese JV, for example, was the 1991 Buick New Century, which retailed in Shanghai for $44,000

 

“Again, if you are a crony this is the thing that you love,” Hsieh says. “You love to be able to sell crap for high prices.”

 

GM was in for a surprise, however, when it attempted to roll out a cheaper model in China using blueprints from its Korean subsidiary Daewoo: another car company, Chery, headquartered in Wuhu, Anhui province, had found the blueprints and beat GM to the market with a clone of its Daewoo model.

 

Chery on top

 

The case of Chery is illustrative of the final key feature of China’s crony capitalism: its aggressive export orientation. This arises, according to Hsieh, precisely as a result of municipal Party organs protecting the monopoly privileges of their private-sector cronies. Chery, for instance, only wrangled permission to set up shop as a JV with the government of Wuhu after agreeing not to challenge the markets of favored car producers in Shanghai, Beijing, Guangzhou, etc. After it had saturated Wuhu’s small car market and that of minor Chinese cities lacking their own car monopolies, Chery turned its attention to the export market. Today, with external trade barriers so much lower than internal ones, Hsieh reports that 80 percent of Chery’s revenue comes from exports. (Chery had supplied, for example, more than 500,000 of Colombia’s taxis by 2016.)

 

In short, communism clearly remains alive and well in China, yet capitalist competition is still thriving—albeit at the municipal and international rather than at the firm level. The fact that China’s thousands of local governments are competing with each other, write Hsieh et al. in the abstract to their 2014 working paper, explains “the presence of local ‘crony capitalists’ in each locality, the bias in the provision of public goods towards those benefiting local businesses instead of households, high profit rates and high growth rates among the favored firms, and a biased concentration towards exports.”

 

What’s clear is that the Chinese economic model now appears to be under less political pressure than that of its G7 counterparts. “If you think about what makes this model politically sustainable,” Hsieh concluded in his BFI lecture, “it’s that basically this is a system that gives profits to private businesses, and it also increases the power and wealth of the Communist Party. That is unique. The phrase that I’ve heard is that the goal is to have a marriage of the Communist Party and Goldman Sachs. It’s politically stable because it enhances their power.”

 

If anything—as the US administration currently weighs abandoning the rules-based trade system while dispensing exemptions for favored firms and states, and with the middle class in the United Kingdom, Germany, France, and Italy also increasingly enamored of the nationalist protectionism that economist Raghuram Rajan has called “the first step toward crony capitalism”—it is the G7 nations that today may be more likely to overlap with China on the “cronyism” shaded area of the Venn diagram of economic models.

 

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.  

One comment

  1. China has state capitalism and yet its private sector is growing. It also supports education. The authors of this paper have captured tiny part of China. How about comparing Jiangsu and Zehjiang? China encourages experimentation;and differences that’s why Zehjiang and Jiangsu took different routes.
    Americans can envy how China has supported development;and also improved its rust belt-while the abandonment culture means rust belt of NE still festering!

    US already has cronyism;and so does UK. Their private sector is suffering. What’s the difference? In US SMEs are shafted;while large firms are favored at local, state and federal level. Yet large firms (mostly public) are being strangled by shareholder value even as there is less competition because of mergers.
    In Germany, there is a public/private system that helps SMEs-that is why has lions’ share of “hidden champions. Germans left British behind by 1910;and and gap between two has only grown.

    IN UK Tom Brown’s book is an eyeopener. In UK financial sector rules;but other sectors suffer.
    UK has been declining since 1870s. Brexit will be final nail in coffin.

    US will start suffering hugely in ways not mentioned on this blog because of segregation. You are based in a city whose segregation parallels apartheid in Johannesburg! The result is when the nonwhite Americans enter work force the applecart will be upset permanently as it start bad cycle and its feedback loop!. Nonwhite Americans are majority in school. So by 2020s they will start entering work force as aging boomers (with low savings/if any) exit.

    Segregation is a legacy of the British. Only one person understood how toxic it was:Lee Kuan Yew. That is why what he achieved southerners cannot dream of. they didn’t invest in human capital;and he did. Sutherners are still committed to low wage economy;which is now infecting rest of US because of influence of shareholder value.

    By the way, something to wonder, why do all English speaking western countries have smaller midle classes than European countries. Note these countries include Italy-the land of weak governance, corruption, tax evasion, north/south economic gap, and string mafia!

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