Download Title: China`s Possible Next Step Forward Teaser: Beijing`s handling

Title: China's Possible Next Step Forward
Teaser: Beijing’s handling of the global financial crisis has exposed flaws in China's economy
that may lead Beijing to consider some political reforms necessary.
This week, China celebrates the National Day of the People's Republic of China (PRC), the
annual commemoration of the founding of the People's Republic of China on Oct. 1, 1949. In
the 62 years since the PRC's founding, China has reached a number of impressive economic
benchmarks. From 1978 alone, the country’s Gross Domestic Product (GDP) has grown at a
nine percent yearly clip -- maintaining double-digit growth for a large part of the past decade - and China is now the world's second-largest economy. China parlayed its mass population to
foment a labor-intensive economy that has become a crucial link in the global economy
because of its low-end manufacturing assets. National income has surged and the population
has urbanized en masse.
However, STRATFOR has long argued that the <link nid="160215">nature of the Chinese
economic structure is unsustainable</link>. Since the outset of the global financial crisis in
2008, a number of structural problems have become more apparent -- for instance, the
slowdown of the export sector due to lack of external demand and the low level of domestic
consumption. But the issues currently facing leadership are not only economic -- they are
also political. Reforms in politics have long lagged behind economic developments, and this
has led to a number of economic imbalances. The question is, has the economic problem now
intersected this political bottleneck, and will it impede Beijing's attempts to invigorate the
economy?
In most countries, including those with market-oriented economies, economic development is
linked to the political process. This is especially the case for China, where the state retains a
strong degree of control over the economy. This arrangement can push the economy in a
positive direction, as happened in the past with measures promoting economic liberalization,
but can also serve as an impediment.
<h3>The underpinnings of China's economy</h3>
What has been called China's economic miracle largely originated from Deng Xiaoping’s
opening-up policy in 1978, which laid the ground for the country to integrate its economy into
the international system, after nearly three decades of isolation following the founding of the
PRC. Beijing began to allow foreign investment, legalized private entrepreneurship and
installed an agricultural reform that released surplus labor force. This ran parallel to a
loosening of ideological control <link nid="145454">and a political decentralization</link>
that strengthened local autonomy and greatly increased the size of the public sphere.
Following the economic and political turmoil at the end of 1989, which led leaders to
centralize control and tighten their economic grip -- 15 percent of private companies shut
down in the space of one year in 1989 -- the state in 1992 decided to clear ideological barriers
to the growth of the non-private sector, and established a market-oriented economy. Market
reforms furthered by following administrations included large-scale privatization initiatives, a
reform of state-owned enterprises, and measures to spur greater integration into the global
economy.
This model led China to a situation of relative wealth and unprecedented growth and helped
enhance the legitimacy of the Communist Party of China (CPC). Since Deng's opening up,
essentially, that legitimacy has been closely linked to the economy's growth rate.
There are problems with this model. First, it relies on large infusions of inefficient,
government-led investment, which is fueled by <link nid="158162">Chinese household and
corporate savings</link>. Beijing also keeps labor costs artificially low, allowing China to
remain highly competitive in manufacturing and absorb a huge labor pool.
Further problems with this model have come to the fore since the onset of the global financial
crisis. When the crisis emerged, the state continued relying on government-led investment to
sustain the economy. The credit extended by the state, however, largely flows to State Owned
Enterprises (SOEs), which have better access to the political process, instead of private Small
and Medium-sized Enterprises (SMEs), which tend to be more efficient and dynamic. This
does relatively little to drive the economy, perhaps even exacerbating inefficiencies.
Longstanding low incomes have also paired with inflation to make consumption largely
stagnant. Purchasing power has been squeezed and rests largely in the hands of an elite that
controls a large majority of the nation's wealth and resources. The export sector has also had
to absorb rising costs and is heavily dependent on external demand, which is worsening as
global economy continues to sputter.
Beijing has clearly recognized that economic growth is due to slow over the next few years.
Aside from attempts to shift public perception, one solution being enacted by Beijing is a
further centralization of power and control of the economy, to better manage distribution. In
its new Five Year Plan, Beijing emphasized wealth distribution, with the aim of <link
nid="201209">boosting domestic consumption</link>. However, the existing political
structure, in which the influence of political and business elite plays a significant role, may
bring about policies that do more to further a consolidation of wealth than to boost the
economy.
<h3>Lack of political reform</h3>
Even as China installed privatization and market-oriented reforms, changes to its political
system since 1978 have been far less ambitious. Political intervention created links between
politics and business. SOEs remained the primary engine for economic reform. A large
bureaucracy was created, resulting in increased political intervention. Political officials
became deeply involved in the country’s business affairs and many business leaders were
relatives or patrons of the political elite. A number shifted from one arena to the other. This
created a capitalist economy, but one controlled by the country's elite and still very much
directed by the central government.
As a result, the state’s latest economic policies have been demonstrably less effective.
Government-led investment largely benefits SOEs, with marginal benefits for economic
growth. SMEs are finding it hard to keep their doors open. The gap between wealthy and poor
has gotten demonstrably larger and the <link nid="197899">general public's purchasing
power is diminishing</link>. A fraction of the population -- 0.2 percent -- controls 70 percent
of China's wealth. Business elites are using political connections to further enhance their
wealth, while their counterparts in politics use their position to extract personal benefits from
the business realm. Meanwhile, social mobility for much of the population is limited by
social systems such as <link nid="200390">Hukou</LINK>, exacerbating the perception of
imbalance and leading to frustration among sectors of society.
China in the past has used economic policy to alleviate problems that might be addressed in
other ways. Due to the increasing monopolization of power in the country, this in many cases
actually entrenches structural problems, frequently working in favor of the elite rather than
the general population. In any case, with economic growth likely set to slow in the next few
years, economic tools, including offering investment incentives or increasing lending, may
generate less impact.
Beijing knows that the pace of political reform in China has lagged well behind reforms in the
economic realm and is clearly aware that changes are necessary. However, Beijing is largely
reluctant to adopt a different model and bring about a radical but temporary shift: for
example, allowing short, sharp social instability amid more significant structural changes, as
Korea did, or allowing classes across society to share economic malaise, as Japan is currently
doing. Ultimately the CPC fears such approaches may result in social instability and a loss of
some of the legitimacy it has built up. This leaves open the question of how intent Beijing is
on initiating a political solution and bringing about at least limited political reforms.
Following such a course, for Beijing, would also affect the interests of the business and
political elite on which the CPC has relied to sustain its authority. As such, if there is reform
on political front, it is unlikely to bring any meaningful changes.
The CPC has managed to forebear political changes in the past by fostering a social consensus
around the idea that the CPC is capable of anchoring political stability in China. The question
moving forward is whether, if economic benefits waver, that social consensus will hold and
political reforms can continue to be put off. And if so, for how long?