Will China Cripple Itself?

In the past two decades company after company in the West has outsourced its manufacturing to China to take advantage of the nation’s low-cost structure and production capabilities. For many organizations, Chinese companies have become their manufacturing departments. (I’ve been to these Chinese plants and have witnessed this firsthand.) As a result, China has powered ahead startling the world with its economic growth and new-found wealth.

But will China’s growth continue? Will the Chinese system, by its very nature, apply brakes on the nation’s ability to engage in fundamental innovation and hence to continue its present trajectory?

Inclusive and Extractive Institutions

There are several factors that determine why nations succeed – or fail. One framework that provides real insight is in Daron Acemoglu and James Robinson’s book, Why Nations Fail. The authors describe how national success is governed by “inclusive” or “extractive” practices in its political system, and equally by “inclusive” or “extractive” practices in its economic system.

Political institutions are inclusive if they encourage participation, are transparent, ensure power is dispersed and are open to change. Western democracies generally fit this description. The U.S. is inclusive politically on the scrutiny scale. One only needs to look at the challenges to President Trump from his political opponents and the media, to see the transparent nature of the U.S. system at work. It also provides an important ingredient to national success, highly relevant in this era of rapid technological change: the ability to adapt. The result is a gross domestic product (GDP, or national output) per head of around $US60,000.

Political institutions are extractive when power is concentrated in the hands of a few, they’re secretive and don’t permit dissent. North Korea is a classic example. It discourages visitors from the outside and since its formation in 1948 has been ruled by three men from the same family. Citizens are supposed to obtain permission to travel within the country and if they’re found viewing or listening to foreign programs on television or radio they receive stiff penalties. This means that North Koreans have little idea about the outside world and are taught from an early age that their leaders are powerful gods. The result, North Koreans are short of the basics. The most fundamental of all is food with many North Koreans existing on the brink of starvation. The country’s GDP per head, while difficult to estimate in such a secretive country, comes in at a miserable $US1,300.

Contrast this to South Korea whose political system in inclusive. Separated by merely a wall but by light years in terms of their systems, South Korea has left North Korea behind. South Korea’s GDP per head as a result is $US30,000.

So, what about economic systems?

Economic systems are inclusive if free enterprise is encouraged, investment in new technology is supported, competition is promoted, property rights are secured, and a system of law exists which is unbiased. This encourages investment and risk taking by entrepreneurs and by business generally. What follows is fundamental innovation – a prerequisite for sustained economic growth. The U.S. figures highly here and it has been an innovation powerhouse via locations such as Silicon Valley. But in true inclusive and innovative style, other tech centres are now challenging Silicon Valley’s continued dominance.

Extractive economic systems lack these features. The now defunct Soviet Union, and Russia today, fit this mould. While Russia is different in many ways from the Soviet Union of old, it retains a common feature - the dominance of state-controlled business. By concentrating wealth in the hands of a few (of his political allies), President Putin is choking competition and suffocating innovation. This has led to stifling corruption, inefficiency and a quelling of the private sector. The Russian economy is stagnating and its GDP per head is around $US11,000.

Where Does China Sit?

So where does China sit on the scales of inclusion and extraction?

China is extractive on the political front. Like Russia and North Korea, it runs its political institutions with one thing in mind – control. There’s no tolerance for any discussion of an alternative system, or fundamental changes to its existing one. Nor, it appears, an appreciation of the innovative effects and economic benefits that freedom of thought might bring to the nation. Instead politics is driven by the desire to keep the population in check. This preserves the status quo and the power and personal privilege of the political elite.

Further evidence of the political system becoming increasingly extractive and so ossifying, can be found in the recent vote by China’s National People’s Congress to remove time restrictions on Xi Jinping’s tenure as President. He has been appointed President for life .

When it comes to economic institutions and systems China’s an interesting and mixed case. It doesn’t conform to the strict extractive example of North Korea. China’s reform began in 1978 under President Deng Xiaoping. It took place first in the rural sector. The turning point occurred at the National Party Congress. Up to that point farming had been state-run, with farmers given a quota of food to produce. In the 1980s, farmers’ quotas were reduced significantly and what they produced beyond this they could sell at local markets. This proved to be a great success in producing more food and raising the standard of living.

Buoyed by these results President Deng Xiaoping turned his attention to the industrial sector and manufacturing. By applying the principles of capitalism, the Chinese Communist Party permitted private enterprise to flourish. Although all urban land in China is state-owned, long-term leases facilitated the establishment of profit-seeking businesses. Over time Special Economic Zones were established with greater independence from the central government and with tax incentives to encourage foreign investment. This also created an environment in which business could thrive. The rest, as they say, is history. Today China’s GDP per head has climbed to around $US9,000.  

Current Trends in China

There’s a move towards tightening the state’s grip and propping up less efficient, state-run enterprise over their privately-owned competitors. Under the current President, Xi Jinping, the Chinese Communist Party is gradually making the economic system less inclusive. China’s one-party state, which bans protest and tracks the activity of its citizens searching for misdemeanours, is extending its control to business. Private sector organizations are increasingly writing into their articles of association or charters details to ensure management policy reflects the policy of the Chinese Communist Party. There’s a push also to have a Communist Party branch inside all foreign and joint venture companies with more than 70 per cent of joint ventures and 90 per cent of state-owned enterprises complying.

It seems that China, with its current low-cost base, may very well retain its status as a manufacturing powerhouse. But even this is far from certain as the nation becomes a middle-income country and its costs start to rise. Vietnam, for example, has managed to take a slice of China’s previously taken-for-granted manufacturing share. For example, 47 per cent of Nike’s production is now sourced in Vietnam and only 26 per cent in China.  

Creative Destruction and China’s Future

How does this play into China’s future?

The process of creative destruction, a term coined by Joseph Schumpeter in 1942, is a fundamental feature of capitalism. This describes the incessant desire by firms: to gain advantage over the competition; to lead as well as to follow consumer trends; and to be in the forefront of technological and business-model change. It also entails a mindset that says, “there’s always a better way.” It accounts for over 50 per cent of productivity growth in the long term.

Complacency is an anathema to creative destruction as are state-owned monopolies that dominate industries, and never face disruption. They produce horribly obsolete products. Who can forget the Soviet Union’s idea of a car, the Lada? Creative destruction sits uneasily with extractive institutions.

Acemoglu and Robinson think that it’s inevitable that China’s growth will hit the wall. As they say: “this growth will run out of steam unless extractive political institutions make way for inclusive institutions. As long as political institutions remain extractive, growth will be inherently limited, as it has been in other similar cases”. They go on to point out: “Because of the [Communist] party’s control over economic institutions…history and our theory suggest that growth with creative destruction and true innovation will not arrive, and the spectacular growth rates in China will slowly evaporate”.

Only time will tell if the Chinese experiment plateaus as the state seeks greater and greater control. Could it morph into the Soviet Union of old?

----------------------------------------------------------------------------------------------------------------Graham Kenny is managing director of Strategic Factors, a Sydney-based consultancy that specializes in strategic planning and performance measurement, and president of Reinvent Australia, an organization that focuses on the nation’s future development.