Carnegie's China Program and the U.S.-China Business Council hosted a special lunch forum at the Carnegie Endowment to discuss Senior Associate Minxin Pei's recent article "China's Governance Crisis." Minxin Pei presented and Dr. Nicholas Lardy, Senior Fellow at the Brookings Institution, and Dr. Robert Kapp, President of the U.S.-China Business Council, responded. George Perkovich, Carnegie's Vice President for Studies, moderated the event.

Intro: George Perkovich
Minxin Pei
Nicholas Lardy
Robert Kapp
Q and A

Minxin Pei began by noting the primary motive behind his article. The almost single-minded interest in the personnel matters surrounding China's upcoming leadership transition ignores a far more important point: very serious underlying issues of governance await China's next leadership, no matter who this might be. Pei admitted a growing uneasiness over one fundamental question: does China's leadership possess the basic capacity to govern effectively?

Pei identified three symptoms that suggest an emerging crisis of governance in China: a deterioration of the CCP; an increasingly dysfunctional fiscal system; and rising tensions between regime and society. Though not yet full blown, these worrisome trends could degenerate should the leadership fail to adequately address them. Indeed, a recent book, I told the Premier the Truth, provides shocking first hand evidence that some parts of rural China are already witnessing the deterioration indicative of this crisis.

In a party-state, the ruling party holds the key to the health of the state. Pei recalled Deng's prescience in observing long ago that should problems arise in China, they would first come from within the communist party. Pei pointed to three sets of maladies signifying the deterioration of the CCP and calling into question the health of the state.

First, since reforms began, the CCP's base of social support has significantly narrowed. No longer mass-based, the CCP has become an elite-based party. While support for the party among workers and peasants is in a precarious state, ties between the CCP and business class are quite close. Rather than providing reason for unqualified encouragement, recent party initiatives embracing private entrepreneurs threaten to yield crony capitalism of the ruling party at the expense of rebuilding much-needed ties between the CCP and the working people.

Second, the CCP is in the midst of an acute identity crisis-it is a party without an ideology. Among political parties, ideology provides the coherence necessary for the ruling class to effectively carry out its functions and to identify with the masses. Lacking any such ideology, the party risks growing disenchantment among the people as party actions do not follow party rhetoric.

Third, a breakdown of political accountability within the CCP raises serious concerns over the party's capacity to govern effectively. Presently, corruption pervades the CCP, and even more damaging, official collusion abounds. Local officials collude with one another to cover up mistakes and deceive superiors: a built in process of political decay results. Using three different sets of data, Pei calculated that only 6 percent of those found guilty of wrongdoing get sent to jail. With the ruling party incapable of dealing with this political rot, state performance inevitably deteriorates. Trendlines of government provision of public goods attest to this: performance indices such as housing, environment, public safety and education continue to steadily decline. China's declining state performance comes during a period of strong economic growth, thus defying conventional wisdom. According to Pei, the quality of China's economic growth explains this paradox: China's high growth is of low quality and consequently, is accompanied by corruption, social investments, inequality and environmental decay.

China's increasingly dysfunctional fiscal system marks the second symptom of an emerging crisis of governance. Two main reasons account for this. First, half of government revenue is spent off the books, that is, half of government revenue is not spent on social investments. Second, poorly constructed political incentive provides local officials with little reason to use local revenue for social investment. Promotions are awarded on the basis of short-term performance, so local officials use revenues to build "image projects." While school buildings decay, local government buildings, immediate roads and shopping centers rival those of Hong Kong.

Together, these factors-the deterioration of the CCP, corruption, collusion and declining provision of public goods-raise tensions between the regime and society. No dependable institutional mechanisms currently exist to address the concerns of those losing out in transitional processes or to redress the grievances of aggrieved parties. As a result, disputes that might be peacefully resolved find expression in violent means. According to official Chinese data, the 1990s saw a four-fold increase in the number of collective protests and riots. Potential instability is most acute in the countryside. Not only are rural areas taxed at rates between 30-50 percent (while the urban aggregate tax rate is 25 percent), but rural areas also suffer most from the deterioration of public services.

Pei concluded by discussing the implications of these symptoms. Chinese leaders cannot assume that economic development will solve all of China's problems. Institutional malaise may severely impede China's high rates of growth. The US government must similarly reexamine core assumptions. While China has been hailed as an emerging main economic competitor, and soon, a military rival, the reality may be very different: the more likely scenario of a stagnant China poses a very different challenge for the US. For the business community, tempered expectations are in order. Although they have so far enjoyed "a very good ride" with China, problems of governance could cause China's stock to look not very different from another familiar stock-Enron.

Nicholas Lardy, Senior Fellow at the Brookings Institution, responded by painting a more optimistic picture of China's economic growth and political well being.

Lardy first acknowledged the very real and serious nature of the problems discussed by Pei. For example, China's income inequality has more than doubled between 1978 and today and has one of the highest rates of inequality among developing societies. Moreover, Lardy emphasized that major challenges of fiscal sustainability certainly exist. Even beyond growing government deficits, off balance sheet liabilities such as unfunded pensions, the need to finance the recapitalization of the banking system and problems of corruption must be addressed. Still, Lardy disagrees that a crisis of governance or a failing state threatens.

Lardy's critique begins by first analyzing China's economic situation. Lardy stated that very few Chinese people are poorer than they were ten years ago. China's economy is 6 to 7 times larger than a decade ago in real terms, and rapid growth raises real income and living standards even while income inequality rises at an unprecedented rate. According to Lardy, the real challenge will be presented by slowed economic growth, as tolerance for sustained income inequality would be questionable.

Lardy then reassessed China's provision of public services. Rather than focus solely on the input side of public services, Lardy emphasized the output side of China's admittedly modest investments. Though China and India are equals in education spending, China's investment yields much greater results: China's literacy rate is 80 percent versus India's 50 percent and female literacy in China doubles that of India. Problems in financing education and health certainly remain, but analysis of the outputs of current investment points to a more healthy state than an analysis of the inputs alone.

Lardy also pointed to the fiscal system as reason to doubt that China's state is failing. China's tax revenues have almost doubled since 1997, over a four-year period where the government estimates the economy expanded by one-third. Lardy attributed this to the implementation of tax reforms, the scaling back of extra budgetary revenue controlled by localities and cracking down on smuggling. Moreover, employment in the state sector has been drastically reduced-34 million fewer people worked in the state sector in 2001 than in 1997. According to Lardy, the government's avoidance of implosion in the wake of this restructuring is more than "dumb luck." Indeed, new jobs are being created, foreign investment continues to pour in, and the government has created programs to provide unemployment insurance severance payments and other measures to cushion such transitions. Still, despite these positive signs, Lardy acknowledged that major problems of corruption still exist and which may prevent some of these government payments from reaching the people.

Finally, Lardy offered China's successful implementation of WTO measures as evidence that the state is not in danger of failing.

Lardy concluded by noting that China has not yet exhausted continued rapid economic expansion in the absence of more far reaching political reform. What is more, Lardy wondered what the beginning of a transition to a post party-state might look like. Rather than provide reasons for alarm, Lardy offered the possibility that factors pointing to the declining party instead might suggest the beginning of a peaceful transition to a multi-party system.

Dr. Robert Kapp, president of the US-China Business Council, continued the panel discussion by drawing on history to assess China's present state. Though noting that Pei was not forecasting the coming collapse of China, Kapp proceeded to distinguish three important differences between the China of today and the China of an earlier time in which the regime was on the edge of collapse. First, China does not face socially ruinous inflation. That is, a wheelbarrow of worthless paper money is not necessary to buy simple goods such as toothpaste or rice. Second, no organized opposition with a territorial base and ideology currently threatens China's leadership. In fact, such an opposition does not seem even to exist. Third, China's century of humiliation at the hands of foreign invaders is over. As a result, China's relationship with foreigners is relatively strong. Based on these distinctions, Kapp asserted that China is not approaching an impending collapse of regime.

Kapp noted that Pei's observations are pressing. But encouragingly, issues such as income inequality are heavily discussed within China, as both internal and non-internal documents attest. The ongoing drain out of western China continues, but such issues are coming to the forefront in China. Kapp did warn against allowing the lack of attention paid to catching the rural sector up to the cities to persist. Serious attention given to rural growth is necessary if Shanghai and other cities are to continue their robust growth.

In conclusion, Kapp focused attention on China's drastically improved business environment. Business leaders perceive a drastic improvement in the leadership's capacity to govern, as the technical sophistication, conceptual thinking and increasing effectiveness in adjudication far surpass the conditions of twenty years ago. Kapp closed on a light note by answering his own question: Is the business community hopelessly myopic? Not until the regime collapses and on that day the answer might be yes.

During the question and answer period that followed, Pei was asked to assess the party-state's ability to reform itself. Pei first noted that any assessments and predictions must be humble, as the picture of China is so varied, very different conclusions may be reached depending on the factors focused upon. That said, Pei reiterated his uncertainty over the system's health. The common practice of buying government office, and the massive flight of capital ($30 billion per year) are not encouraging. Still, Pei hoped that the healthy aspects of China might outgrow the degenerative parts. The party is certainly not beyond salvation because the CCP is a coalition, with many interests encompassed under the party rubric. A constructive battle between these groups may soon take place.

A question was then raised as to whether China's response to the HIV crisis confirms an emerging crisis of governance. Pei asserted that the HIV crisis does indeed demonstrate the weakness of the China's government. During the Maoist era, it cannot be denied that the problems of drugs and prostitution were eliminated and sexual diseases contained. By contrast, the present HIV crisis displays all the symptoms of a malfunctioning state: blocked information flows, local collusion to cover up the problems, a central government that ignored the crisis, and the absence of political accountability (rather than be held accountable, officials involved in covering up this crisis have won promotions).

Another question asked what level of growth is critical to generate the resources necessary to China's stability and to meet the needs of society. Lardy responded by acknowledging that the sustaining of fairly robust growth is a prerequisite for dealing with China's present problems. Though he did not offer an exact number, Lardy said growth would have to exceed zero or one percent. A slump would endanger fiscal sustainability and exacerbate income disparity, making for a potentially explosive scenario.

The final question sought policy prescriptions based on the foregoing analyses. Noting the shortage of time, moderator George Perkovich proposed that a future session should soon be organized to fully explore this extremely significant question. On this note, the event concluded.