Originally published in the Financial Times, December 10, 2002

Of all the challenges facing China's new and largely untested leadership, none is more critical to the survival of the Communist party than containing rampant official corruption.

To be sure, corruption has always been a scourge for Chinese rulers. But even by China's own lax standards, corruption since the mid-1990s has become intolerable. The blending of a semi-reformed economy, authoritarian politics, decentralisation and burgeoning links to the outside world has allowed corruption to mutate into a voracious and dangerous strain.

In aggregate, estimates of the magnitude of corruption range from 3 to 5 per cent of gross domestic product. Kick-backs from government purchases and construction projects account for a large share (about 1.5 per cent of GDP). Another principal source of corruption is illegal use of public funds. In 2001, for example, China's national auditing agency uncovered illegal spending of more than 160bn yuan - about 1.7 per cent of GDP. Because 8-13 per cent of GDP in government revenues is not spent according to budget rules, huge misuse of public funds is inevitable.

Such estimates understate corruption's real damage to China's economic prospects and regime survivability. Corruption in authoritarian regimes tends to amplify systemic risks and undermine the rulers' legitimacy. It also makes the regime particularly vulnerable to crises.

Beijing's leaders should be especially alarmed because corruption seems to have infected the financial system, as in Indonesia before the 1997-98 crisis. Symptoms of corruption in the financial sector include massive theft of bank funds by insiders. In October 2001, bank auditors discovered that managers at a Bank of China branch in Guangdong province had stolen more than $483m (£310m). All the suspects fled China with their loot. In other instances of banking scandals, senior managers, including the head of the Bank of China, were found to have authorised big illegal loans to cronies that eventually went bad.

China's porous banking system, along with the country's exploding trade and investment ties with the outside world, has also facilitated massive capital flight abroad. The Chinese government estimated that capital flight averaged $20bn a year in the late 1990s. According to press reports, many corrupt officials often transfer their ill-gotten gains and set up havens abroad for their family members before they themselves decide to flee. When a former governor of Yunnan province was arrested for corruption, the police found he had illegally obtained five different foreign passports as preparation for flight abroad.

An official press story in January this year claimed that more than 4,000 corrupt officials, with $600m in stolen funds, were on the run (many supposedly abroad). Officials fleeing with stolen assets have become so routine that a vivid term - "evaporation" - has been coined to describe sudden disappearance by fugitive officials.

But, from the perspective of China's corruption-fighters, worse than evaporation is systematic official collusion. In recent years, corruption cases involving groups of senior officials have grown in frequency and size. In Xiamen and Shenyang, large cities with millions of inhabitants, almost all the main municipal officials were involved in criminal activities in the late 1990s. Most disturbingly, some symptoms associated with the late stages of regime decay - such as illegal subcontracting of tax collection and the sale of government offices - have emerged, mainly in agrarian provinces in the hinterlands.

Unfortunately, Beijing has adopted mostly administrative measures to combat corruption. It selectively prosecutes certain high-profile individual cases to demonstrate its commitment (official data show that only 7 per cent of all Communist party members proved to have engaged in wrongdoing are criminally prosecuted). Such half-hearted efforts have eroded public confidence in the government's ability to contain corruption.

A government that is committed to stamping out corruption must, as experience in other countries shows, take three measures: reduce government influence in the economy; enforce the rule of law; and unleash the press and the forces of civil society. Alas, these steps would force Chinese leaders into a new dilemma. As a popular Chinese aphorism puts it, corruption will destroy the state but fighting it will kill the Communist party.