China’s new leadership appears to be cautious on economic reforms but hard hitting on corruption. The campaign has the strong support of the public but its immediate economic implications are more mixed. Officials appear hesitant to make decisions and conspicuous consumption has declined — all of which have accentuated the current slowdown. These concerns raise questions about the role that corruption has played in shaping China’s development success over the past several decades.
The discourse on corruption in China is wide ranging and often confusing. How does one define corruption? What is its impact on the economy? And what are sustainable remedies? To simplify these issues, let’s define economic corruption as the use of public office for personal gain. Thus illegal or immoral acts solely between private individuals may be bad but they are not examples of corruption.
In discussing the economic implications of corruption, three issues stand out. First, most of the academic studies based on cross country experiences have shown that corruption retards economic growth. But China is always the outlier. This raises an obvious question of whether China managed to grow so rapidly because of or in spite of rampant corruption. Second, the more a country develops the more likely that corruption diminishes but in China’s case the opposite seems to be happening. And third, many studies conclude that by contributing to an economic decline, corruption leads to political instability. This has encouraged speculation about whether corruption in China will eventually lead to political liberalization.
Corruption has featured prominently in China’s dynastic history but this current bout stems ironically from the well-regarded reforms launched by Deng Xiaoping. His opening up of the economy beginning around 1980 paved the way for a hybrid socialist market economy, which (similar to the former Soviet Union republics) is particularly prone to corruption in the transition. And his famous saying that “to get rich is glorious” removed any moral qualms about making money legally or, as it turns out, illegally.
The creation of a “dual track economy” with parallel market and state driven activities created the incentive for corruptive interaction among three key players. One is the private entrepreneur who saw the potential to prosper by providing a better product but lacked the resources to do so. The solution often was to co-opt a representative of a state enterprise who could provide the resources, especially financing from state-owned banks. Both, however, needed the blessing of the local official, almost always also a party member who had the authority to make the collaboration politically acceptable.
Corruption and growth thus went hand in hand. In other countries, corruption typically retards growth because it represses investment and investment is the primary determinant of growth. But China is different since its investment rate has been increasing if anything too rapidly rather than too slowly. Corruption in China helped to get around the excessive regulations and controls in its overly centralized bureaucracy and thus improved efficiency.
Moreover, China’s unique regionally decentralized administrative system checked the growth inhibiting aspects of corruption, by setting investment and production targets that incentivized local officials. This fostered a unity of purpose so that even as corruption flourished, the collaborators worked to make growth the guiding principle for governance. This was reinforced by competition among the localities to meet these targets and to support productivity enhancing economic reforms.
Corruption in the transition phase was also exacerbated by the existence of dual prices for consumer and producer goods – one market determined and the other subsidized. This created the opportunity for illicit gains through price arbitrage. In the initial stages of China’s reform process, huge illicit profits were realized by manipulating the official and unofficial prices for basic consumer items. Unification of output prices eliminated most of these rent-seeking opportunities years ago.
Today the problem lies in the distorted prices for key inputs such as land, energy, capital, and labor. Many of the most egregious cases in the headlines are about illegal land seizures by local authorities and private developers for commercial development, diversion of subsidized lending to state firms for unintended purposes, and misuse of energy resources. That is why President’s Xi Jinping’s corruption campaign has been targeting the energy companies early on and why land acquisition practices and interest rate liberalization are so high on the reform agenda. Few realize that at the heart of the China’s new urbanization program, liberalizing labor migration and residency eligibility would have a significant impact in curbing corruption since there is even a market for buying residency rights in major cities as part of the employment process.
China’s rapid growth encouraged ever rising levels of corruption, since more wealth creation meant more could be siphoned off. Corruption was also nurtured by the increasing gap between salaries being paid to public officials compared with their private counterparts in an increasingly globalized world.
The most vulnerable period is the transition from a centrally-controlled to a market-driven economy when the rules of the game and property rights are unclear. The danger is becoming stuck in the transition. Thus the defining question is whether China will eventually fulfill its Third Plenum pledge of more than a year ago that the market will be the primary force for allocating resources and not the state. Otherwise corruption will continue to flourish.
While corruption has not led to its characteristic economic stagnation, its negative consequences — in the form of the demoralizing effect on perceptions about equity and justice — are driving the current corruption campaign. Campaigns tend to be run by “moralists” who argue that fundamental changes in values are needed to curb corruption — in this case to preserve the credibility of the Communist Party. It is this legitimacy aspect that drives President Xi’s actions.
Economists like Premier Li Keqiang tend to focus more on altering incentives by eliminating regulations that nurture corruption. Thus simplifying investment procedures and lowering tax rates are the focus of attention, making the negotiation of Free Trade or Investment Treaties instruments to reduce corruption.
The current corruption campaign is heavy on dealing with non-structural factors and moral suasion by trying to reign in bribes and greed through enhanced penalties. The chance of going to jail for corruption according to one study is only 3 percent in China — making corruption a low risk, high return gamble. Prosecuting more “tigers and flies” changes the risk-benefit calculation. But ultimately President Xi will succeed only if more is done to address the structural factors driving corruption.
This means breaking the corruptive relationship between the key players in the dual economy by separating the roles and responsibilities of the four major agents driving China’s system — the party, the government, enterprises, and banks. At present, there is no firewall between the roles of the government and the Party and their influence on enterprises and state owned banks. While on paper much of the economy has become more and more “private,” the influence of the state permeates much of the major decision-making among economic entities regardless of their formal ownership structures. Breaking these relationships would require some form of political liberalization to build more effective mechanisms for accountability and transparency, which would make it more difficult for corruption to be sustainable.
Many seeking precedents for what might happen in China look to the Arab Spring movement or failed states elsewhere. But more appropriate are the experiences of the very few highly successful developing economies formerly with autocratic political systems, such as South Korea and Taiwan. Worth noting is that political liberalization in both countries began around the same time in the late 1980s, at the same PPP adjusted per capita income level of around $13-15,000 – and same level of urbanization (70 percent) which triggered a sharp rise in the share of services in the economy. It is no coincidence that the rise of urban based and higher value services centered on a more sophisticated middle class generated the pressures for political liberalization. The process in China will not follow the norms of western type democratic movements and is more likely to be driven by the Party structures with its own unique China specific characteristics.