In a single generation, China has transformed itself from one of the poorest places on Earth into a rising industrial superpower. Yet despite the speed and scale of the transformation, China’s economic miracle remains a “work in progress”: many stress points have developed and some pose serious threats to its continued success.

Widening income disparity, worsening pollution, serious product quality scandals, artificial entry barriers to many sectors and regions, severe resource constraints, an aging population, and the often chaotic and discretionary administration of laws and regulations are just some of the issues that have come to the fore.

Approved by the National People’s Congress in March 2011, the 12th Five Year Plan recognises these stress points, and proposes goals aimed at transforming China into an advanced market economy.

The Plan’s long list of objectives will take years to complete. Rather than being attained by decree, achieving most explicitly require a switch from central to decentralised planning: changing the government’s role from that of economic engineer to economic referee.

In the China envisioned by the 12th Five Year Plan, reform by decree and exhortation invites catastrophic failure

The need for this decentralisation is evident in plans to professionalise China’s bulky state-owned enterprises, banks, regulatory bodies, and other institutions.  The Plan envisions this process largely eliminating corruption and cronyism, with important economic decisions made on the basis of economic principles rather than connections.

However, efficient decentralisation and delegation are easier planned than implemented.  Managers of banks and other financial institutions for example will allocate resources in accordance with the economic logic of these objectives only if appropriately incentivised to do so.  If bankers’ careers are advanced by allocating loans politically, to gain favour with cadres, loans will be allocated politically. Similarly businesses will invest to upgrade their productivity only if this proves better for their top managers than investing in political rent-seeking (i.e. doing favours for politically powerful individuals or their families).

These unfortunate truths arise because large, dynamic economies are inherently so complicated that even the most diligent and energetic honest overseers cannot possibly monitor all the millions of decisions people in banks, businesses, and government offices must make.  Moreover, government agents will use their powers to promote the Plan’s goals only if they benefit more from doing so than from doing otherwise.

Building people the CapitaLand wayEven before 1978, in a vastly simpler Chinese economy, the direct government control system worked poorly and often created serious economic and political problems. In the China envisioned by the 12th Five Year Plan, reform by decree and exhortation invites catastrophic failure. Other developed countries have found that only well-crafted incentives can generate broadly efficient decision-making.

The goals listed in the Chinese plan demonstrate that central government officials appreciate that the fundamental economic underpinnings of an advanced market economy are strong institutional foundations that make it economically rational for people to work hard and use resources efficiently. These include laws, regulations, customs, and morals that lay down the expected scope of people’s self-interested actions.

Rule of law

One of the most important institutions in advanced market economies is the rule of law – the generally correct expectation that most people obey laws and regulations, which are enforced even-handedly. The expectation that most people will act this way makes doing business dramatically easier than it is where such institutions do not constrain behaviour.

Certainly there are exceptions. Wealthy American financers may violate the rules and get away with it by bribing politicians. But if such things happen too often – as perhaps in Italy or Greece – the economy suffers. Likewise politicians who use public monies to bail out ill-run or corrupt businesses deemed “too big to fail” often put their future careers in grave peril. People in advanced market economies genuinely value the rule of law.

In the absence of rule of law, the only people who can run businesses are those able to draw on strong political connections.

This reasoning can gel into a self-sustaining cycle. If the law is enforced fairly and without regard for personal or family connections, people accept the rule of law; and this includes the people charged with enforcing it. Obeying the law becomes a source of personal and family pride.

But the circle can also be self-defeating. If the law is administered selectively or for private gain, the rule of law cannot become established. Instead, people look to family or close associates, rather than public officials, for protection or retribution. Successfully evading the law can even become a source of personal and family pride.

Because officials have discretionary power to allocate resources and economic opportunities, businesses expecting “help” from high-up government officers invest in connections in ways that enrich those officials, their families, or their associates. This gives officials incentives to gain further powers, making connections an even more essential investment. And businesses that have already invested money in official connections encourage this because it makes their past investments even more useful.

The result is that the economy becomes mired in – at best – middle income levels, and can easily slip back into poverty and backwardness, as has been the unfortunate story of some Latin American countries.

We view the “institutional reforms necessary for the successful realisation of the 12th Five Year Plan goals” as basically those necessary to achieve the rule of law – to transform China into a huge Germany, rather than a huge Peru.  Obviously this is not easy: the world has many economies like Peru and only a few like Germany.

Unfortunate cycle

The challenge is the stability of the unfortunate cycle. In the absence of rule of law, the only people who can run businesses are those able to draw on strong political connections.

road280The rapid “catch-up” phase of growth is coming to an endWithout such connections, a successful business entrepreneur risks losing everything to corrupt officials, or to rivals with friends in high places. This situation encourages those without political influence to keep their businesses small and invisible to the politically powerful.

Because of these problems, most large businesses in poor countries are either SOEs or are controlled by politically powerful elite families. This severely limits economic growth in the long run for several reasons.

First, connections tend to be passed along through families, so a connection-based economy quickly becomes an economy controlled by a powerful hereditary elite composed of a few old-moneyed families. The founders of these dynasties may once have been the country’s most talented and patriotic people, but their descendants need not be.

In such economies, people unaffiliated with politically powerful families can generally not deal with government officials, and any outsider with a business idea can only implement it by coming to an accord with one of these families.

Rational government officials in such a country soon appreciate that their careers and wealth are best advanced by obeying the powerful insiders and reducing the impotent outsiders’ profits to zero through demands for bribes, or through adverse regulatory decisions against those who refuse to pay bribes.

The result is a sclerotic economy. Markets are plugged by regulations designed to protect established firms and extract bribes for officials. And ordinary peoples’ savings are channelled into ill-run elite-controlled firms that lose all their outside investors’ money in periodic crises – while politically connected elite families are typically bailed out by the government.

The Latin American equilibrium

This situation unfortunately describes much of Latin America, the Middle East and South Asia. We call this situation the Latin American equilibrium because the history of that region, more than any other, displays repeated brief bouts of energetic economic growth punctuating centuries of relative stagnation.

Unless the rule of law takes root, a very real danger exists that only those with political connections will be able to run large Chinese businesses

No country escapes these problems entirely, but the world’s current high income countries have all found ways to limit these problems sufficiently to encourage private entrepreneurship and historically unprecedented wealth creation for most of their populations. These solutions all involve subjecting their government officials to the rule of law.

Our fear for China is that, unless the rule of law takes root, a very real danger exists that only those with political connections will be able to run large Chinese businesses. This risks wasting the talents and discouraging the effort of a billion plus unconnected Chinese people.

To avoid this, China needs reforms to make its officials enforce the law even-handedly and predictably so that honest and well-intentioned people can obey the law without any need for government connections. In other words, government officials must themselves be unequivocally subject to the rule of law.

Our worry is that China’s current situation risks imparting stability to this unfortunate circle described above. At present senior officials who gain wealth and power by using their discretionary powers stand to lose much if the rule of law prevails. Likewise, those who have spent time and money developing valuable connections resent reforms that make those investments worthless.

In these circumstances, senior government officials cannot realistically expect a decree to be effective that lower level officials refrain from abusing their discretionary powers. The officials might want to do so from a personal moral standpoint, but they cannot because failure to honour their connections invites disclosure of their past sins and the consequent termination of their careers.

This circle effectively prevents the development of the rule of law in many developing countries. Instead, what has happened is that senior officials, some well-meaning and others cynical, enact ever more complicated, confusing, and convoluted rules and regulations – ostensibly to attack corruption, but effectively to cause confusion and ultimately augment the value of connections with officials who can help bend or break those regulations and laws. This is the Latin American equilibrium that we very much hope China can avoid.

Separating government from business

To develop the rule of law, advanced market economies therefore find the fundamental separation of business from government essential.

chinaseal280Separating government from business requires political willThis entails making the legislative and regulatory process open, so that officials who favour particular businesses risk exposure and disgrace, as well as making businesses transparent so that illegal government favours become visible.

This is why, in many jurisdictions, business leaders and their families must disclose their incomes and wealth, as must government officials and their families. This is also why wealthy people who become government officials must place their wealth in a” blind trust” –  surrendering control of their businesses and investment portfolios to unrelated and independent trustees until their government careers are ended. It is also why public officials exposed as having favoured their friends, relatives, or associates earn disgrace in most high-income economies, as do those they have favoured.

No country has achieved this situation perfectly, but higher standards of living correlate closely with proximity to this ideal.

The successful implementation of the laudable objectives in China’s 12th Five Year Plan thus requires resolving a paradox. Professionalising business and the civil service necessitates separating business from government. But this requires limiting the discretionary power of government officials, because otherwise business leaders will continue to see official connections as essential. And limiting the discretionary power of government officials challenges longstanding Party principles.

Elephant in the room

The problem of subjecting officials to the rule of law is not unique to China.

The British, for example, have not yet clearly decided whether their parliament can pass a law limiting its powers because, if it could pass such a law, it can surely also repeal that law.  Nonetheless, the country’s common law courts effectively subject the government to the rule of law by deriving limits to official power from longstanding judicial traditions.

The Americans solve this problem, to an extent, with a system of checks and balances:  people in one arm of government can gain by highlighting any misdeeds in other arms. Enough of this creates pressure on everyone to be passably honest.

But the conundrum is especially difficult in China because the constitution gives the Chinese Communist Party a leading role.  Many interpret this to mean that the CCP has the final say – a factor we see as the real “elephant in the room”.

Retaining the CCP’s leading role, yet subjecting government (and Party) officials to the rule of law, is not beyond the ability of creative legal experts. In Canada, a 1980 constitutional reform preserved the traditional supremacy of the Canadian parliament while simultaneously subjecting parliament to the rule of law. Parliament can enact a law “notwithstanding” that the country’s Supreme Court deems the law unconstitutional, but only in certain situations and amid open public debate. Few governments have employed this process, and it has acquired an unpropitious aura through disuse.

In such ways, other advanced market economies have found ways of coming to terms with historical legacies of unlimited state power while imposing effective rule of law. So China is clearly not alone in confronting this issue.

Critical transition

But as China nears the end of its early “catch-up” growth phase, in which direct government planning still works to an extent, the need for a transition to efficient decentralised planning is correctly raised by the 12th Five year Plan. This transition cannot be effected unless businesses can be run without government connections. We see this transition as critical to the plan’s success.

For example, we support calls for sound financial regulations, but note these can only be as good as financial regulators’ respect for the rule of law. We agree with the need for modern regulatory agencies charged with safeguarding the environment, product safety, and fulfilling many other such legitimate roles.

The continued success of advanced market economies requires accepting intrinsically unplannable innovations as the engine of the growth

But we fear that they can only work if officials throughout these agencies, and throughout the Party and government, are themselves all constrained by the rule of law. We also support greater reliance on markets, but this too will go wrong without the rule of law.

In short, while the objectives of the 12th Five Year Plan are laudable, their successful implementation requires the rule of law, which is in turn preconditioned on the political will to separate government from business

Finally while praise must also be given to the Plan’s emphasis on promoting innovation, one must also note that innovations are, by definition, “new things” that were not planned. Advanced market economies depend on successive innovations for their continued prosperity, and so must accommodate things that simply cannot be planned.

The continued success of advanced market economies requires accepting intrinsically unplannable innovations as the engine of the growth; and dealing with the ensuing uncertainty with social security programs, unemployment insurance, education, vocational training, and so on. Oddly, these programs, once seen as socialist intrusions, have come to be essential to developed market economies.

Fortunately, China is well-placed to overcome all these challenges. The success of the current economic engineering model has delivered enough taxable economic activities to provide the government revenues for the enhanced social security, health care, and other social services that let people cope with the uncertainties of an innovation-driven economy.

This gives today’s China an immense advantage, for which the country’s leaders can justly take credit. But the long-run sustainability of that success is what ultimately concerns us, for we see this depending on the successful implementation of the Plan’s call for professionalised governance across all sectors, which, in turn, requires the rule of law.

The 12th Five Year Plan sets great goals; and presents a golden opportunity for the CCP to lead China past the mid-income traps that have limited development in other once promising emerging economies in Latin America and elsewhere, and to take the country through a successful long march to an advanced, innovative, and efficient economy with harmonious sustainable growth.