I figured when  I applied to the GIC that I would use my knowledge of the political scene in various countries of emerging economic interest to help paint a more complete picture of the investment environment. That having been said, this is my first crack at so bear with me for a moment. I recently revamped a paper I wrote not too long ago about what makes the Chinese economy tick for a class on economic growth and development and I thought that, given the nature of our organization here, you guys might like to get a look at some socio-political theory before you start slapping your money around. So here goes:

As I imagine most of you are aware, the People’s Republic of China (PRC) is currently under the control of the Chinese Communist Party (CCP) and has been since the end of the Chinese civil war in 1949. Without getting into too much history, it was then that the CCP under Chairman Mao Zedong took full control of mainland China and the Chinese Republican Party (KMT, from the severely Anglicized Chinese) were relegated to the Republic of China on Taiwan. Skip a little bit of failed communist command economy and we find ourselves in 1978. The CCP is wondering what in the world they’re going to do now that Mao is gone and the economy is in shambles thanks too a few failed Great Leaps Forward and everyone’s favorite catastrophic social movement the Great Proletarian Cultural Revolution (actually I prefer the purges under Stalin in the USSR, but that’s the subject of a heretofore unwritten blog post). But the point is that the Chinese system was basically broken and the higher ups in the party realized that maybe they should try to be a bit more practical and bit less communist. Reforms began under CCP leader Deng Xiaoping in the early 1980s and have continued at a decent clip ever since.

So what’s the big deal? China had some issues but they’ve worked around them since then, right? It’s all capitalism and democracy, right? Perfect place for us budding investors to get our feet wet and in the proverbial door? Well, not exactly. See, the CCP hasn’t quite gotten around to appreciating things like democracy and personal freedoms like we do here in the states. Their argument for retaining a tight authoritarian hold on the country isn’t entirely unfounded either: As Dr. Ken Lieberthal of Ross School, Brookings Inst., and NSC fame contends, the CCP authority feel as though allowing open contestation of the government  would leave China open to the kind of unrest and social instability that the PRC quite frankly has had quite enough of this last century. That having been said, it’s easy to see why they’re afraid of loosening things up. But if the CCP still retains both the right and the motivation to interfere in the lives of its citizens, what incentive is there for individuals in China to work and accumulate wealth if the government can just take it all away on a whim? How then has China managed not only to pull itself out of a failed communist funk but become one of the strongest economies world with an annual GDP growth rate averaging at 9% for the past 15 years?

The answer lies in the nature of the system. Since the beginning of massive systemic reforms in the early 1980s, the the governing system of the PRC has slowly grown to resemble a federalism not very much unlike that in the United States. The Chinese do not have a very developed sense of the rule of law that most political scientists would argue is a keynote of a strong market system (this is primarily because all judicial appointments are made by the party and most judges are more likely to rule along the party line) but what they do have is a finely balanced incentive system which in the end functions almost the same. It is what Barry Weingast of Stanford University calls a market-preserving federalism (MPF) and requires the following five criteria to be met :

1. There must be a hierarchy of government in which each level is autonomous within its own jurisdiction.

2. Each subnational government must have complete authority on economic policy within its own sphere of control.

3. The national government must limit its interference in the economy to encouraging the free flow of inputs within between the states (or in this case, provinces).

4. Each level of the government should be faced with real budget constraints (ie. the central government should refrain from bailing out the provinces in the event of some kind of fiscal malaise so that they must reap what they sow).

5. There must be a strong system of rules that keep the government from reallocating authority over various spheres at will.

So basically it’s a system that utilizes the competitive nature of the sub-national governments to sustain a free market. The real key to Chinese economic success has been the fact that the wages of the provincial officials are tied directly to the industries under their jurisdiction. If the economic conditions within a given province are such that they foster growth and development of industry, more and more industries are likely to relocate to that province. The more successful these industries become the more tax money the local officials can claim. Obviously if their taxation methods are extreme or otherwise unfair the firms will move away, so it is in the officials’ best interest to run a clean, competitive operation. And because the central government refrains from bailing out the provincial governments if they have problems with their budgets, the provinces have incentive to practice responsible fiscal policy. Perhaps the biggest economic good to come out of this balance is the incentive for the subnational governments not to play too strong a hand in the affairs of individual firms. If the Chinese government in one province commonly expropriated a firms assets with little or no call to do so the firms would just pack up and leave in search of a more accommodating area to do business. The end result is a system that preserves the free market sans a deeply integrated and enforced rule of law.

So fortunately for the Chinese and for those of us looking to take a slice of the expanding market in Southeast Asia, the situation in China isn’t as grim as one might think at first glance. That’s not to say that things don’t get a little dicey here and there. At the ASEAN business conference I spoke with a gentleman from Chicago who’s name and place of business currently escape me. He said that of all the nations in the ASEAN he preferred doing business in Malaysia. The Chinese, he said, had a tendency to change the rules of doing business internationally with the wind, although, he admitted, none of these changes had made a negative impact on his business. Not yet, anyway.

The good thing is that, as the provinces gain more and more authority among the citizenry by fostering economic growth and development, it is becoming increasingly more difficult for more hard-line members of the CCP to push policies that tend toward retrenchment into the old ways. The steady thaw of the system coupled with global influence through foreign presence and communication are slowly getting the Chinese accustomed to this freedom, and it looks now as if the only safe way for the CCP to go is up.

But political stability is the topic of another blog post, and I’m sure you guys are getting tired of reading my quasi-academic prose. I promise next time I’ll talk about something more fun, like oil politics in the South Caucasus. Oh… that’s not a bad idea, come to think…

-JG