"I think this is manageable slowdown. We have come into a new stage where we emphasize more on structural changes and economic reform” said Zhou Xiaochuan, the Governor of People’s Bank of China, in May 2014. Holding a mandate for reform from China’s revisionist President Xi Jinping, Xiaochuan – who is in his third term as Governor – has been well aware of Chinese economy’s endemic issues rooted in bureaucratic corruption and low productivity of state-owned enterprises amidst decreasing growth rates. Since then, however, the nature and pace of reforms implemented have remained superficial and sluggish – not to a last extent due to the political constraints coming off from the old-guard faction of the ruling Communist party. In this prism, how much trouble is China’s economy really in, and what types of reforms need to be implemented to ensure long-term sustainability of, at the least, modest levels of growth?
Xi-Ruption – Panacea For Chinese Corruption?
One of the forefront initiatives adopted under Xi Jinping has been an anti-corruption drive with an aim of cracking down on “tigers” and “flies” – top party bosses and ordinary bureaucrats – alike. As a result of this campaign, hundreds of thousands of officials have been investigated and dozens of leaders with the rank of vice-minister or above have been arrested. Surprisingly, the purge against rampant corruption did not revolve around the emerging intra-party factionalization, targeting high-profile apparatchiks across various factions instead.
For observers outside of China, it came as a major disappointment that despite these seemingly successful efforts, the country fell dramatically in Transparency International’s Corruption Perception Index from 80th place in 2013 to 100th in the 2014 list. Here is a comparative index of the volume of GDP PPP, and score on Transparency International’s Corruption Perception list (scaled to 1-10, with 10 being the highest), that contrasts China’s latest results with those of the US and leading Asian economies:
It is evident that while surpassing the US as the world’s largest economy by purchasing power parity, China ranks considerably below its competitors in Asia as well as the United States on corruption perception. Transparency Interntional placed the country on par with Algeria and Suriname among highly corrupt countries in 2014, citing public sector corruption and mismanagement of budgetary funds as unresolved paradigms. Furthermore, additional emphasis was placed on the continuing ease and impunity with which corrupt officials transfer and hide money abroad – a trend that usually gains significant impetus amidst an organized state-sanctioned fight against corruption.
The hitherto failure of the anti-corruption drive to improve China’s global standing on corruption can be traced to Xi’s hesitancy to convert his political capital earned from initiating this drive, into long-term institutional reforms that would fundamentally alter the status quo of widespread bureaucratic corruption. The lack of political reforms that would guarantee independent judiciary operating outside of the party’s purview, as well as free media that could reveal corruption within the party’s ranks, has also prevented the development of systemic vaccines to the virus of corruption that are found in developed countries. In essence, Xi’s campaign has undertaken an ad-hoc mode yielding short-term results for public display, but failing to introduce a true effort to uproot corruption in the economy and especially, in state-owned enterprises.
Chinese Leviathan: The Curse of SOEs
A dominant role in the Chinese economy is played by state-owned enterprises (SOEs) that are managed and overseen by the State-owned Assets Supervision and Administration Commission (SASAC). Roughly 155,000 SOEs operating in China make up about two-fifths of the country’s total production and provide one-fifth of employment for the economy. These SOEs have stakes and investments in a vast array of businesses, from shopping malls and real estate to oil and gas, and are often times controlled by the local governments. Beginning in the 1990s, the central government provided the SOEs with cheaper interest rates from state banks and other incentives to ensure their competitiveness with the private sector. The underlying goal of such strategy has been to retain control over an increasingly mixed economy of China. Initial results were sound, as the SOEs’ return on assets – an index of productivity – rose from a zero benchmark in 1998 to almost 7% before the 2008 crisis, nearing the private sector rates.
Nonetheless, a clear divergence in productivity of the SOEs from that of the private sector emerged in the aftermath of the 2008-2009 financial crisis. While the private sector’s return on assets rose to near 10%, the same index for the SOEs stalled at below 5% despite the institutional advantages and handy credits provided by the government. Managerial and structural factors have certainly impacted the slowdown in SOEs’ productivity. A number of reports and studies have revealed extensive networks of cronyism and corruption developed at SOEs by managers who prioritize personal rise in party ranks over business efficiency. Moreover, the embedded structural inefficiency of state allocation of resources came to produce huge losses for SOEs, majority of which became naturally less competitive in the post-crisis period of stiff rivalry for demand.
This leads to the key aspect that is essential in explaining the rapid fall in SOEs’ productivity: the unprecedented expansion of China’s credit market in the decades before that had paved the way for the country’s economic “miracle.” China’s bond market underwent rapid growth from having been practically nonexistent in the early 1980s to becoming the third largest in the world at over $4 trillion in 2014. The largest portion of this growth has stemmed from issuance of government bonds to fund wide-scale infrastructural projects through SOEs across the country. Substantially higher yields offered on these government bonds attracted lines of investors, subsequently making easy credit provided by the government available to SOEs.
The financial crisis became a central critical juncture for China, as it took place during the period of the economy’s transition into maturity stage, with investors getting lesser bang for every yuan. This trend was not, however, recognized by the SOEs – as well as in part, by the private sector – that continued vigorously seeking credit in the market. The result was a credit boom, amidst slowing economic growth, that ultimately inflated China’s total debt-to-GDP ratio to near 300% for a total of $28.2 trillion debt by early 2015, depicted in graphs below. Most importantly, about $9 trillion of corporate debt has been accumulated in the real estate sector that has developed into a housing bubble with emergence of notoriously constructed, yet uninhabited “ghost cities” across the country. 
Classical economic literature would describe this path of skyrocketing credit and debt ratios as prelude to financial crisis – a prediction seemingly unfolding at a steady pace as China’s Shanghai Composite stock market lost 30% of its value within a single month of June 2015, and faced as much as 8% loss in a single day. As a response, the government resorted to its traditional policy of intervention by banning half of companies listed on the Shanghai Composite from trading. Nevertheless, the outflow from the Chinese market has continued, sending a clear signal to the authorities. Just like the unsuccessful corruption reforms, the core issue with government’s policy is its political hesitancy to reform the way it conducts business.
Avoiding “hard landing” – a period of slow growth replaced by no growth – is achievable through increasing productivity of the SOEs, which in the current scenario can only be achieved through incremental, but gradually complete privatization of all SOEs owned by local governments in a longer-term period of up to 20 years. This process would not only rid the municipalities off of subsidizing loss-generating SOEs, but also serve as means of repaying their long-term debts while relying on the central government to support them in repayment of immediate debt. Simultaneously, the central government has to formulate specific capital efficacy metrics for the SOEs and concentrate its portfolio only in sectors it had announced as its priorities – among them aviation, telecommunications, defense, power, and oil.
Thus, systemic, incremental, and non-corrupt privatization of all inessential sectoral SOEs is the only way to gain long-term increase in productivity of the Chinese economy. In the short-term, there are two factors that safeguard China from falling into financial abyss: firstly, the government’s $3.69 trillion foreign reserves are the largest in the world and can be instantly injected to bail out the financial sector. Secondly, while the Chinese stocks constitute meager 3% of the world’s total stock volume, the Chinese economy remains the largest in the world on purchasing parity basis with substantial levels of foreign direct investment. Utilizing its financial cushion, the government should refocus its strategy on establishment of investment boards that on a large scale fund innovative, hi-tech, and private sector infrastructure projects in many provinces that remain underdeveloped. The era of managing the slowdown through cosmetic interventions is ought to be replaced by sustainable political reforms that bring about long-term, market-driven competitiveness, if the country’s leadership is invested in transforming China into a developed nation.