The local growth hoax ruining China's bigger picture

Career incentives have led to an explosion in local Chinese government infrastructure spending. But resulting structural imbalances are crowding out private sector growth and fuelling corruption.

China’s economic success has been closely tied to its unmistakable move toward the market since reforms first began in 1978. In the first 20 years of reform the role of the state diminished substantially, and it is only in the last 10 years that the state has come back to the forefront of economic activities.

There appears to be a consensus within the Chinese establishment and among many international China-watchers that state dominance has been a salient factor behind China’s economic success. But, against this view, most economists in China believe that state dominance has impeded rather than propelled China’s economic growth.

The significant presence of large state-owned enterprises and a mercantilist approach to foreign trade have been cited by many China-watchers as evidence of China’s state capitalism. From an international perspective, these are major issues that have constantly caused tensions between China and its trading partners. But as China moves away from its export-driven growth model – a natural process consistent with the country’s structural change – these problems will eventually abate.

The same cannot be said for the expansion in local government spending that has been the main reason behind the revived role of the state. Local government officials must develop local economies because their opportunities for professional advancement are tied to local GDP growth. They have been correct to invest in infrastructure, new urban development, highways, industrial parks and the like. Yet instead of opening up investment opportunities to the private sector, almost all local governments have opted to borrow money from banks and invest it themselves. The booming real estate market has made them confident that their investment will pay off. Along the way they have also set up new financial companies and delegated to them the task of managing infrastructure building and finance.

The consequences of this round of government expansion are severe. Local governments have become seriously indebted. Although most of the debts are secured against some form of collateral (meaning that a financial meltdown is unlikely to happen), they will still be a big burden for many cities in the years to come.

Another problem is that government investment in infrastructure acts as an in-kind subsidy to industry, especially to the secondary sector (composed of manufacturing, transportation and construction industries), which is more capital intensive and therefore pays its workers less than the service sector. As the share of labour income in the national income declines, so too does the share of household consumption in the national GDP. In essence, local governments’ excessive investment in infrastructure contributes to China’s structural imbalances problem.

The current round of state expansion has also intensified the problem of corruption. A significant number of corruption cases have been related to infrastructure projects. In Henan province, for instance, four consecutive bureau chiefs of the transportation department have been caught in corruption scandals.

Additionally, government projects and government-owned companies have had a strong crowding-out effect on private businesses. In the past several years, infrastructure lending has taken up more than one third, sometimes close to one half, of the total bank lending. This inevitably squeezes the already confined space left for small- and medium-sized private companies.

The government is likely to roll out some major plans for reform in the Chinese Communist Party’s Third Plenary Meeting of the 18th Congress scheduled for this November. Adjustment of central-local fiscal relations is likely to be one of them. One of the rationales for this is that local governments take part in economic activities, especially real estate development, because their regular revenues are not enough to pay for their regular expenditures. The hope is that by adjusting the central and local shares of revenues and expenditures, local governments will retreat from those activities. But this is probably just wishful thinking. Local officials have a short tenure in a city, often limited to three to four years, and so it is perfectly rational for them to prop up local growth rates in the quickest way possible, which has been through investment, especially in real estate.

To change local government behaviour the root of the problem must be addressed, which involves asking why the role of the state has been expanding in China. This has to do with the lack of checks and balances in the country’s governance structure, most significantly the lack of accountability on the part of the officials toward their constituencies. In such a system, officials are free to pursue the one goal that affects their careers the most, that being short-term economic growth. Real change therefore demands bold political reform to strengthen democratic participation in policy formation.

This article appeared in the most recent edition of the East Asia Forum Quarterly‘Leading China where?’.

Yao Yang is Director at the China Center for Economic Research and Dean at the National School of Development, Peking University.

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