The Truth About Chinese Corruption

A generation from now, historians may look back at Chinese President Xi Jinping’s tenure as marking a break with the past; rather than defining a “new normal” for the Chinese economy, the time will be remembered for XI’s crusade against corruption. Thus far, China’s leadership appears to be more aggressive in dealing with corruption than in addressing economic reforms. The current corruption 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 economic slowdown.

Some observers are optimistic that these efforts will eventually succeed in curbing rent-seeking activities and establishing a more efficient and sustainable growth path. Others see these actions through a political lens, with the objective of eliminating more egregious behaviors and restoring the sense of fairness that is needed to preserve the legitimacy of the Communist Party. These concerns raise questions about the role that corruption has played in shaping China’s development path over the past several decades.

Corruption in China

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. Corruption, under this definition, is therefore clearly more pervasive when the state plays a major role in the economy through ownership or control of resources that are needed to facilitate profitable activities. This is the case in China, but corruption can be just as pernicious in other economies where the state’s interventions are less prominent. Despite a steady increase in the role of the private sector in China, corruption has been increasing.

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 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 it is 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 in turn has encouraged speculation that corruption in China might eventually lead to political liberalization.

Corruption features prominently in China’s dynastic history, but its current iteration stems, ironically, from the well-regarded reforms launched by former Party chairman Deng Xiaoping. Around 1980, Deng began to open China’s economy, paving the way for a hybrid socialist-market economy. Economies are particularly prone to corruption during such a transition, as we also saw in the former Soviet republics in Central Asia. Deng’s allegedly 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 markets 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. Enter player two: a representative of a state enterprise who could provide the resources, especially financing from state-owned banks. Both, however, needed the blessing of player three, the local official, who almost always was also a party member and had the authority to make the collaboration politically acceptable.

For this process to work there had to be the potential for considerable gain since their interactions were not strictly legal and there were few existing rules or regulations to guide the process. This gave rise in the early stages of China’s opening up to the development of township-village-enterprises (TVEs) – a marriage of private interests with resources controlled by local authorities to establish small-scale manufacturing activities. These TVEs have been described as pioneering examples of economic reform in China’s initial phase of industrial development. Thus, early on, it was hard to differentiate budding reform initiatives and examples of corruption.

Corruption and growth 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; if anything, investment has been growing too rapidly rather than too slowly. In the early stages, forms of cooperation such as the TVEs made it possible for more productive investment to occur in a system where the state controlled the totality of resources. Later, corruption in China helped to navigate around excessive regulations and controls in an overly centralized bureaucracy; corruption made it easier to do business. Together, it is easy to understand why, early on, corruption facilitated the growth process rather than impeding it.

But how does one explain why such corruptive behavior did not lead eventually to excessive waste as was the case in Eastern Europe, elsewhere in Asia – notably India, Bangladesh and Indonesia – as well as in Africa and Latin America, not to mention the fragile states in the Middle East?

Unique Administrative System

The explanation lies in China’s unique governance structure. China’s system of governance can be described as a regionally decentralized, authoritarian system. It provides the regions with the flexibility to experiment with economic reforms in response to goals established by Beijing. The strategy was supported by growth and financial targets for each province backed by resource flows from the center. This was enforced by linking the promotion of senior provincial officials to these targets. Regional leaders – from Party secretaries and governors down to city and village mayors –  are appointed, and routinely rotated under the auspices of the central Party apparatus. Unlike a federalist system, where senior regional officials are elected by their local constituents and thus responsive to their needs, in China, regional leaders must adhere to signals emanating from Beijing.

This system helped to counter the growth-inhibiting aspects of corruption, by setting investment and production targets that gave local officials incentives to promotion expansion. It fostered a unity of purpose so that even as corruption flourished, the collaborators worked to make growth the guiding principle for their actions. This was reinforced by competition among the localities to meet targets and to support productivity-enhancing economic reforms. This competitive element helped to curb waste and ensure a modicum of efficiency despite the high degree of state intervention in commercial activities.

Manifestations

Corruption in the transition phase was exacerbated by the existence of dual prices for consumer and producer goods – one market determined and the other subsidized. Two decades ago, the focus of rent-seeking activities was on securing access to state subsidized consumer products such as rice and textiles and then reselling them on grey markets at much higher prices. This created the opportunity for illicit gains through price arbitrage. Unification of output prices, however, eliminated most of these opportunities years ago.

Today, the problem lies in distorted prices for key inputs such as land, energy, capital, and labor. This has spawned a plethora of examples in the headlines about illegal land seizures by local authorities in cahoots with private developers, diversion of subsidized lending to state firms for unintended purposes, misuse of energy resources, and reforming labor residency policies.

The corruptive nature of these transactions is most strikingly illustrated in the way that land transactions have been handled over the past decade. A private property market was created in the late ‘90s when households were allowed to buy their homes from their employers – typically government agencies or state-owned enterprises (SOEs). Previously, there had been no market for private property and its underlying value, as determined by land prices, could not be established. That all changed in 2003-4, when the auctioning of state-owned land for development was initiated. The result was a 500 percent increase in land values over the past decade.

Both collectively owned rural land and urban property controlled by SOEs and local authorities were made available for commercial developments – converting underutilized or well-located land had the potential to generate huge profits for those who were well connected. These transactions were often at the expense of rural interests, whose ownership rights to collectively owned land was unclear, making it feasible for local authorities to easily transfer use rights to developers in exchange for a share of the profits.

Preferential access to financing underpins another major source of corruptive activity. SOEs get funding from state-owned banks at below-market rates, supposedly for investments that serve the interests of the state – but at times such funds are diverted to serve private purposes in exchange for illegal payments. In areas like energy, where the state controls its use with differential prices depending on purpose, there is enormous potential for corruption.

It is not surprising, then, that President Xi Jinping’s anti-corruption campaign targeted energy companies early on, and why land acquisition practices and interest rate liberalization are so high on the reform agenda. Curbing corruption permeates many of Xi’s programs. For example, few realize that at the heart of China’s new urbanization program, liberalizing labor migration and residency eligibility could have a significant impact in reducing corruption as there is even a grey market for buying residency rights in major cities.

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 and their private counterparts, many of whom work for multinational firms. During the transition from a centrally controlled to a market-driven economy, when the rules of the game and property rights are unclear, the system is most vulnerable to corruption. The danger is becoming stuck in the transition. Thus the defining question is whether China will eventually allow the market (and not the state) be the primary force for allocating resources – otherwise corruption will continue to flourish no matter how many flies are swatted or tigers caged.

Corruption Campaign

While corruption has not led to its characteristic economic stagnation in China, the damage inflicted on public perceptions about inequities drive 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. This legitimacy argument drives 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 for reducing 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 tougher 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. Persecuting more “tigers and flies” changes the risk-benefit calculation. The recent scaling back of salaries for senior executives in state-owned enterprises is another symbolic gesture but one that is unlikely to help, since it widens the gap between what Chinese SOE managers are paid compared to their private sector counterparts abroad as well as domestically. This will only increase the incentives to be corrupt. Ultimately, Xi will succeed only if more is done to address the structural factors driving corruption.

This means breaking the corruptive relationships between the key players in the dual economy by separating the roles and responsibilities of the 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 the economy has become increasingly driven by the private sector, the influence of the state permeates much of the decision-making among economic entities regardless of their formal ownership structures. The heads of all the major SOEs and state-owned banks are appointed by the Party’s Central Organization Department and rotated periodically, with their appointments shaped more by their political standing than their commercial expertise. All the key administrative officials, such as the governors of provinces and mayors, are one step down in the power structure than the Party Secretaries shadowing those positions. This has created parallel Party and administrative structures that make it difficult to separate the oversight and executive roles of officials.

The focus of much of the attention in the current corruption campaign lies in the state-owned commercial banks and enterprises. The Third Plenum policy statement promulgated by the new leadership in late 2013 indicated that the market should be dominant in guiding the economy. But the same statement also mentioned that the state will still play an important role. Reconciling these two contradictory sentiments is critical to dealing with the systemic factors driving corruption.

Most of the corruptive behaviors lie in the state’s control over resources and financing, and the influence of local officials on their distribution. Privatizing those SOEs that do not play a strategic role would be a tangible first step. But thus far, the government’s intention has been less dramatic: advocating more diversified ownership by allowing private interests to purchase minority shares. Without the power to influence decisions, however, the private sector has shown little interest in investing in these SOEs. Similarly the state-owned banks have an outsized influence on economic activity through their preferential access to the huge savings of Chinese households. The pressure that these banks feel to enter into transactions that are unduly influenced by Party and local officials is a major vulnerability in the current system.

Abusive land practices are now being addressed as part of the new urbanization program, but doing so means tackling some very sensitive issues, including the rights of individual farmers to sell land that historically was under collective ownership. In urban areas, it will be necessary to put in place a more transparent system for developing land parcels that would eliminate much of the illicit activities that have flourished in recent years.

For these issues, the problem is that accountability is diffuse and regulatory versus executive roles are blurred. Clarifying these relationships would require some form of political liberalization to build the necessary mechanisms that would make it more difficult for corruption to be sustainable. Many of these transgressions can only be revealed by more transparency and allowing the public to play a watchdog role. Yet in today’s environment, for an individual or civic group to do so is risky.

Political Liberalization and Corruption

Many seeking precedents for what might happen in China look to the Arab Spring movements or failed states elsewhere. But more appropriate are the experiences of the very few highly successful developing economies that formerly had autocratic political systems, such as South Korea and Taiwan. It’s worth noting that in both Taiwan and South Korea, political liberalization began around the same time in the late 1980s, at the same purchasing power adjusted per capita income level of around $13-15,000 and the same level of urbanization (70 percent), which triggered a sharp rise in the share of high-value services in the economy. It is no coincidence that the emergence of a more knowledge-based economy generated the pressures for political liberalization.

In these countries, the rise of a large and more sophisticated urban middle class made it more difficult for the state to handle social protests. Moreover, more globally connected services and IT-related activities made it increasingly difficult to control the flow of information because it was not only part of the clamor for free expression but also a necessity for economic progress. The process in China will not follow the norms of Western-type democratic movements and its system is not the same at that of its East Asian neighbors. Thus the transition process in China will be driven by internal Party structures and will have its own unique China-specific characteristics.