Will centralizing power solve China’s economic problems, or worsen them?

The relationship between the central government and local authorities is perhaps one of the least understood and most important questions about how China works today.

The past is, as per usual, probably better understood than the present. There is a pretty strong consensus on the importance of local initiative in the 1980s and 1990s–see Yuen Yuen Ang’s book How China Escaped The Poverty Trap for a good recent account. Yukon Huang’s new book, Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong, is also good at giving a more top-down macro account of the importance of the decentralized model:

In China’s system, local authorities are motivated to promote growth. By encouraging competition, this has helped China to contain the worst aspects of the distorted signals and “soft budget constraints” that afflicted the other centrally planned economies in the former Soviet Union. Efficiency comes from having different jurisdictions and their affiliated enterprises compete against each other for their relative positions. They also compete to build the new institutions that China needs as it moves toward becoming a more market-oriented economy.

There is indeed a lot of evidence that this competition for growth among local authorities was an important positive feature of China’s system in the past. But the dynamics of that competition are not the same today as they were three decades ago:

When the state and the market complement each other, the results can have a dramatic impact on productivity and living standards, as has been the case during most of the post-Mao era. Since the onset of the global financial crisis in 2008, however, a confluence of events has altered these relationships. The creation of local-government financing vehicles (LGFVs) put local governments into direct competition with existing firms in property-related commercial activities and also enlarged the opportunities for corruption by local authorities. The government’s stimulus program channeled loans through the financial system to SOEs and local authorities, which made such opportunities even more attractive. Initially, these relationships helped redirect resources that were monopolized by the state, such as land, into more productive use in partnership with private agents. Over time, however, this process has become distorted, resulting in wasteful expenditures that the leadership is currently trying to address.

While local competition may have previously made socialist “soft budget constraints” harder than they otherwise would be, the post-2008 changes in the financial system seem to have led to an epidemic of soft budget constraints. These concerns are related to the argument in “The Long Shadow of China’s Fiscal Expansion,” by Chong-En Bai, Chang-Tai Hsieh, and Zeng Song (previously discussed here). Here’s a longer excerpt from that paper:

[Prior to 2010] local governments were actively providing special deals to favored businesses, but could not borrow from or influence the lending decisions of state-owned banks. The effect was that the assistance provided by local governments to favored firms largely consisted of exemptions from the country’s thicket of rules and regulations, but local governments could not provide the private firms they were trying to assist with preferential access to capital. These two institutional features—high-powered incentives to provide special deals, along with restrictions on access to capital—explain how China was able to grow rapidly despite seemingly low-quality institutions.

We show that the off-balance-sheet financial institutions created to fund the fiscal stimulus program changed the nature of the special-deals regime. Specifically, we show that the off-balance-sheet financial institutions continued to grow even after the stimulus program was over, because local governments now had a powerful new tool, the LGFVs, to provide support for favored firms. …

This might have had positive effects on welfare and growth if local governments had used these resources for projects that would have high social returns but had been starved of resources. However, we provide evidence that in addition to funding infrastructure projects, the relaxation of financial constraints also made it possible for local governments to channel financial resources to commercial projects favoring certain firms.

Other observers also see significant changes in the decentralized growth model in recent years. A recent piece by Barry Naughton suggests that the central government is moving away from encouraging local competition for growth and toward more top-down direction of the economy:

Since about 2010, China’s “miracle growth” era has come to an end, due to rapid changes in labor force conditions, incomes, and external markets. In the wake of this change, the complementarity between bureaucratic incentives and the plan appears to be declining.

The Xi Jinping administration has since 2012 reduced the focus put on economic growth in official success indicators, squeezing in new indicators such as managing local government debt, reducing poverty, and improving the environment. At the same time, the most recent 13th Five-Year Plan (2016–2020) GDP target of “more than 6.5%” growth is close to, or perhaps even above, growth potential. The 13th Five-Year Plan seems to have become an instrument to maintain high-speed growth, even as the bureaucratic incentive system becomes less single-minded.

It is a paradox of contemporary China that administrative interventions are increasing in size and multiplying in form just as growth potential is slowing and the benefits to a less-interventionist stance would seem to be increasingly evident.

Given that local governments get the blame, fairly or not, for the rapid accumulation of debt and wasteful investment projects in recent years, it’s understandable that the central government would try to change things. But it’s not really clear yet what model is replacing the old regional growth competition dynamic, and what the effects of this attempted shift might be.

Has regional competition now become a malign force that must be disciplined? Or will the weakening of regional competition sap China’s economic dynamism? Or both?

Here is Huang once more:

President Xi’s consolidation of power has been interpreted by the more optimistic observers as a precursor for bolder economic reforms in the coming years. For them, China will eventually allow the private sector to play a “decisive” role in guiding the economy as stated in the Third Plenum policy statement. But the many pessimists see in recent actions only hesitancy in addressing much needed productivity enhancing measures. Consolidation of authority means more centralized control over economic activities, continued protection of major SOEs and less competitive pressures in the market space. Thus China’s move from its former collective leadership to relying on a single powerful leader might lead to a less dynamic economy and eventually political instability. Only time will tell if either of these two scenarios becomes the reality.

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