Should China’s Meltdown Be Surprising?

As stock markets decline around the world, apparently in response to stalled economic growth in China, one might ask whether China’s difficulties should come as a surprise.  After all, has not China “liberalized” its economy in recent decades, paving the way for the spectacular growth that capitalism can deliver?

Alas, China has liberalized in some dimensions, but its economy remains highly controlled in other dimensions; it  has state capitalism, not true capitalism. In a recent Cato Research Brief, Donghua Chen, Dequan Jiang, Alexander Ljungqvist, Haitian Lu, and Mingming Zhou provide evidence for this claim:

The key function of an economic system is to allocate scarce resources efficiently. Having proved superior to central planning, Western liberal capitalism, based on markets and private enterprise, was in the ascendant following the collapse of the Soviet Union. More recently, however, state capitalism has won adherents as an alternative to Western capitalism.State capitalism, as practiced in China, Russia, and elsewhere, combines the power of the state with capitalist tools: the state controls access to capital, picks winners, and influences investment decisions, while at the same time listing state firms on domestic or overseas stock markets.

In our research, we ask how efficiently state firms allocate capital. Our focus is on China, the country where state capitalism is perhaps most entrenched. Because China’s capital markets are relatively underdeveloped and firms cannot access them without political approval, we focus on firms’ internal allocations of capital, the internal capital markets operating inside business groups. As we show, Chinese firms rely more heavily on capital obtained from fellow group members than on external capital markets.

We investigate the efficiency of capital allocation by contrasting how state business groups and privately owned business groups in China allocate capital across member firms. An efficient internal capital market allocates more capital to units with relatively better investment opportunities. This is exactly how, according to our evidence, private groups in China allocate capital. State groups, in contrast, do the opposite.  …

Our results suggest that state capitalism does a poor job of allocating capital, at least in China’s state business groups. This likely reflects the fact that the objective of the Chinese Communist Party (CCP) is not just maximizing profits or shareholder value but also maintaining a “harmonious society.” Consistent with this, we document that the chairmen of state groups are rewarded with promotions to higher office not only for raising productivity but also for avoiding large-scale job losses. These aims can be in conflict and over time may be incompatible. State group chairmen appear to let their career incentives influence their internal capital allocation decisions. Not only do we find that internal capital allocations are used to prop up large and struggling employers with poor prospects, consistent with the policy aims of the CCP. We also find that capital allocations are particularly distorted when group chairmen are up for promotion and cease to be distorted once a group chairman becomes ineligible for promotion under the CCP’s rules on mandatory retirement.

The surprise, therefore, might be that China’s economy has done as well as it has until now.