Where is China headed?

This morning I read “Mr. China”, Tim Clissold’s account of the travails of a fund he was involved with investing in China between 1995 and 2002. He describes how Western investors lost their investment to incompetent or evasive managers and politics. It is a cautionary tale of optimism coming to grief in the face of a culture that the investors could not understand. Despite this I am not convinced that Westerners are the ones who should be most concerned by this book. Losing even staggering amounts of capital like the amount sunk into China is mostly a concern for those who lost it and has little lasting effect on our way of life. By contrast, the effects that the culture of venality which the book exposes will be having on China will already be huge and could become catastrophic.

The best account I’ve read of the origins of the Asian Financial Crisis is that provided by John Shuhe Li. He argues that it was the result of a move from relation-based to rules-based governance. Relation-based governance offers a sensible way to overcome transaction and information costs in a lesser developed economy as businesspeople gain a first hand knowledge of those they transact with. This allows them to trade and invest even when contracts are hard to specify and enforce and information on different supplies is scarce. Rules-based governance is more transparent and offer lower transactions costs later on as the advantages of more dispersed trading increase and information costs fall. The problem is with the transition where a business culture used to relation-based governance misuses the possibilities created by financial liberalisation. It was this transition going wrong that caused the Asian Financial Crisis.

Relation-based governance was smeared as “crony capitalism” by Krugman which did not give the system credit for what it did well. However, in China, where in much of the country “the hills are high and the emperor far away” as one character in Mr. China opines, it is closer to the truth. Unaccountable local officials still wield huge amounts of power in the economy. This will increase the misallocation of resources that, through a lack of transparency, is the major cost to relation-based governance. This, in turn will make the transition to a more liberal system still more risky.

I think that this source of crisis is the most plausible for China. However, even if this is not the final cause we can be sure that it can’t maintain its current rate of growth indefinitely. It could be a severe slowdown elsewhere in the global economy reducing demand, spikes in commodity prices or any one of a host of other factors. When this happens the political trade off in China with the Chinese accepting severe restrictions on their freedoms in return for a promise of high growth will be placed under severe stress. There will be political pressure and the government will be able to respond in one of three ways:

1. Crack down. Given their success in the past it might well be that the Party leadership will believe they can maintain order by force indefinitely. This is the tried and tested option but risks doing further damage to the economy or provoking a backlash and revolution.

2. The Galtieri strategy. Take an aggressive foreign policy stance and stoke up nationalistic fervour. This could actually be quite a sensible option from their point of view if it was thought that the West would not intervene to protect the target, probably Taiwan. If America is looking weak and it appears likely that it will not choose to bear the cost of war with the PRC to protect Taiwan then the prospect of reuniting Taiwan with the mainland and securing enormous popularity might be worth the risk. To prevent this option looking enticing the US needs to find some way of making a credible commitment to defend Taiwan. One way might be to station some fighter planes on the island in hardened bunkers. The US lead in that technology is so strong that even a small force would be significant and it would not need to be as vulnerable as the trigger forces in South Korea.

3. Liberalise. In particular, even if elections were limited to local officials that would make them accountable to the populace and might reduce petty abuse and corruption. These local officials and their misdemeanours are responsible for so many of the worst problems in China. However, this strategy or any other further liberalisation would probably be discredited by a crash and the Party are very wary of the trap Gorbachev fell into.

It is far from certain that China will experience a crash but it will experience a slowdown and this will cause an upsurge in the, already widespread, restlessness in large parts of China. I’d say that the chances of a Galtieri-style foreign policy adventure are quite low but the possibility is very real and the consequences could be truly dire. Good old fashioned deterrence is the way for the US to stop this happening. There isn’t a lot that the West can do to affect the chances that a liberal response will be preferred to an authoritarian one.

In the long-term I’m hopeful. The impression that I took away from my brief time in China was that there was no good reason that we should not get along. Clissold chose to end his book with the same message. There is no advantage to a confrontation for either side and the logic that great powers should necessarily clash seems small minded. We should not let the Chinese leadership imagine that we will allow them to abuse their new power but equally we should not treat a showdown with China as a foregone conclusion. Adding so many millions to the population of the rich, stable and free world is such an opportunity.