State capitalism: The secret to China’s boom

One of the biggest changes we’ve seen in the world since the 2008 financial crisis can be summed up in one sentence: Security is no longer the primary driver of geopolitical developments; economics is. Think about this in terms of the United States and its shifting place as the superpower of the world. Since World War II, the U.S.’s highly developed Department of Defense has ensured the security of the country and indeed, much of the free world. The private sector was, well, the private sector. In a free market economy, companies manage their own affairs, perhaps with government regulation, but not with government direction. More than sixty years on, perhaps that’s why our military is the most technologically advanced in the world while our domestic economy fails to create enough jobs and opportunities for the U.S. population.

Contrast the U.S. and its free market economy with China’s system. For years now, that country has experienced double digit growth. Many observers would say that China’s embrace of capitalism since 1978, and especially since joining the World Trade Organization in 2001, has been responsible for its boom. They would be mostly wrong. In fact, a new study prepared for the U.S. government says it’s not capitalism that’s powering China, but state capitalism — China’s massive, centrally directed industrial policy, where the government positions huge amounts of capital and labor in economic sectors it intends to nurture. The study, prepared by consultants Capital Trade for the U.S.-China Economic and Security Review Commission, reads in part:

In a world in which central planning has been so utterly discredited, it would be natural to conclude that the Chinese government and, by extension, the Chinese Communist Party have been abandoning the institutions associated with the communist economic system, such as reliance on state-owned enterprises (SOEs), as fast as possible. Such conclusion would be wrong.

In a G-zero world where no country can claim the mantle of international leadership, China has pulled an accomplished head fake. While the media focuses on China’s special economic zones, like Hong Kong and Macau, and the rise of the banker class and Chinese tech industry, state directed spending is the real engine of growth. Capital invested in infrastructure like factories, heavy industry, roadways, and high speed trains continues to power annual double digit growth in GDP. Reliable data from 2004 shows that 76% of Chinese non-financial firms are classified as State Owned Enterprises (firms with government ownership of greater than 10%).

In short, while the U.S. has spent decades and vast treasure building up its defense system (and yes, by extension, the sectors of the economy that service it), China has spent its time and money building up control over the broad direction of its entire economy. In today’s world, where the first sentence of this essay rings true, which country currently looks better positioned to, pardon the pun, capitalize, in the years ahead?

During last week’s euro zone bailout talks, French President Nicolas Sarkozy went hat in hand to China, painting a stark picture of China’s still-growing economic importance internationally. Never mind that the phone call didn’t result in any particular action; the mere act raised Chinese President Hu’s profile going into the G-20 talks in France this week. Not only that, the entreaty by Sarkozy made plain that China has nothing to hide about the economic path it’s chosen for itself. After decades of hectoring from the West, the tables are perhaps about to turn. After all, what economic model should China emulate? Europe’s? The United States’? “With all due respect,” you can almost hear President Hu saying, “we like the way our system is working, thanks.”

There is, though, a fatal flaw with state capitalism. It works, and it will continue to work, until the day that it doesn’t. China’s economic growth is built on the back of cheap labor. As China’s wealth and per capita GDP (currently $4,400 compared to the U.S.’s $47,000) continues to rise, that labor will one day cease to be cheap — perhaps not compared to the U.S.’s, but certainly compared to the labor forces in India, Turkey and across Southeast Asia. This trend is already beginning, as we have seen multinational companies turn to countries like Indonesia, Vietnam, and Thailand for cheaper labor in the region.

State capitalism requires that the state have access to a cheap good or service that has high value in trade. Saudi Arabia has oil, Argentina has mines. Reaching back further, as New Yorker writer John Cassidy has recently noted, the British had access to cheap Indian opium that 19th century China snapped right up. When China’s emperor protested the drugging of his people, the British sent warships to force its ports open. State capitalism, in other words, has a long history as midwife to economic powerhouses. China’s cheap resource continues to be its labor. The leadership there is going to protect that resource as long as it can, through any lever its government can control. When state capitalism breaks down, the results will be ugly if the government has not adequately braced the economy for fundamental change.

At the heart of every military conflict, after all, is some sort of trade war. It’s not a bad thing that the U.S. has invested so much in its own security. But in a world where economics drives geopolitics, the U.S. will be in a decades-long race with China to maintain its perch as the world’s largest economy, and it will have to do so with a much smaller population and relatively anemic growth, compared to China’s rapidly urbanizing population and its double-digit annual GDP bonanzas. That assumes, of course, that China weathers the shocks that state capitalism will bring, and manages to overcome a looming demographic problem as the population ages without an adequate social safety net in place.

Make no mistake — China’s leaders are well aware of the economic power they currently hold, but they also recognize the potential for more prosperity and influence if they can carefully manage their economy for future generations — and the consequences should they fail. It’s good — and long overdue — that the U.S. learns more about their system, and Capital Trade’s important new study is a step in the right direction.

Bureau Report

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