How to Handle an Overheated Economy

To keep China strong, its premier must prevent local politicians from meddling in the economy, fight official corruption, and cut the red tape.

BY BARRY NAUGHTON | NOVEMBER 1, 2004

MEMORANDUM

TO: Wen Jiabao
Premier of China
FROM: Barry Naughton
RE: Cooling the Chinese Economy

As perhaps the best-prepared Chinese leader since Deng Xiaoping, you became premier 18 months ago set to preside over an ambitious reform agenda, impressive institutional development, and a major economic boom. You and President Hu Jintao positioned the government as supportive of the weak and disadvantaged, fair to ordinary citizens, and less tolerant of the corruption that permeates the ruling elite. Yet today, a wave of problems -- from resurgent inflation and electricity shortages to wasteful investment and continued corruption -- has swamped your carefully prepared economic program. Moreover, you're bogged down in an effort to impose central government administrative controls over local governments. Your political rivals are taking potshots. What went wrong? How can you fix it?

Your term certainly started off well. You initiated policies to improve living standards in rural areas and began work on the financial sector reforms essential to restoring confidence in China's banking and corporate governance systems. You also developed some of the regulatory muscle needed to manage the economy now that China has joined the World Trade Organization (WTO). Even the SARS epidemic last year was only a minor setback, because once you took charge, you handled the crisis effectively and with as much candor as possible. In mid-2003, economic and institutional reform seemed well on its way.

Fast forward to today's discontent. There is no question that the economy is seriously overheated. Inflation is back. In July 2004, the consumer price index surged above the 5 percent "redline" for the first time in seven years. Rippling electricity shortages cause blackouts and inflict significant economic damage. Huge investments in real estate and popular industrial sectors generate useless capacity that threatens to sap the country's economic strength for years to come. Your financial reforms are wallowing, and some may be on hold indefinitely. The almost weekly scandals in the financial sector are making investors nervous and sinking important deals.

At the same time, you are engaged in a wrenching program to slow down investment by scrutinizing existing ventures, restricting the volume of credit that goes to certain overheated sectors, and revamping land allocation procedures. It's no surprise that these policies generate stubborn resistance from local governments. Economic conditions are therefore deteriorating in the midst of nasty conflicts among politicians and interest groups. Here is some advice for navigating this harsh environment:

Depoliticize the Economy: This is tough advice for politicians, because they thrive on the ability to distribute goodies to their supporters. But China is more politicized than other economies, and the last two years have shown how harmful that can be. In China, almost every investment involves a government decision, political influence, or semiofficial payoff. That's the main reason the economy deteriorated so quickly. Today's economic bubble began in 2001, when local officials initiated a spate of construction projects to showcase their achievements and to ease the leadership transition at the 16th Communist Party Congress in 2002. This "political-business cycle" accelerated as new leaders took office and committed themselves to another round of public and private investment projects. The abuses you have uncovered -- such as the Tieben steel mill in Jiangsu, built with shady funding on land expropriated from peasants -- are only the worst among many ill-advised economic interventions by local officials.

It's tempting to respond by outmaneuvering the most corrupt politicians and shutting down the worst projects. But experience shows that you won't overcome political interference in the economy by fighting with local officials and interest groups over each project, corruption case, or regulatory decision. Even a skilled bureaucratic operator such as you will be overwhelmed by the strategies of resistance that local officials have honed for decades, even centuries. The most you can do is grab opportunities to unleash economic forces, and then sit back and let them work. Market forces can punish the types of behavior you want to discourage and force people into line with your policies. The best policies are those that work at arm's length: permitting competition whenever possible, allowing interest rates and exchange rates to alter prices, changing incentive structures, and privatizing.

Twenty-five years of economic reform in China clearly show that government-designed and politically calibrated reforms rarely succeed. Market-driven reforms, however, often work. They force systemic change by convincing actors that prices, opportunities, and the rules of the game have changed. You and your predecessor, Zhu Rongji, seem to have recognized as much when you pushed hard for China's WTO accession, gambling that market forces would drive reform within the country. That gamble is already paying off. Now it's time to take another risk by creating conditions that will curb politicians and local officials from meddling in the economy.

 SUBJECTS: CHINA, ECONOMICS
 

Barry Naughton is professor of Chinese and international affairs at the University of California, San Diego. His most recent book, coedited with Dali Yang, is Holding China Together: Diversity and National Integration in the Post-Deng Era (New York: Cambridge University Press, 2004).