Asia July 12, 2007, 8:33AM EST

Broken China

Beijing can't clean up the environment, rein in stock speculation, or police its companies. Why the mainland's problems could keep it from becoming the next superpower

by Pete Engardio, Dexter Roberts, Frederik Balfour and Bruce Einhorn

COVER STORY PODCAST

When the bureaucratic machinery of China rolls into action, it is a sight to behold. A mayor announces a plan to reclaim hundreds of acres from the sea and build a massive industrial complex. A few years later, busy factories and roads stretch as far as the eye can see, families are living in thousands of new apartments, and 10,000 workers have launched Phase Two.

This is the side of China that awes the outside world. The mainland's extraordinary ability to mobilize people and capital to accomplish daunting feats in record time is the reason it has averaged annual growth of 9.5% for three decades. It is why China is an export juggernaut in everything from T-shirts to TVs, has the world's fastest-growing consumer market, and has amassed enough wealth to snap up South American mineral reserves, IBM's (IBM) PC division, and a big stake in private-equity firm Blackstone Group. Will Beijing complete all of the stadiums, expressways, and hotels in time for the 2008 Summer Olympics? Count on it. It's also a decent bet China will achieve its goal of winning the most gold medals.

Why, then, is it so hard for this same government to crack down on exporters of dangerously tainted seafood, toothpaste, and medicine, despite years of warnings by local and foreign experts? The relentless headlines about unsafe products from China reveal a scary truth: Probe even a little into the Chinese economic miracle and glaring administrative failures abound. Product safety is just one aspect of Beijing's inability to enforce needed regulation in everything from manufacturing and the environment to copyrights and the capital markets.

The same Communist Party apparatus so proficient at censoring the Internet can't keep peddlers in the heart of Beijing from selling knockoff Callaway golf clubs and fake iPods, despite solemn promises to Washington since the early 1990s about enforcing intellectual property rights. Shanghai's stock exchange may be one of the world's hottest and may boast a state-of-the-art paperless trading system. But it was a casino when it opened in 1990 with eight listings, and after years of flaccid regulation it's an even bigger casino with 1,118. Beijing proclaims all sorts of green initiatives, yet heavily polluting new factories and coal power plants keep going up. The party has talked for decades about building a social safety net, yet as the working population ages the government isn't investing nearly enough to head off looming crises in health care, education, and pensions. China spends more than Japan on research and development, according to the Organization for Economic Cooperation & Development (OECD), but its record of innovation is underwhelming.

"A CRITICAL POINT"
China observers dismiss these flaws as the growing pains of a nation making a breathtakingly fast transition from a command economy to a free market. But now it's becoming clearer that these and other structural problems aren't being addressed. The same policies that have been so successful at boosting the gross domestic product by developing new export industries and public works projects, it turns out, undermine initiatives that might move China's economy to a higher level. In its pursuit of growth at all costs, China skimped on investments needed to provide basic affordable health care and the regulatory machinery that can enforce environmental, safety, and corporate governance regulations nationwide. Solving these shortcomings will require a massive shift of the resources that are now being plowed into capital projects. While Beijing would like to cool the economy, however, it is wary of doing anything that would slow the high growth needed to generate jobs for the millions of youth pouring into the workforce each year, especially with a pivotal leadership conference scheduled this fall. "China's economic development model was based on the simple concept of expansion of production," says economist Chen Xiushan of People's University in Beijing. "This model has reached a critical point."

A more intractable problem is China's power structure itself. Although Beijing holds a monopoly on politics, local Communist Party officials enjoy wide latitude over social and economic affairs. They also have huge professional and financial incentives to spur GDP growth, which they often do by ignoring regulations or lavishing companies with perks. As a result, China has built a bureaucratic machine that at times seems almost impervious to reform. Even if Beijing has the best intentions of fixing problems such as undrinkable water and unbreathable air, it is often thwarted by hundreds of thousands of party officials with vested interests in the current system.

Beijing knows it must change course. China's $1.2 trillion in foreign reserves—the most ever amassed by any country—and soaring trade surplus may seem like signs of strength, but they're actually evidence of an overreliance on exports, weak domestic consumption, and a primitive financial system. And a dearth of social services makes a widening income gap between urban and rural areas politically explosive. Conjuring ancient Confucianism, President Hu Jintao harps repeatedly on the need to attain a "harmonious society," implying that China today is anything but. In March, Premier Wen Jiabao labeled the economy "unstable, unbalanced, uncoordinated, and unsustainable."

DYSFUNCTIONAL ADMINISTRATION
To their credit, Chinese officials have unveiled a blitz of corrective measures. Regulators this year shut more than 180 illegal food producers. A directive ordering government agencies to use legitimate software has helped cut the share of pirated programs to 82% from 92% in 2001. Beijing is launching new health-care initiatives, trying to tame the runaway stock market, and passing stringent environmental rules. And in 2006 alone, nearly 30,000 officials were prosecuted for corruption.

If this reformist agenda fails, watch out. The working assumption from Washington to Tokyo is that China is on a trajectory to become a modern market economy and a responsible global citizen. But if its problems persist, the world will have to keep living with a giant trade partner that can't guarantee safe products, control piracy, or curb pollution. China could keep growing rapidly for years, but a scenario of dysfunctional administration calls into question whether it will really become an economic superpower with world-beating corporations that challenge the West in innovation—a Japan Inc. on steroids.

China doesn't lack the finances to fix its shortcomings, and it has the legal structure for regulating the environment, health care, and worker safety. What Beijing does lack is the will to overhaul a political structure that gives party officials down to even the smallest villages huge influence over many facets of economic life. "The laws in China compare with some of the best in the world," says activist Liu Kaiming, founder of the Migrant Workers Community College in Shenzhen. "But it is not able to enforce the laws fully because local governments are focused on pleasing the big bosses in companies." What's more, few mainland enterprises are proving they can move beyond low-cost commodity goods and succeed on a global stage with innovative products, a function of both their limited managerial vision and flawed high-tech policies from Beijing.

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