Broken China

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The roots of China's ersatz capitalism go back to devil's bargains made in the 1980s and '90s to accelerate China's takeoff. Late paramount leader Deng Xiaoping declared it was O.K. to "get rich," a green light for legions of cadres to discard their Mao suits and rush into business, often by setting themselves up as middlemen or grabbing stakes in communal assets. Beijing also granted great latitude to provincial and local officials to manage development and social services such as education and health care. The two requirements: Remain loyal to the party and meet high economic-growth targets.

The system spans China's 657 municipalities, 2,862 counties, and 41,636 townships. Because roughly 70% of a typical official's annual performance assessment is based on GDP growth, says University of Michigan Sinologist Kenneth G. Lieberthal, the cadres shower local businesses with perks. These can include access to cheap credit, land, licenses, protection from competitors, and exemptions from regulations. The opportunities for graft are staggering. "What is unsaid, but understood, is that if your locality becomes wealthy, so do you," Lieberthal says. "Instead of the Chinese Communist Party, it ought to be called the Chinese Bureaucratic Capitalist Party."

The fuzzy nature of corporate ownership in China heightens the conflicts of interest. Officially, state enterprises account for just one-third of the economy, compared with 80% two decades ago, but that statistic is misleading because it includes only companies directly controlled by Beijing-based ministries. In truth, many mainland companies have financial ties to county, city, and township governments. In some respects, that policy of giving members of China's immense bureaucracy a personal stake in growth has worked brilliantly. Big-ticket industrial projects get finished in record time, and infrastructure is smoothly put into place. Daniel H. Rosen of the Institute for International Economics estimates that while it takes four years to build an aluminum smelter in the West, similar projects can take less than a year in China.

ENFORCEMENT STRUGGLES
These Red capitalists, though, have evolved into a powerful and wealthy elite with an enormous stake in the status quo. Truly private capital markets would strip officials of their power to reward cronies with bank loans and stock market listings. Copyright enforcement might do wonders for China's software industry, but it's blocked at the local level by cadres more interested in safeguarding the jobs and profits that flow from knock-offs. Although Beijing gives provinces funds for schools and health clinics, much of that money winds up elsewhere. The National Audit Office has reported that 10% of audited central government funds—including money allocated for pensions, health care, and unemployment—are diverted into illegal loans to companies, construction of posh government buildings, and other questionable investments. "All the things we see as competitive advantages for China now are translating into disadvantages," says Rosen.

Beijing is doing what it can to rein in rogue players. On July 10, Zheng Xiaoyu, the former commissioner of the State Food & Drug Administration (SFDA), was executed for accepting bribes of about $850,000 from eight drug companies seeking quick product approval. Worse, on his watch the agency gave the green light to many flawed drugs, including an antibiotic that killed more than 10 people. The Shanghai party secretary, Chen Liangyu, was fired last year after being accused of plowing $400 million in pension funds into real-estate projects and toll roads. And last September, authorities discovered that two senior executives at a state-owned insurer had deposited $4 million-worth of premiums in the bank accounts of friends and family.

These high-profile punishments serve as a warning, and enforcement is improving. But the central government still struggles to impose its will on local officials nationwide. China's State Environmental Protection Agency employs about 300 people at its headquarters in Beijing, while some 60,000 employees are scattered at environmental protection bureaus across the country. Those numbers may look impressive compared with the U.S. EPA, which has a payroll of 17,500. But those 60,000 environmental watchdogs report to provincial and local governments, which tend to favor economic development over green considerations. A 2006 OECD study says that while pollution fines are rising, they're usually far below the cost of installing equipment to cut pollution. And authorities often negotiate down the charges. "For the sake of their own political scorecards, some local officials have joined forces with businesses seeking windfall profits," Pan Yue, SEPA's deputy chief, told the China Daily on July 3.

To understand how bureaucrats and business leaders flout SEPA's rules, take a trip to Lake Taihu, the source of drinking water to 2.3 million residents of the city of Wuxi. In the 1990s, as industry sprang up on the lakeshore and Taihu grew more polluted, authorities ordered local factories to clean up their waste water. Then in 1999, local officials said the problem had been licked as factories installed treatment plants. But those new facilities were often idled as companies refused to shoulder the cost of operating them, and factories continued to dump untreated waste into the lake. The situation worsened, until this spring the lake turned an iridescent green. "I'm angry with the government because it can't solve the pollution problem," says Lydia Li, an executive assistant at a foreign-owned manufacturer in Wuxi. In May, she says, she had to buy nearly 50 gallons of bottled water after yellowish water smelling of sulfur started running from her tap.

Oversight of food production in China is similarly troubled. The SFDA employs 1,700 people, but 80% of China's food producers—some 350,000 enterprises—have fewer than 10 employees and often lack any real understanding of safety standards. And again, there's little local incentive to crack down on scofflaws. "If local governments close all the companies that violate food safety regulations, a lot of workers will lose their jobs," says Luo Yunbo, dean of the food and nutrition college at China Agricultural University in Beijing.

The misplaced economic priorities explain the decrepit state of social services. Top leaders have been pledging to provide basic public health-care and retirement plans since they began downsizing giant state enterprises in the '80s, dismantling the "iron rice bowl" of cradle-to-grave benefits. But responsibility was divided among different ministries, and funding social programs was delegated to local governments. Compared with spurring growth, social services got short shrift. It would cost Beijing around $40 billion—a sum it could easily afford—to set up a national primary health care system similar to Britain's, figures Huang Yanzhong, director of the global health studies program at Seton Hall University. "But I'm not optimistic," Huang says. Responsibility is fragmented among too many competing ministries in Beijing, and at the local level, cadres still are judged on GDP growth. "If you try to tackle this with policies rather than deep changes in political institutions, the government won't be able to bring accessible, affordable health care," he says.

So, many people go without. Huang cites government surveys showing that nearly half of Chinese say they can't afford to visit a doctor when ill, 70% lack health insurance, and 30% refuse hospitalization due to cost. And the system is corrupt. Hospitals earn most of their revenue selling drugs, and get kickbacks from pharmaceutical suppliers—creating an incentive to overprescribe. Chinese media are filled with stories such as that of a 75-year-old cancer patient in Harbin who was billed over $500,000 for imported medicines, many of which were found to be unnecessary.

Meddling by party officials is hobbling China's stock markets, too. The booming Shanghai Stock Exchange, started in 1990 to raise funds for state enterprises, boasts first-rate facilities, and shares have nearly tripled since 2005. In the first five months of this year, companies raised $17 billion, and issues that will likely fetch tens of billions more are in the pipeline. But despite some improvements in oversight, trading remains volatile, weakly regulated, and driven by rampant speculation. That's in large part because the exchange has evolved little from its original mission. Markets are supposed to allocate capital efficiently to the best companies. But in China, notes Carl E. Walter, managing director at JPMorgan Chase & Co. (JPM) in Beijing, "the primary function remains funneling money to state-owned companies."

Again, it comes down to the cozy relationship between government and industry. Some 95% of the stocks on the Shanghai bourse are state enterprises, and last year no private companies were permitted to list there. But 14 state enterprises did. The reason: By floating 10% to 30% of their shares, state companies can ease their dependence on bank loans without ceding any real control, while insiders make windfalls on the stock offering. Although regulators occasionally fine companies that don't disclose key data, delistings or prosecutions for governance lapses are rare. "The central government wants a healthy stock market," says finance professor Chang Chun of the China Europe International Business School in Shanghai. "But companies are owned by strong local and provincial governments, and they have more connections within the party. [Regulators] are either afraid of going after them or may not have the power to go deeper."

Misguided government policy isn't the exclusive preserve of the local party structure. Beijing is in charge of the Chinese drive to become a power in science and technology. China already boasts superbly equipped labs in everything from life sciences to nanotechnology to optics, churns out over 60,000 masters and doctoral degrees in science and technology each year, and has made big strides in military technology and manned space flight. And Chinese scientists publish an impressive number of papers in international journals.

Writing scientific papers, though, doesn't necessarily equal innovation. "China is spinning its wheels," says Zhu Jian-Gang, director of Carnegie Mellon University's electrical engineering department and an adviser to China's national optical lab in Wuhan. While government and university labs have first-rate facilities, Zhu says most of the work is unimpressive. These institutions are focused on turning technologies into money-making products rather than discovering breakthroughs. "They do a lot of research, but it isn't important," Zhu says. One problem is that promotions are too often based on seniority and connections rather than on merit. "That does not create an environment that attracts young people," he says.

REWARDING REPETITION
Another problem is that state agencies press for quick results. "The bureaucratically driven process in China creates a strong incentive to push R&D money into product development," says Anne Stevenson-Yang, a former head of the U.S. Information Technology Office in Beijing and current president of Twin Poplars, a startup focusing on incubating innovative Chinese enterprises. The result? "Companies are rewarded for replicating existing technologies."

Witness Beijing's drive to produce homegrown alternatives to technologies pioneered elsewhere. While Beijing can proudly say it has its own technologies for DVD, Wi-Fi, and superfast third-generation (3G) cellular service, the cost to Chinese companies has been high. Even though Beijing also plans on using the two global standards already in existence, regulators have delayed the launch of all 3G services because the Chinese technology is years behind schedule. That has hobbled telecom equipment makers such as Huawei Technologies and ZTE and handset producers TCL and Ningbo Bird. "The continued delay of 3G in China is hurting the whole industry," says Jing Wang, Qualcomm Inc.'s (QCOM) Asia chief. "If China had already embarked on 3G, these vendors would be more important players."

The list of shortcomings in China's economic model is long, but is it fair to expect any different? After all, China's many defenders are quick to note, the mainland has come a long way in just three decades. Its growth record is unparalleled in history, and it took the U.S. and Europe centuries before they developed modern financial systems and methods for ensuring food safety, providing pensions, and protecting the environment. "Americans tend to think China should be held to the same standards that we have today, disregarding that we had these problems ourselves in the not-too-distant past," says United Technologies Corp. (UTX) CEO George David.

But the West ultimately implemented social reforms after upheavals that led voters to elect new governments. And South Korea and Taiwan tamed crony capitalism following traumatic democratic transitions. The Chinese Communist Party, in contrast, appears to be nowhere near tolerating political change. In fact, it's clamping down on dissent.

It is just as fair, then, to ask a different question: After decades of efforts by reformers, why assume China will build the financial, legal, and administrative systems required to become a modern industrial society? The only way up is to tame the unregulated, raw self-interest that flows from Deng's historic compromise with the party and the people. That would require a legal system that doesn't let local cadres circumvent regulations, grading officials on metrics that go well beyond simple GDP growth, and capital markets that nurture and reward entrepreneurs. In short, it means getting the party out of business. At this stage, such revolutionary change seems politically impossible. So it's just as plausible that the flawed China we see today is basically what we will have a decade from now, after all.

Engardio is an international senior writer for BusinessWeek. Roberts is BusinessWeek's Beijing bureau chief. Balfour is Asia Correspondent for BusinessWeek based in Hong Kong. Einhorn is a correspondent in BusinessWeek's Hong Kong bureau .