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Broken China


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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.

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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.

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 (see BusinessWeek.com, 7/13/07, "China: Due for a Reality Check?").

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.

Join a debate about China's economy.

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


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