Curious Capitalist

China’s Chicken-and-Egg Problem: What Comes First, Wealth or Freedom?

There are many questionable bits of conventional wisdom about China, but one of the most persistent is this: The Middle Kingdom must get rich before it becomes free.

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This article is the third in Foroohar’s series on Chinese business developments and their effects on the global economy; find the rest of the series here.

There are many questionable bits of conventional wisdom about China, but one of the most persistent is this: The Middle Kingdom must get rich before it becomes free. The notion is that as China develops into a middle-class nation, it will eventually come to adopt various aspects of Western-style liberal democracy, including better and more transparent governance, a stronger and more independent judiciary system, and a broader array of protected civil rights. But as I have been traveling in China for the last two weeks, I’ve heard an interesting twist on the conventional wisdom: That if China is to become richer, it needs to become freer – and soon.

The argument centers around two factors. First, China is already a middle-income nation. Per capita income in China is now above $5,000 per year, and many coastal areas are double that (Shanghai and Beijing are above $17,000). This is a range that’s often defined as an international middle class (keep in mind that the cost of living in China is far below what it is in the US). Indeed, many Chinese are far wealthier: There are over one million millionaires in China, and many Chinese can afford all the trappings of Western yuppies. Cities like Shanghai, Beijing, Wuhan, and Chengdu are full of upscale children’s boutiques, teeth whitening clinics, bustling Starbucks selling lattes at U.S. prices, and pricy Kaplan-style test prep centers designed to get Chinese teens into American and British boarding schools.

At the same time, China’s economy is changing. It’s less and less about cheap exports, and more about complex manufacturing, nascent services, and real estate. According to Andy Rothman, a highly respected macroeconomist at Shanghai-based CLSA bank, a sclerotic state-owned sector means that private enterprises now represent nearly 100% of new job creation in China. And private enterprises require more robust contract law to survive. “You’ve got an economy that’s increasingly driven by enterprise, intellectual property, and real estate, and yet you have no rule of law,” says Rothman, referring to the fact that the judiciary system is ineffectual and rulings tend to be erratic. As the economy slows, as it is now and will continue to do as China moves up the economic food chain, the risk of legal conflicts grows. State data shows that between 2008 and 2012, civil, commercial, and maritime lawsuits involving foreign parties, often in dispute over things like intellectual property, rose by 57%.

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Even when contracts are defended, penalties are minor. John Ford, general manager of Wuhan based Diamond Power, a boiler parts company that is a Chinese subsidiary of an American firm, told me that although his company contends with numerous local copycats, they haven’t brought a suit because they are nearly impossible to win, and the cash payoff is “chicken feed.” The local government in Wuhan wants Diamond to make more advanced equipment there, but Ford says his parent company is “wary” about IP theft. “China needs a better system to deal with this,” says Rothman, or investment will be dampened. Experts from places like the World Bank and the Shanghai Institute for International Affairs agree. Ideally, the Communist Party would be subservient to the country’s legal system, something that the Chinese constitution actually calls for. But, say Rothman and others, you probably won’t see that kind of shift in the next ten years, a drag that will continue to be a headwind to China’s economic rebalancing.

What you may see much sooner is civil rights reform, or more particularly reform of China’s “hukou” system that divides citizens into two unequal classes – rural dwellers, and urban ones. Since the 1950s, China has prevented rural people who migrate to the cities for work to receive social benefits like healthcare, pensions, and education. They can only receive such benefits if they go back to their villages – and the social services on offer in the countryside are a fraction of those enjoyed in the city. Migrants also have no urban legal rights; they can’t send their children to local schools; they make a fraction of what legal residents do; and can’t buy property in cities, which represents 60% of all Chinese individual wealth. As the World Bank 2030 report on China recently observed, the hukou system has created huge inequities—financial, social, and educational—between legal urban dwellers, and the 230 million unofficial migrants who now make up 17% of the urban population.

Earlier this month, the Chinese ministry of public security announced that it was working on new guidelines for hukou reform. The impetus for change is both political and economic. For the first time in the history of modern China, there’s an underclass of illegal city dwellers (one the size of Indonesia) that are not doing better year to year – and this presents a huge social stability problem for the government. “When you have a group of people who are trapped in poverty, that’s not a good thing in a democracy; but in an autocracy, it’s a recipe for really bad stuff,” says Rothman. Indeed, the Chinese Communist Party leadership was quite unsettled by the Arab Spring, which has become an impetus for moving ahead with hukou reform now, according to Chinese foreign policy experts. The plan is to slowly roll out new benefits and legal status for some migrants, city by city. But Rothman believes that once things start the process will move quickly, as migrants around China realize what’s happening in other cities and the government is forced to move to prevent mass relocation.

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The cost for reforming hukou with a starting group of 20 million migrants would be about $320 billion (roughly $16,000 per worker, with costs split in thirds between the government, companies, and workers). But Gan Li, the Chinese economist who directs the state’s household income survey, says that increased government and employer transfers would bolster Chinese urban income by 29%, which would boost consumption and help create the kind of consumer society China needs to grow. Indeed, millions of people would suddenly be able to buy property and begin buying consumer goods for those homes. (Rural residents and migrants spend only 45% of what legal urban residents do on durable goods.)

Hukou reform would also help increase the size and quality of the Chinese workforce—migrant workers typically have several years less schooling and are less productive than legal contract workers. A survey of multinational companies recently found that while going from temporary migrant workers to contracted legal ones upped costs by 4.5%, output per worker rose by 27%.

Of course, the economic benefits of such legal reforms can snowball in unexpected ways. Hukou reform shines a spotlight on China’s overall property rights system, in which all land is owned by the state. When the state decides to take that land for development, rural residents are often paid far less than market value. Lawyers in Tsinghua University law school in Beijing say that land dispute cases are on the increase, putting pressure on the Party to move to a truly market oriented system of property ownership – a step that some economists believe could unlock over a trillion dollars of wealth in the Chinese economy.

For the Middle Kingdom, freedom itself may bring a Big Bang of prosperity – but only if the Party is resilient enough to evolve. Loosening its grip enough to create true rule of law in China will be the chief challenge — and economic opportunity — for the Chinese government in the coming decades.