CLAREMONT, CALIFORNIA - China's current economic slowdown has no shortage of causes: Europe's financial turmoil, sputtering recovery in the United States, and weak domestic investment growth, to name the most commonly cited factors. Since exports and investment account, respectively, for 30 per cent and 40 per cent of China's GDP growth, its economy is particularly vulnerable to weakening external demand and accumulation of non-performing loans caused by excessive and wasteful spending on fixed assets.
But China's vulnerability to these factors, as serious as they are, is symptomatic of deeper institutional problems. Until these underlying constraints are addressed, talk of a new consumption-based growth model for China, reflected in the government's recently approved 12th Five-Year Plan, can be no more than lip service.
After all, China's major trading partners, international financial institutions such as the World Bank and the International Monetary Fund, and senior Chinese officials themselves have long recognised the structural vulnerabilities caused by excessive investment and low household consumption. And, for nearly a decade, China has been urged to undertake reforms to redress these economic patterns, which have undermined the welfare of ordinary Chinese and strained the global trading system.
The best-known feature of China's macroeconomic imbalances is heavy dependence on exports for growth, which is typically attributed to weak domestic demand: as a middle-income country, China lacks the purchasing power to consume the goods that it produces. With nearly unlimited access to advanced-country markets, China can tap into global external demand and raise its GDP growth potential, as it has done for the past two decades.
If this view is right, the solution is straightforward: China can correct its imbalances by increasing its citizens' incomes (by cutting taxes, raising wages, or increasing social spending), so that they can consume more, thereby reducing the economy's dependence on exports. Indeed, nearly all mainstream economists prescribe this approach for China.
But there is another explanation for China's excessive export dependence, one that has more to do with the country's poor political and economic institutions. Specifically, export dependence partly reflects the high degree of difficulty of doing business in China. Official corruption, insecure property rights, stifling regulatory restraints, weak payment discipline, poor logistics and distribution, widespread counterfeiting, and vulnerability to other forms of intellectual-property theft: all of these obstacles increase transaction costs and make it difficult for entrepreneurs to thrive in domestic markets.
By contrast, if China's private firms sell to Western multinationals, such as Wal-Mart, Target, or Home Depot, they do not have to worry about getting paid. They can avoid all of the headaches that they would have encountered at home, because well-established economic institutions and business practices in their export markets protect their interests and greatly reduce transaction costs.
The Chinese economy's institutional weakness is reflected in international survey data. The World Bank publishes an annual review of 'the ease of doing business' for 183 countries and sub-national units. In its June 2011 survey, China was ranked 91st, behind Mongolia, Albania, and Belarus. It is particularly difficult to start a business in China (151st), pay taxes (122nd), obtain construction permits (179th), and get electricity (115th).
Faced with such a hostile environment, Chinese private entrepreneurs have been forced to engage in 'institutional arbitrage' - taking advantage of efficient Western economic institutions to expand their business (most export-oriented businesses are owned by private entrepreneurs and foreign firms).
Unfortunately, as China has already claimed a large share of the world's merchandise exports (10.4 per cent in 2010) and economic stagnation in the West is constraining external demand, this strategy can no longer work. But reorienting their businesses toward the Chinese domestic market requires far more than government policies that put more money in consumers' pockets.
In order to enjoy the same low transaction costs that they have in exporting, China's entrepreneurs need a much better business environment: an effective legal system, a sound regulatory framework, a government that protects their brands by fighting intellectual-property theft, dependable logistics and distribution networks, and a graft-resistant bureaucracy.
China cannot create such an environment quickly. In essence, the Chinese government must transform a predatory state into a nurturing one, and treat private entrepreneurs as creators of wealth rather than targets of extraction. In nearly all other countries, such a transformation was accomplished by establishing the rule of law and/or moving from autocracy to democracy.
The impossibility of sustaining growth in the absence of the rule of law and political accountability presents the Chinese Communist Party with an existential dilemma. Ever since it crushed the pro-democracy movement in Tiananmen Square in 1989, the party has vowed not to surrender its political monopoly. The investment boom and the globalisation dividend of the last two decades allowed the Party to have its cake and eat it - maintaining its rule on the basis of economic prosperity, while failing to establish the institutions critical to sustaining such prosperity. Today, this is no longer possible.
So in a sense, the Chinese bubble - as much an intellectual and political bubble as an economic one - has burst. As China's economic deceleration exposes its structural vulnerabilities and flawed policies, the much-hyped notion of 'Chinese exceptionalism' - that China can continue to grow without the rule of law and the other essential institutions that a modern market economy presupposes - is proving to be nothing but a delusion.
Pei Minxin is Professor of Government at Claremont McKenna College.