China's Prospects
In an effort to spark growth and economic prosperity in what has formerly been a stagnant economy, China has been transforming itself over the past decade through reforms in economic, political, and legal spheres. In doing so, it has achieved impressive growth and is on the track to becoming a major global economic player. While China displays huge market potential, or at the least, ever-increasing market importance on the global scale, certain indications remain that investment in China is risky business. These risk indicators include a weak rule of law, and poor system of corporate governance. With China’s recent induction into the World Trade Organization, pressure has been added to remedy these factors, and there is evidence that China is taking steps to do so. Membership, however, is also likely to bring with is significant economic shocks. These shocks, at least in the medium-term, are likely to destroy value before creating it. On balance then, while China appears to be increasing in attractiveness for investment, the magnitude of reform that is still required, combined with the unpredictable effects of its recent WTO membership, mean that, at least for now, the best decision for investors looking to China is to wait-and-see. China is a country of 1.3 billion citizens and a per-capita GDP (measured in purchasing-power-parity) of $4,400 USD. While China remains a communist state, it has been increasingly embracing the market system and free trade while maintaining the dictatorial structure of its government. China’s productivity and GDP growth slumped in the several decades of planned economy, but it has more than quadrupled in the last twenty years as China moves to an open market system. A discussion of this transition, and the corresponding economic, political and legal reforms which enabled the shift, forms a major component of this paper. The most obvious reform in the last twenty years has been the decision of China’s government to phase-in a market system to replace the planned economy which dominated throughout the mid-twentieth century. The most important consideration for China at the beginning of this transition was how to move towards free market production in an environment where there is no rule of law and correspondingly little protection from expropriation by powerful bureaucrats (used to the old way of doing things.) Yingyi Qian, an economist at the University of California, Berkeley, identifies five methods used by China in this transition which cover market, firm, and government reform. For brevity, I will touch only on the first four. First, rather than completely releasing price controls in a “single stroke” and letting the laws of supply and demand take over, a “dual-track” approach was used. This approach blended the previous planned government procurement system with free-market production by allowing for production and sale of goods in the free market outside of planned production quotas. By doing this, the potential losers (those who had benefited from the economic rents created by artificial prices and demand) were protected, and by allowing producers to benefit from the marginal profits from their extra production, incentives were created for producers to increase efficiency and boost output. The next two reforms involved the government turning over the ownership of firms to local governments so that the resulting businesses were neither state owned, nor private. This method meant that the profit from any extra output producers could manage was shared by the producer and the local community governments. Qian argues that this created an essential alignment of interests, not only for the producer to produce more, but also for local governments to foster this production and protect the firms from expropriation—a critical outcome since the rule of law was completely absent at the time, and property rights were consequently very weak. The final reform worth noting is the introduction of anonymous banking. In an autocracy, the only material constraint on the government’s taxation policy is the risk of rebellion by the poor. Perfect earnings information for all citizens would allow the government to levy a 100 percent marginal tax rate on only the rich and avoid the risk of rebellion by the poor. Obviously, such a policy would greatly discourage profit-earning and savings. Anonymous bank deposits tie the government’s hands, as it is not willing to risk revolt by taxing all citizens at 100 percent, and therefore only appropriates a fraction of aggregate savings (the maximum possible before starvation would ensue and a revolt would become likely.) In time, the planned track of the “dual-track” transitional strategy has become less and less significant because of both the rapid growth of the market track and the deliberate gradual phasing-out of the planned track.