China’s Corruption Paradox: Curse or Blessing?

Imagine an economy in which the politically elite are untouchable, entire networks of people from security forces to media stations under their control. Bribery and blackmail are daily occurrences and allow for a pathway to even greater power and influence. This scenario might seem farfetched, but it actually describes a common occurrence in China. China’s strength as an exporting and manufacturing power is well known by the international economic community, but corrupt activity runs rampant behind the scenes of the world’s second largest economy.

Corruption, defined as misuse of power by public officials for private gain, is a problem throughout the world, not just in China. The definition seems straightforward, but corruption can take on various forms and is difficult to detect and measure. Corrupt activity can occur in several forms, sometimes officials directly steal from government tax revenue or even privately sell state property. These perpetrators often target the private market and real estate through means of extortion. Another form of corruption is bribery and trading favors. Because of the secrecy of an under-the-table deal, it is difficult to identify and even more difficult to prosecute the alleged parties, especially when the deal involves high-ranking officials since they usually will not incriminate each other. In addition, officials with enough influence can further take advantage of their authority to protect themselves through bribery or blackmail. While both parties benefit from this type of transaction, the former is likely to have a much more harmful effect by rendering property rights insecure and encouraging capital flight, resulting in the weakening of the formal economy and its core structure.

The relationship between corruption and economic growth has been broadly studied by academics and policymakers, who note that many countries with poor economic growth suffer from widespread corruption. This is true, but a variety of factors affect how strong the negative relationship between growth and corruption is. Studies show this relationship holds for countries with a high degree of financial openness but rarely for those with a lesser degree. Quality of institutions plays a role as well, with corruption being detrimental to growth in countries with high-quality political institutions. The results of a 2010 study by Mendez and Sepulveda show that the level of corruption that maximizes growth is greater than zero; in other words, corruption is actually beneficial to growth at low levels of economic development. These results seem to contradict our intuitive understanding of corruption, as advanced countries suffer more from corruption than developing countries.

China, as well as several other East Asian countries such as South Korea and Indonesia, experienced high levels of growth despite high levels of corruption. Between 1980 and 2010, per capita GDP increased thirteen- fold, according to the IMF. China had the second-largest gain in per capita GDP during this period, outdone only by Guinea, which achieved wealth as a result of oil only to lose it to an even more corrupt system than China’s. This brings to mind several questions: Why has China been an exception in terms of the negative relationship between growth and corruption? What effect is corruption having on China’s economy today? Would less corruption stimulate even further growth?

China’s economy is described as a socialist market economy, a form of state capitalism. A socialist economy is distinguished from a capitalist economy by the extent of state control over its assets. These economic assets or wealth, consist of both human and nonhuman assets. Nonhuman assets include physical assets, intangible assets, and enterprises. Because all assets generate income, they are inherently valuable. Under capitalism, nonhuman assets are mostly privately owned while very limited restrictions exist for human assets. Under socialism, nonhuman assets are largely owned by the state while human assets are subject to more restrictions. Visitors to China may experience poor service as a result of the structure of the economy. Stores, hotels, and airports are all government owned. The incentive to provide better service is lessened because people are managing assets in the name of the state, which advocates maximum economic gain for minimal cost. In a situation of authority, there is a high chance of abuse of power. For example, a traveler at an airport security check might not be allowed to pass unless he offers something in return, often an under-the-table payment. Others might use their power to grant privileges to friends and family, and providing excellent service to only those who can offer something in return. This type of behavior is detrimental to the economy in several ways. First is the lack of labor incentive due to insufficient compensation for workers’ additional effort. Investment in human capital is also discouraged, because younger generations do not look forward to future rewards as a result of success, thus investing less in their own education. Overall, the quality of life of Chinese citizens is lower as a result of these restrictions and inability to advance into higher positions.

Several factors explain how China was able to sustain high growth despite the presence of corruption. First, corruption was not a serious impediment to the initial phases of growth. Second, the peak period of corruption coincided with large-scale transfers of value from the state to the emerging market economy as mentioned above. Finally, China’s anti-corruption efforts managed to control corruption by the early 2000s. The first two factors combined to create a situation where higher growth led to an increase of corrupt activity. At that stage of development, corruption was kept at a level not exceedingly high for a developing economy.

China’s reform involved a transition from a planned economy towards a market-oriented economy in 1978, when Deng Xiaoping took control of the Communist Party. During this period, China experienced a marked worsening of corruption as officials manipulated the allocation of valuable resources in exchange for bribes valued at hundreds-of-thousands of Chinese renminbi. More senior officials became involved because they were in a position to sell assets that would yield profits equal to the difference between the nominal value and their actual market value. Much of the corruption that emerged during the 1990s can be linked to transactions transferring assets from the state to the market. The nature of China’s economic reform created conditions in which some corruption was compatible with rapid growth. In the early stages of reform, the control over the agricultural sector transferred production to individual households. During this period, farmers had incentives to pay bribes to secure productive plots while local officials attempted to leverage “considerations” in return for providing farmers with access to state provided goods such as fertilizer, pesticides, and fuel. Because these transfers also spurred rapid growth, the result was a concurrent worsening of corruption and acceleration of growth. This observation does not indicate that corruption was beneficial to the economy. Rising corruption imposed real and marginal costs. Inefficiency and misallocation were problematic because they led to losses that could have been realized from future investment.

Rapid growth also created a high demand for capital. During the time of reform, China lacked a developed capital market, meaning government agencies were the main sources of investment. Most government agencies either controlled capital stock or had accumulated substantial funds for offering illicit loans at higher interest rates than those of regular banks. State-owned enterprises often profited from arbitrage borrowing by re-lending to entrepreneurs who could not obtain bank loans. The profits generated by reform and the demand for capital thus created further opportunities for corrupt officials to capitalize on. Some corruption problems are a result of the incomplete nature of the reforms and their inconsistent application in practice. Property rights, legitimate business practices, and other basic elements of market economics remain poorly defined. Despite the shift away from a planned economy, the state and its bureaucrats still remain influential. Reform and growth have failed to create legitimate channels of access between bureaucrats and entrepreneurs with a lack of distinction between those roles.

China also experienced major expansion of infrastructure since the reform period, spending trillions on new projects. Public works contracting is a major source of corruption worldwide. The development of China’s high-speed rail system for example, has resulted in numerous cases of corruption in which China’s Minister of Railways and deputy chief engineer both allegedly embezzled millions from. China’s surge in corruption can be attributed to other factors as well. China entered the reform era with a limited capability to fight corruption and without a functioning judicial system.

China’s business culture also relates strongly to the reasons for corruption. New businesses frequently were founded on questionable foundations, often through connections with government officials being paid for favors. This type of environment eventually was seen as the norm as it continued to spread, creating a culture of corruption where a bribe payment was expected to secure benefits or to influence the authorities to look the other way. With corruption becoming a part of everyday life, it became even more difficult to point out the unlawful.

The first attempts at combating corruption also played a role. As noted earlier, corruption becomes most destructive when state institutions simply become fronts for illicit activity. Action taken by the state prevented such a transformation in China, although this did not solve the problem. The result was a dynamic where the efforts undertook were minimally sufficient in keeping corruption below extremes levels. Recent efforts seem to be much more successful. Since Xi Jinping became general secretary of the Communist Party in 2012, he has launched China’s biggest anti-corruption campaign since 1949. The numbers are astounding: 63,000 party officials have been investigated and punished for corruption including 30 senior members with nearly 70 officials committed suicide. The campaign reached its peak with the formal investigation of one of the most powerful men in China: Zhou Yongkang, former domestic security chief and member of China’s standing committee. Zhou was once considered untouchable because he oversaw the police, courts, and intelligence agencies. The campaign shows that no one is exempt, even those in his own party, and the effects are being felt throughout several sectors of the economy. Since the CPC introduced a number of anti-graft and anti-extravagance measures in 2012, the luxury goods market has suffered the most, which includes high-end retail, catering, hotels, and the travel industry.

When the economy faltered earlier this year, one explanation was that officials were reluctant to approve investment projects, not wanting to risk being accused of taking bribes. Some executives with state-owned enterprises do not want to travel abroad because they are afraid that enemies will portray such trips as evidence of extravagance. After rising strongly for a decade, foreign direct investment by Chinese companies fell by 5% in the first six months of the year. Despite the talk that the anti-corruption effort is hurting the economy, businesses have found ways to adapt to the changing market. Officials are staying away from private clubs and five-star hotels, which have downgraded themselves to four stars to appeal more to the general public.

Many economists are now hesitant to support the case that corruption is beneficial. At best, corruption may generate some economic activity in the short-term but will fail to sustain long-term growth as corrupt officials will pursue higher and more frequent payments. In addition, corruption deters private investment, misallocates resources and generates social grievances as conventionally believed. In the past, China’s anti-graft campaigns ultimately improved growth. Investigations in Beijing in 1995 and in Xiamen in 1999 slowed growth briefly but recovered quickly. Throughout China, areas opposed to corruption tended to have higher incomes than those that did not. Furthermore, any decrease in consumption as a result of a decline in corruption will not hurt the economy. Tax dollars returning to public projects should lead to improved infrastructure and public services as well as generate jobs. This would be beneficial in the long-run, restoring confidence in the economy and laying the groundwork for more extensive reform.

Although the results of Xi’s campaign are evident, only systematic legal and political reform can yield long term results. Going forward, Xi must focus on such reform, strengthening institutions such as the judicial system and seeking more transparency regarding the management of tax dollars and state assets, otherwise a new wave of corruption will inevitably return and reverse the achievements China has seen so far.

ANN Chinese Corruption