Will China ever get rich? Only if it tackles state ownership and strengthens its legal system

At the annual meeting of China’s parliament last week, it was announced that the country would maintain its growth target at about 6.5 per cent in 2018 while targeting “high-quality growth” and containing financial risks. It seems that worries about slowing growth have receded. Chinese growth is hovering between 6.5 per cent and 7 per cent, but economists see it decelerating to closer to 6 per cent in the coming years. Will China’s growth slow so much that it never becomes a wealthy nation?

China is unusual in that strong growth has taken place while it remains a communist state governed by the Communist Party. It is therefore unsurprising that the rule of law and other market-supporting institutions, such as private property protection, are weak, as there is no independent judiciary. This gives rise to the “China paradox”, because the country has grown well despite not having a well-developed set of institutions. China’s economic growth is, therefore, in many respects both impressive and puzzling.

Indeed, one of the most complex areas of Chinese growth is the role of legal institutions. The predominant view is that market-supporting institutions, such as those which protect property rights and provide contracting security, are important for growth. China as an outlier requires a closer examination. Specifically, the reliance on relational contracting – transacting with those you trust – can help reduce reliance on the judicial system which is being gradually improved as more Chinese firms clamour for better protection of their inventions, for instance.

The role of informal institutions such as social capital, also cannot be overlooked. Entrepreneurs in China have relied on social networks, known as guanxi , to overcome the lack of well-developed legal and financial systems. The cultural proclivity towards interpersonal relationships meant that social capital played a key part in the development of self-employment and the impressive emergence of the private sector. That China would allow entrepreneurs to emerge within a communist system is, perhaps, not something Marx would have anticipated.

After reaching “middle-income status” in the early 2000s, China found that it needed to rebalance its economy to grow in a more sustainable manner. Its ability to overcome the “middle-income country trap”, whereby countries start to slow after reaching upper-middle-income levels and never become rich, depends on it. Poor countries tend to grow through exports and cheap manufacturing. Growth in a middle-income country is driven more by consumption by its own middle class, leading to a diversified economy that is not heavily reliant on exports to consumers in other countries. China has also shifted towards services so that the “factory of the world” now has a bigger services sector than manufacturing. The country is still upgrading manufacturing, expanding overseas investment and opening up its financial sector more. It is also promoting the internationalisation or global use of its currency, the renminbi.

To achieve these aims will require examining the institutional framework of the economy, including the role of state-owned enterprises and the legal system. The retention of large state-owned firms and the problematic lack of a level playing field for both foreign and domestic private firms vis-à-vis state-controlled companies raises doubts as to the efficiency of China’s markets and thus its ability to grow.