Only the rule of law can ensure sustained prosperity in China

Over the past quarter of a century, China has escaped poverty and joined the ranks of the middle-income countries. The statistics are staggering: nominal gross domestic product in US dollar terms has increased by more than 20 times, exports more than 40 times, and electricity production over eight times. China today consumes more energy than the US. The World Bank calculates that China's GDP will exceed America's this year in purchasing power parity.

The remarkable success is a combination of good policy and luck. The most important decision was shifting to a stable currency policy in 1994. Repeated devaluations before then kept the economy small at market exchange rates.

With a stable currency policy, the focus for other decisions is on efficiency to maintain competitiveness. The subsequent structural reforms, such as joining the World Trade Organisation, corporatising state-owned enterprises, privatising the housing market and building modern infrastructure, wouldn't have happened without the currency constraints.

When a country achieves a period of spectacular growth, it's not just due to good policies or a benign global economy. Society must have strong fundamental human resources to begin with. China's modernisation began a century before the reform and open-door policy of 1978. While economic development was periodically interrupted by wars and revolutions, the development of human resources continued. In the 1930s, parts of China's eastern seaboard had already caught up with developed economies.

Between 1949 and 1978, the government wiped out mass illiteracy through a national education system. It also implemented basic health care. These two achievements were critical to the subsequent economic development.

The government has been firmly in control of economic development. The lack of institutions to check excesses has fostered a mentality of taking short-cuts. A race to the bottom in behaviour has accompanied the rapid growth. Some have mistakenly seen a causality between the two. In fact, most challenges that haunt China today could have been avoided without significantly hurting growth.

Take the environment. Many are pushing the view that China's environmental degradation is a result of rapid economic growth. The purpose of such talk is to persuade people to tolerate pollution.

True, there is a trade-off between the environment and growth. But the extent of the trade-off is not even close to what China is experiencing. Unchecked greed is the main driver for China's environmental degradation. Without the rule of law, why would any business want to pay for pollution control? It is much cheaper to buy off local government officials.

Rising income inequality is also often explained away as a price of growth. It is good propaganda aimed at the masses so they will accept their unsatisfactory position in society. They are told they would be even worse off without growth. The reality is that the concentration of power at the top is the main reason for rising income inequality. China's growth is based on its labour competitiveness. Yet, the gain in wealth has hardly benefited the people who work in the factories or on construction sites. The people who play with money have come out ahead. The rapid monetary growth in a system that centres around government power has enriched the ones closest to that power.

Rapid monetary growth has been the bane of China's economic development since reforms began in 1978. Bouts of high inflation, accompanied by devaluation, triggered the political instability in the 1980s. As another bout of inflation in 1992-93 threatened more instability, macro tightening was introduced.

From printing money, the growth strategy shifted to improving efficiency. The subsequent reforms culminated with China joining the WTO, which unleashed the productivity of Chinese labour into the global economy and supported a decade of export and investment-led growth.

When China's growth took hold, the bad habit of printing money returned. The difference was that it happened as the currency came under appreciation pressure, largely due to the benefits from joining the WTO. China should have either allowed the currency to appreciate fully, or kept the peg while allowing inflation to adjust the currency value.

The actual policy was to create a slow and predictable upward trend. The "sure bet" inflamed a frenzy of hot money inflows, which led to a massive property bubble. The bubble became the main revenue source for local governments and served to enrich some people; the ones close to power, of course. It all happened at the expense of inflating away labour income and savings. That policy is responsible for today's high income-and-wealth inequality.

The current government is facing a crisis situation just like in 1993. It has to undertake structural reforms to shift the growth model towards efficiency and away from printing money. The key is to decrease government power and let the market make most decisions. This is why the anti-corruption campaign is the heart of the structural reform. It is the only way to cut government power. As long as the government maintains its anti-corruption campaign, in five years, China's economy will experience another decade of good growth, which would make it the largest in the world.

China's modernisation has been on and off for a century and a half. Whenever the environment is peaceful and government power is contained, China prospers. It reflects the fundamental competitiveness of Chinese people.

Unfortunately, the main model for getting rich in China is to take a slice from every person. This is why most rich people achieve success by cultivating guanxi (relations and connections) with government officials. It is the main reason that, whenever the economy prospers, the government expands its role in the economy.

The anti-corruption campaign is the only way to rein in government power in the absence of the rule of law. If the right institutions are not put in place, government power will expand again when the economy is healed. Such a cycle of instability is inevitable until China adopts the rule of law and checks and balances in limiting political power. When such institutions are all in place, China's per capita income will catch up with those of the advanced economies, and China's economy will be as large as those of Europe, Japan and the US combined.

Andy Xie is an independent economist