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?

The answer to the question of whether one-fifth of humanity will become prosperous will transform not only the livelihoods of people in China, but also the world economy. But is it possible for a communist country to become rich? Although China has veered far from its Marxist roots, there are communal principles derived from Karl Marx, such as elements of communal property and state ownership, that still permeate the economy. China would be the first mixed economy to become affluent.

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.

From Made in China to Created in China: how nation turned itself from world’s sweatshop to global innovator in just one decade

There’s also the issue of financial stability. All major economies experience a crisis eventually. We know from past experience that an economic crisis, depending on the causes, could trigger a long-lasting downturn. Marx would view this as inevitable in a capitalist economy. In China, a financial crisis linked to too much debt or some other issue in its banking system would not be surprising. Estimates of total Chinese debt by the Bank for International Settlements and others place it around 260 per cent of gross domestic product, similar to Europe and the US. But a key difference is the large amount of corporate debt in China, which is more worrying than government debt if there is a risk of large-scale bankruptcies that could bring down the banking system. And part of that debt is owed to the shadow banking system, where lending is done outside the formal banks. Shadow banking debt isn’t measured accurately, so the overall level of Chinese debt is a concern.

The growth of shadow banking is linked to the Chinese government not introducing sufficient competition into the state-owned banking system. A rapidly growing economy, powered increasingly by private entrepreneurs, requires credit. As private firms sought funds that the formal banking system, which predominantly lent to state-owned firms, was reluctant to provide, unlicenced lending grew. Progress in reforming the state-owned banks that dominate China’s financial system is slow, owing to the powerful vested interests that benefit from running state-owned banks. Here, the communal property system hampers the growth of the marketised economy, and yet reform is difficult in a communist regime.

Evolution, not revolution, is the key to a fair grade of China’s report card on economic reforms

How ‘Communist’ China has embraced capitalism but remains Leninist at heart

So, can China grow rich? It will require addressing some key challenges related to its communist political system and the partial retention of state ownership.

China’s transformation into a largely market-based economy, still ruled politically by a communist party, would not have been foreseen by Marx, for whom communism and capitalism could not coexist. Marx might have been intrigued by the continuation of the communist political system governing an economy that shares challenges such as inequality with the most capitalistic of economies, the US. If China overcomes its challenges and becomes rich under capitalism, then perhaps Marxists might have to reconsider the role that his principles played in guiding communist China – because in Marx’s theory, after capitalism takes hold, there is always scope for a worker rebellion and revolution in the future.

Linda Yueh is Adjunct Professor of Economics at the London Business School and author of The Great Economists: How Their Ideas Can Help Us Today