TCS Daily


China Syndrome

By James V. DeLong - February 6, 2008 12:00 AM

Two recent books strongly advise the U.S. investor to bet part of his/her portfolio on the continuing development of China.

Co-author of From Wall Street to the Great Wall: How Investors Can Profit from China's Booming Economy, is Burton Malkiel, Princeton professor and author of A Random Walk Down Wall Street, which may be the most successful investment book ever published. Jim Rogers, a rather more flamboyant longtime investment guru, wrote A Bull in a China: Investing Profitably in the World's Greatest Market.

These are serious analysts, very far from the race-track-tout flavor of mass mailings and Internet spam, and they deserve serious attention.

Both contain a bit of history, recount the current determination of the Chinese government to nurture development, examine various sectors of the economy, and provide rational arguments for their optimism. Malkiel and company delve somewhat deeper, and include a list of risk factors that reads like the cautions in a U.S. Form 10K. Malkiel likes funds; Rogers lists a number of individual companies, though he eschews actual recommendations.

Both books have an odd gap. Neither pays much heed to the political side of the situation. They are content to note that China's leadership is committed to economic growth and to opening the nation to investment and trade, that it has accepted the need for markets, and that this creates opportunities. They do not delve into the meaning of "socialism with Chinese characteristics," even though understanding its nature would seem crucial to any assessment of the long term economic prospects.

Quite a few other observers, who do delve into the political issues, are more saturnine, highlighting China's problems of wealth and income disparities, ethnic conflict, rural land tensions, nepotism (the "princeling" children of important cadres), corruption, and pollution. They point to the tens of thousands of demonstrations that occur each year and raise possibilities of descent into chaos. For a useful survey of these arguments, see the unsentimental look by Rowan Callick, "The China Model," in The American (Nov/Dec 2007), and for more detail check out China Fantasy: How Our Leaders Explain Away Chinese Repression; China: Fragile Superpower: How China's Internal Politics Could Derail Its Peaceful Rise; or The Writing on the Wall: Why We Must Embrace China as a Partner or Face It as an Enemy (all available on Amazon)..

So the question must be asked, is the political system stable enough for the nation to carry through on its development efforts?

Here, one must make a preliminary choice. Callick notes that the China model of development is attracting the attention of the kleptocrats of the world because it raises the possibility that: "]R]ulers can gain access to immense wealth through creaming off rents while at the same time their broader populations become content, and probably supportive, because their living standards are also leaping ahead."

If one thinks this is what the China's leaders are aiming at, then one should flee. Leaving aside any moral objections, this is to work out as a long-term investment. Callick finishes his thought by adding: "This formula also entails hard work, application, policy consistency, and administrative capacity spread through the country." These are not the strengths of kleptocracy.

So, for an investor to be interested in China, he must start by assuming the Chinese leaders are people of good faith, in the sense that they want to build and create, to improve the lot of their people and their nation. This does not mean they are saints, but that they are people of morality who, while willing to do well, also want to do good. Their ethics are at least as high as those of U.S. or European politicians (not a high bar, admittedly).

Given this assumption, how does the situation look to them? To understand their thinking, several initial points are crucial.

* First, to the hardline leftist, the importance of economic development ranks far behind the maintenance of the moral purity of the communist vision. If the people cannot make the communist system of "from each . . . to each" work, then they deserve to suffer until they become sufficiently enlightened to make it work.

* Second, democracy is an important value, but only in the context of structure. There is no need to recapitulate the long history of leftist political thought, with its concepts of "false consciousness" and "vanguard of the party," but Communism is a quasi-religion that must be interpreted by the priest-equivalents, not voted on by 900 million peasants. So democracy must be limited to the enlightened, and to a limited set of issues. It cannot be allowed to challenge the fundamental direction chosen by the party. The "vanguard" language is significant in the most recent Constitution of the Communist Party, as adopted in October 2007.

* Third, the Chinese do not accept the Western assumption that democracy, free markets, and economic development are all part of a single Gestalt. They would point out that economic take-off in the West occurred under much less democratic regimes than exist today, and that there is a serious possibility - perhaps, in their eyes, a certainty -- that democracy leads to economic stasis over a not-too-long period. Advocating Chinese democracy, especially the sentimental versions depicted in the U.S. mass media, will be viewed as an attempt to destabilize China and inhibit its development. (The Chinese are too cynical to believe that we really are as superficial in our thinking about democracy as we appear to be.)

* Fourth, order is a virtue. Americans are in awe of our own Civil War, which killed 600,000 people in the 1860s. During the same period, the Taiping Rebellion killed 30 million. WWII, the Communist Revolution, the Great Leap, the Cultural Revolution, and Tienanman Square are well within living memory.

The genius of Deng Xaioping, the "paramount leader" from 1978 to 1992 and one of the critical figures of the 20th Century, lay in his ability to deal with the first of these points, the insistence on the moral purity of the communist vision. He established the principle that poverty is not a virtue and that there is a time dimension to the vision. It will ultimately be achieved, but that day can and should be postponed for the sake of fostering the economic development that will in the end make everyone rich.

He gave Communists permission to learn from history and experience. In particular, they are allowed, indeed, compelled, to make use of the efficiencies of markets in allocating resources, and to recognize the inefficiencies of state-owned enterprises that do not respond to the market, if this is what is required to promote the overall economic development of the Chinese people.

This was a major shift, because allowing the market to allocate resources has a cascade of implications for the freedom and the ownership of both labor and capital, and for determining who gets to keep the rewards. Markets don't work unless rewards are real, so once the value of the market is acknowledged, there is no way to avoid traveling at least some miles down "the capitalist road."

No other communist party made this transition. All remained stuck in economic retrogression, prisoners of the ideology. So it is not surprising that many Chinese have never been entirely convinced by Deng's ideas. Deng Xaioping's son was permanently paralyzed as a result of being shoved out of a second story window by the Red Guard, and he himself survived at least seven assassination attempts, says Wikipedia.

Not only was there was opposition at the start, but since Deng there has been a continuing dialectic. Subsequent party congresses have tinkered with the ideology, by adopting the "Three Representations" of 2002 (a further step down the capitalist road) and the Harmonious Society and Scientific Development Concepts of 2007, a step back in the name of non-developmental values. The October 2007 Party Congress named two possible future leaders, representing the two wings of thought.

There is even discussion of democracy, though the term must be interpreted warily. It means greater democracy within the 71 million members of the Communist Party, and more openness in recruiting for the Party, not any transition to universal suffrage and parliamentary democracy. For the ruling class, political legitimacy is conferred by adherence to right purposes as expounded by the Party. The thoughts of the mostly-agricultural peasant 1.2+ billion Chinese who are not Party members are not solicited.

For the outside investor assessing these complexities, reading the Party Constitution is instructive. The Party "must persist in taking economic development as the central task, making all other work subordinate . . . " This stage of building socialism must last at least a century. "The Party must respect work, knowledge, talent and creation and ensure that development is for the people, by the people, and with the people sharing its fruits." A variety of modes of distribution may co-exist, and it is all right for "some areas and some people to become rich first."

These are fine statements, and extraordinarily important, because they represent the ruling class's (the Party's) internal communications as to the basis of its political legitimacy, its right to rule. For a ruling class to stake its legitimacy not on birth, or divine ordinance, or race, or raw military power, but on the ability to produce economic growth for the masses is an unusual event in history, perhaps unparalleled.

But there is another, and crucial, question that the Party Constitution does not answer: What is the economic function of the 71 million Party members? Exactly how do they encourage development? Is this a system in which managers, property owners, and government officials are also Party members, or are the Party members inserted into the various hierarchies as political commissars, supernumeraries charged with enforcing right-thinking? And are the princelings entrepreneurs or parasites?

In fact, as a forthcoming book The New Rich in China makes clear, the categories of Party member and new-class professional, manager, or entrepreneur are the same thing. It is not a commissar system, in which political watchdogs control (or meddle with) an untrustworthy bourgeoisie. Party membership is a status added to the economic function of manager, worker, civil servant, or government official, and probably necessary if one is to thrive in one of these roles.

This switch away from a commissar system is crucial. If the Party is integrated into the hierarchies that have genuine economic functions, and do not stand as outside kibitzers, then the Party becomes, in principle, a tool for combating the corruption, self-dealing, and abuse of authority that constantly threaten to overwhelm the forces of development.

Whether this possibility "in principle" will also be "in practice" is an interesting question. China skeptics take the view that the Party is, in essence, a criminal gang that institutionalizes corruption, self-dealing, and abuse of authority. This is an improbable interpretation, given the extent to which the Party is staking its legitimacy on economic development. As rapper Will Smith recently noted, no one, not even Hitler, gets up in the morning and asks "what evil and corrupt deed can I do today?" Smith took some hits for this, but he is a more astute observer of human affairs than his critics. People require some structure of self-justification, and, when nobler ideals fail, one of the most common is, "I am caught in a Hobbesian war of all-against-all, so I must get what I can." Chinese thinkers may not be big readers of Hobbes, but a fundamental task of their leaders is to counteract this psychology, and to discipline those who succumb to it.

For example, analyses of the impact of corruption in China and its potential to derail development are indeed disturbing. But much of what is covered by this term seems more nuanced than the English word "corruption" would allow; it is guanxi, a network of relationships which have a moral claim on an individual, so that channeling business to a connection at the expense of your company is not as beyond the pale as a U.S. citizen would regard it. As Indonesian President Suharto once told the head of the World Bank, "what you regard as corruption in your part of the world, we regard as family values."

Given this problem, one of the tasks of the leadership is to use the Party as missionaries in a struggle to reassert the primacy of obligations to institutions, including the nation, over the obligations of guanxi, in the name of the moral imperative of development.

The reverse side of favoritism to friends is bad treatment of strangers. Assessments of economic development often identify as a major problem the lack of trust-at-a-distance that is crucial to efficient commercial society.

In the West, the development of this trust was not automatic, and still is not. It needed institutions of enforcement. In the early 20th Century, for example, having a Morgan director on one's corporate board was worth an extra 30% in stock value. So, again, it would be logical for China's leaders to realize that a disciplined Communist Party can perform an equivalent function of guarantor of probity, and creator of trust. Old J.P., who had a sense of humor, might have appreciated the irony.

One can question whether the religious fervor of the language of the Party Constitution can be carried out in practice, but to deny its power is to embrace what British author and political observer C. P. Snow called "the cynicism of the unworldly." Nor is such ethical reorientation quite as bootless an enterprise as it might appear off-hand. Hutton's The Writing on the Wall notes that making the Party the enforcer of a new and commercial-friendly morality can tap into the deep Confucian roots of Chinese society. In this context, the simultaneous reverence for both Mao and markets makes sense; both involved recovering the lost Confucian ethos.

Conclusions? On balance, it seems that Malkiel and Rogers and their colleagues have a valid case to be optimistic about China. But the investor should recognize that he/she is betting a lot on the Communist Party, and that he/she is regarded in utilitarian terms, as a useful instrument in the long-term construction of a communist state, though the exact end-state is unspecified. There is no particular moral imperative of respect for property rights behind the government's willingness to reward investors, and if the political winds were to shift back to a hard line, the expropriations would proceed without a qualm. China may be willing to allow some to become rich faster than others in name of long-term development, but this logic does not extend to allowing outside investors to become rich if this is perceived as occurring at the expense of Chinese workers.

The utilitarian motivations are strong - rapid development requires foreign capital so as to avoid the need to wring a surplus from low-productivity agriculture, outside investment can bring significant expertise with it, and foreign investors are effective hostages against hostile actions by the U.S. government. But ideology is not rational, so nothing is guaranteed.

Nonetheless, it is a great story. The optimistic view is that the potential for economic development that is enabled by current technical knowledge combined with innate human creativity is so great that it will occur, unless governments manage to screw it up, and that the Chinese government is showing considerable ingenuity in avoiding this. It also needs and deserves all the help we can give it. As UCal economist J. B. DeLong comments:

"It is very important for the late-twenty first century national security of the United States that, fifty years from now, schoolchildren in India and China be taught that America is their friend that did all it could to help them become rich. It is very important that they not be taught that America wishes that they were still barefoot and powerless, and has done all it can to keep them so."

This is Part I of a two-part article. Part II will turn the question around, looking at whether the Chinese should accept the political risks of investing in the U.S.

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