In his Independence day speech this year, the Prime Minister urged States to compete with each other to attract investors. In sharp contrast, extreme subnational economic competition seems to have run its course in China. Here is why decentralisation, once celebrated as a reason for China’s economic miracle, has turned counter-productive.
Unlike India, where city-level governments account for less than 3% of total government spending, a staggering 51% of government spending in China happens at sub-provincial levels. Local governments also have a much broader qualitative mandate. They are almost exclusively responsible for unemployment insurance and pensions, subjects Indians generally associate with the national government.
Yet, China’s extreme decentralisation does not make it a federal country. A key feature of a federal system is that higher-level governments cannot extinguish the powers given to lower-level governments, as the Constitution protects them. No such provision exists in China’s Party-state system. After Deng Xiaoping’s Southern Tour caused local governments to go on a spending spree, the central government severely and immediately restricted their ability to raise money through the Tax-Sharing Reform of 1994.
Overcapacity is structural
Local governments had to find a way out. Since economic growth was an important determinant of local leaders’ political prospects, they started prioritising industrial construction over the provision of public services. They offered industrial land at deep discounts compared to residential land in the hope that industrial outputs would increase regional economic growth and also become a source for future local tax revenues. Local governments attracted investors with attractive land rights. Firms accepted the offer, churned out goods at low rates because of cost advantages, and exported to the world.
This investment-led model is structurally prone to overcapacity. This model of competitive sub-national growth is akin to a car having two accelerators and no brakes. The arrangement worked well till the Hu Jintao period. The central leadership set broad priorities and targets while local governments experimented and competed. The process of crossing the river while feeling the stones created tremendous wealth, while also generating structural overcapacity, wasteful investment, and loss-making entities.
The overall trend remained net positive for two reasons. First, the directives were broad enough for local governments to try different ways to achieve growth or reform goals. For instance, Guangdong interpreted the central goal of economic opening by experimenting with special economic zones. Other regions were free to follow alternate models. Likewise, the central leadership permitted local innovations in the housing sector, rather than imposing a particular solution. This policy innovation process was locally determined and not micromanaged by the centre.
Second, a salubrious geopolitical climate was crucial. Foreign markets were willing and able to absorb China’s ever-increasing capacity. China’s steel sector’s expansion is a case in point. Starting from the turn of the millennium, within six years, China went from being a net steel importer to the largest steel manufacturer and a net exporter. By the beginning of the 2010s, tackling overcapacity in the steel sector had become a prominent policy objective. While many Chinese companies failed along the way, several rode this wave, generating tremendous value for employees and the government.
The car encounters a slope
However, this model began to reach a tipping point around the time Xi Jinping came to power. Researchers at the National Development and Reform Commission (NDRC) in 2014 estimated that half of all investment between 2009 and 2013 was “ineffective”, amounting to a waste of nearly $6.9 trillion. Mr. Xi’s solution to this predicament was to strengthen central control and establish traffic lights to direct state and private capital in desirable domains.
Since then, central directives have become narrower. The desire for self-sufficiency has further resulted in them focusing on specific product lines. For example, the drive to localise the entire supply chain for semiconductors is divorced from market-based demand and the comparative advantages of the Chinese industry. The “Big Fund” began in 2014 intending to build a self-sufficient semiconductor industry. Drawing on this, many local governments indiscriminately poured money into chip-making firms. Ten years later, China has not mastered the production of advanced chips. Nevertheless, many firms continue to milk local governments for funding. The Economist reports that 30% of all industrial firms were making losses at the end of June 2024, beating the previous worst performance during the Asian financial crisis in the late 1990s.
Another reason is that other governments now see China’s overcapacity as a national security threat. This is evident in the geopolitical wrangling underway over tech-enabled Chinese products such as electric vehicles and telecom equipment. Moreover, China’s bad international conduct has exacerbated the negative perceptions of Chinese products and investments.
Shortcomings in the BRI approach
Mr. Xi planned to substitute western markets with increasing domestic demand and find new international markets through the Belt and Road Initiative (BRI). Increasing domestic demand has not worked out because this is unfamiliar territory for a structure obsessed with supply-side stimuli. The BRI approach has not worked because the participating countries are not economically strong enough to generate huge demand.
In short, overcapacity and export orientation are baked into Chinese-style decentralisation. This model has now reached its limits due to China’s arrogant approach to international relations and its drive towards self-reliance. Though we might see a jump in exports for some sectors, China faces an economic decline if it does not transform its political and economic relations with the world’s major countries.
Pranay Kotasthane and Manoj Kewalramani are researchers at the Takshashila Institution, an independent centre for research and education in public policy
Published - September 12, 2024 12:08 am IST
