Who Is Responsible for China's Growth
The State or the Private Sector?

Yukon Huang is a Senior Associate at the Carnegie Endowment for International Peace and a former World Bank Country Director for China.

This is one of six essays in the book review roundtable on Nicholas R. Lardy’s Markets over Mao: The Rise of Private Business in China.

In Markets over Mao: The Rise of Private Business in China, Nicholas Lardy has taken on an arduous task in tracing the increasing role of the market in China over the past three and a half decades. This is a must-read book for China hands because of both the vast amount of information it presents and the skillfulness of one of the leading authorities on China’s economy in dissecting that information. Critical to Lardy’s argument is detailing the rise of the private sector relative to state-owned enterprises (SOE).

That this book is in fact so necessary is testimony to the widely diverging views on whether the market or the state is now the dominant force shaping China’s economy. The answer is that both sides may be right. Lardy has proved his case in favor of the private sector on the basis of facts, but those who make the case for SOEs have a legitimate claim on the basis of sentiments about the how state directly or indirectly has been able to influence economic outcomes.

In meticulously analyzing all facets of this issue, Lardy has presented a convincing case that China’s achievements have come from the rise of the private sector rather than from the virtues of state-led capitalism. A decade ago, this point might not have drawn as much attention. For most economists familiar with China it was already self-evident at that time that the country’s sustained double-digit growth rates were the result of the increased efficiency brought on by market liberalization as China took advantage of a globalization process that altered price signals for firms.

As Lardy points out, early on the state had given up on controlling market prices for most consumer goods (chapter one), and by allowing private firms to expand while the state retreated, the dominant share of industrial activity became the domain of the private sector (chapter three). Moreover, financial liberalization made it possible for the private sector to secure an increasing share of bank lending. If this is clearly the case, then why do so many feel that China’s economy is still largely state-driven?

The numbers showing that market forces and the private sector have steadily increased their presence are, importantly, about the direction of change. But others are also correct in assessing that the state continues to play an outsized role in influencing the behavior of economic entities, which is an argument about the extent to which the state is still involved.

The sense that the state is still dominant was revived by what happened in the aftermath of the 2008 global financial crisis. China’s stimulus program of four trillion renminbis was huge in relation to the size of its economy at the time. Moreover, the speed at which the stimulus played out led to a surge in activity that unexpectedly pushed GDP growth above 11% when it should have been trending gradually down to the 8%–9% levels.

In retrospect, the stimulus was overdone and the resulting pressure in driving up debt levels has created a financial problem that the new leadership is still trying to cope with. Of relevance to this debate is that much of the stimulus was undertaken through credit expansion rather than through the budget and channeled to SOEs and also to local authorities through the borrowings of their affiliated local government financing vehicles (LGFV). These LGFVs were created to borrow directly from banks and other financial intermediaries since local governments are prohibited from doing so. LGFVs took on major responsibilities in ratcheting up investment, not just for infrastructure but also for commercial activities that would normally be more appropriate for the private sector.

Although a significant share of the stimulus-related lending ended up benefiting the private sector, the massive amounts fed into the coffers of state entities gave rise to a general perception that the state was in ascendancy at the expense of the private sector. This was not helped by some glaring examples of waste, as in the much publicized images of “ghost towns,” that gave the impression that the state’s interventions were getting out of hand.

The image of a powerful state sector comes out most vividly in the role that land development has played in driving economic expansion in recent years. Much of this development was accomplished by local authorities through their links with LGFVs. By tapping their access to state-controlled land, authorities were able to finance a range of investments even if many of the actual developers were private entities. That much of this activity was being financed by shadow banking involving complex arrangements between private and state-owned financial entities exaggerated the sense that the state was somehow manipulating things.

Also contributing to these perceptions are the revelations from the ongoing corruption campaign, which have fed into sentiments that the economic system is replete with rent-seeking activities involving state agents and well-connected party officials. This has reinforced the view that the state is still pervasive in terms of guiding economic activity, even if the form of its involvement has become more opaque.

The debate about the role of the state versus the private sector is also complicated by the complexities in defining the major economic agents in China’s system. The standard view of an economy is centered on a profit-maximizing firm producing goods with capital and labor—hence the focus on private enterprises versus SOEs. With market-led capitalism, desirable outcomes are the result of competition between firms operating in undistorted markets. The state is seen largely as a regulator and facilitator of activity except for the provision of public goods.

In China, however, the state plays a major role in shaping growth outcomes that goes well beyond the role that SOEs play elsewhere. What makes China different is its regionally decentralized administrative system where local authorities are actively engaged in a broad range of economic activities that sometimes are in competition with the private sector. They are able to do so because of their access to property and bank financing through LGFVs as well as through their budget allocations. Unique to China, local governments also compete with other local governments both by attracting foreign and domestic firms to invest and operate in their localities and by supporting locally owned SOEs.

Because provincial leaders appointed by Beijing are assessed by how well they meet growth targets, this decentralized administrative system has incentivized local officials toward promoting productivity-enhancing reforms. Thus, China’s economy includes both firms and local governments as major economic players. The latter are affected by incentives that are more open to political pressures. Yet there are limits to how far local authorities can go in their economic undertakings, given competition from other localities and fiscal constraints. Cross-regional competition has helped curb waste and ensure a modicum of efficiency, despite the high degree of state intervention in commercial activities.

Not just state-owned economic entities are subject to government interventions, but the more prominent private firms are also affected by the whims of the state in ways that cannot be easily measured. Their ability to expand and secure financing depends on their relationships with the party system that influences access to commercial opportunities. Some would argue that in China there is no such thing as a purely private firm of any significant size. All major firms are seen as subject to the state’s influence whether they are state-owned or private.

China’s statistics are also hard to interpret as indicators of the state’s power. Lardy argues, for example, that the proposition that SOEs have monopoly power is flawed given that their profit margins are not much different from those of private firms (pp. 26–30). Yet one could also argue that while the profits of SOEs are being pulled down by their losses in serving politically driven mandates, these losses are offset by their monopoly profits elsewhere.

These relationships complicate our understanding of the market’s role in guiding China’s economic activities. Yet Lardy is basically right that the market is now the dominant force guiding economic behavior. This is one reason China is now seen as trending to a “new normal.” With the state having lost the power to control outcomes, China’s growth rate is sliding slowly to levels more characteristic of other market-based systems. As such, growth targets have become just targets rather than a floor that the state has the power to transcend as it consistently did in the past.