Broken China/Business Week

Broken China

Beijing can't clean up the environment, rein in stock speculation, or
police its companies. Why the mainland's problems could keep it from
becoming the next superpower

by Pete Engardio, Dexter Roberts, Frederik Balfour and Bruce Einhorn

When the bureaucratic machinery of China rolls into action, it is a
sight to behold. A mayor announces a plan to reclaim hundreds of acres
from the sea and build a massive industrial complex. A few years later,
busy factories and roads stretch as far as the eye can see, families are
living in thousands of new apartments, and 10,000 workers have launched
Phase Two.

This is the side of China that awes the outside world. The mainland's
extraordinary ability to mobilize people and capital to accomplish
daunting feats in record time is the reason it has averaged annual
growth of 9.5%% for three decades. It is why China is an export
juggernaut in everything from T-shirts to TVs, has the world's
fastest-growing consumer market, and has amassed enough wealth to snap
up South American mineral reserves, IBM's (IBM) PC division, and a big
stake in private-equity firm Blackstone Group. Will Beijing complete all
of the stadiums, expressways, and hotels in time for the 2008 Summer
Olympics? Count on it. It's also a decent bet China will achieve its
goal of winning the most gold medals.

Why, then, is it so hard for this same government to crack down on
exporters of dangerously tainted seafood, toothpaste, and medicine,
despite years of warnings by local and foreign experts? The relentless
headlines about unsafe products from China reveal a scary truth: Probe
even a little into the Chinese economic miracle and glaring
administrative failures abound. Product safety is just one aspect of
Beijing's inability to enforce needed regulation in everything from
manufacturing and the environment to copyrights and the capital markets.

The same Communist Party apparatus so proficient at censoring the
Internet can't keep peddlers in the heart of Beijing from selling
knockoff Callaway golf clubs and fake iPods, despite solemn promises to
Washington since the early 1990s about enforcing intellectual property
rights. Shanghai's stock exchange may be one of the world's hottest and
may boast a state-of-the-art paperless trading system. But it was a
casino when it opened in 1990 with eight listings, and after years of
flaccid regulation it's an even bigger casino with 1,118. Beijing
proclaims all sorts of green initiatives, yet heavily polluting new
factories and coal power plants keep going up. The party has talked for
decades about building a social safety net, yet as the working
population ages the government isn't investing nearly enough to head off
looming crises in health care, education, and pensions. China spends
more than Japan on research and development, according to the
Organization for Economic Cooperation & Development (OECD), but its
record of innovation is underwhelming.

"A CRITICAL POINT"

China observers dismiss these flaws as the growing pains of a nation
making a breathtakingly fast transition from a command economy to a free
market. But now it's becoming clearer that these and other structural
problems aren't being addressed. The same policies that have been so
successful at boosting the gross domestic product by developing new
export industries and public works projects, it turns out, undermine
initiatives that might move China's economy to a higher level. In its
pursuit of growth at all costs, China skimped on investments needed to
provide basic affordable health care and the regulatory machinery that
can enforce environmental, safety, and corporate governance regulations
nationwide. Solving these shortcomings will require a massive shift of
the resources that are now being plowed into capital projects. While
Beijing would like to cool the economy, however, it is wary of doing
anything that would slow the high growth needed to generate jobs for the
millions of youth pouring into the workforce each year, especially with
a pivotal leadership conference scheduled this fall. "China's economic
development model was based on the simple concept of expansion of
production," says economist Chen Xiushan of People's University in
Beijing. "This model has reached a critical point."

A more intractable problem is China's power structure itself. Although
Beijing holds a monopoly on politics, local Communist Party officials
enjoy wide latitude over social and economic affairs. They also have
huge professional and financial incentives to spur GDP growth, which
they often do by ignoring regulations or lavishing companies with perks.
As a result, China has built a bureaucratic machine that at times seems
almost impervious to reform. Even if Beijing has the best intentions of
fixing problems such as undrinkable water and unbreathable air, it is
often thwarted by hundreds of thousands of party officials with vested
interests in the current system.

Beijing knows it must change course. China's $1.2 trillion in foreign
reserves―the most ever amassed by any country―and soaring trade surplus
may seem like signs of strength, but they're actually evidence of an
overreliance on exports, weak domestic consumption, and a primitive
financial system. And a dearth of social services makes a widening
income gap between urban and rural areas politically explosive.
Conjuring ancient Confucianism, President Hu Jintao harps repeatedly on
the need to attain a "harmonious society," implying that China today is
anything but. In March, Premier Wen Jiabao labeled the economy
"unstable, unbalanced, uncoordinated, and unsustainable."

DYSFUNCTIONAL ADMINISTRATION
To their credit, Chinese officials have unveiled a blitz of corrective
measures. Regulators this year shut more than 180 illegal food
producers. A directive ordering government agencies to use legitimate
software has helped cut the share of pirated programs to 82%% from 92%% in
2001. Beijing is launching new health-care initiatives, trying to tame
the runaway stock market, and passing stringent environmental rules. And
in 2006 alone, nearly 30,000 officials were prosecuted for corruption.

If this reformist agenda fails, watch out. The working assumption from
Washington to Tokyo is that China is on a trajectory to become a modern
market economy and a responsible global citizen. But if its problems
persist, the world will have to keep living with a giant trade partner
that can't guarantee safe products, control piracy, or curb pollution.
China could keep growing rapidly for years, but a scenario of
dysfunctional administration calls into question whether it will really
become an economic superpower with world-beating corporations that
challenge the West in innovation―a Japan Inc. on steroids.

China doesn't lack the finances to fix its shortcomings, and it has the
legal structure for regulating the environment, health care, and worker
safety. What Beijing does lack is the will to overhaul a political
structure that gives party officials down to even the smallest villages
huge influence over many facets of economic life. "The laws in China
compare with some of the best in the world," says activist Liu Kaiming,
founder of the Migrant Workers Community College in Shenzhen. "But it is
not able to enforce the laws fully because local governments are focused
on pleasing the big bosses in companies." What's more, few mainland
enterprises are proving they can move beyond low-cost commodity goods
and succeed on a global stage with innovative products, a function of
both their limited managerial vision and flawed high-tech policies from
Beijing.

The roots of China's ersatz capitalism go back to devil's bargains made
in the 1980s and '90s to accelerate China's takeoff. Late paramount
leader Deng Xiaoping declared it was O.K. to "get rich," a green light
for legions of cadres to discard their Mao suits and rush into business,
often by setting themselves up as middlemen or grabbing stakes in
communal assets. Beijing also granted great latitude to provincial and
local officials to manage development and social services such as
education and health care. The two requirements: Remain loyal to the
party and meet high economic-growth targets.

The system spans China's 657 municipalities, 2,862 counties, and 41,636
townships. Because roughly 70%% of a typical official's annual
performance assessment is based on GDP growth, says University of
Michigan Sinologist Kenneth G. Lieberthal, the cadres shower local
businesses with perks. These can include access to cheap credit, land,
licenses, protection from competitors, and exemptions from regulations.
The opportunities for graft are staggering. "What is unsaid, but
understood, is that if your locality becomes wealthy, so do you,"
Lieberthal says. "Instead of the Chinese Communist Party, it ought to be
called the Chinese Bureaucratic Capitalist Party."

The fuzzy nature of corporate ownership in China heightens the conflicts
of interest. Officially, state enterprises account for just one-third of
the economy, compared with 80%% two decades ago, but that statistic is
misleading because it includes only companies directly controlled by
Beijing-based ministries. In truth, many mainland companies have
financial ties to county, city, and township governments. In some
respects, that policy of giving members of China's immense bureaucracy a
personal stake in growth has worked brilliantly. Big-ticket industrial
projects get finished in record time, and infrastructure is smoothly put
into place. Daniel H. Rosen of the Institute for International Economics
estimates that while it takes four years to build an aluminum smelter in
the West, similar projects can take less than a year in China.

ENFORCEMENT STRUGGLES

These Red capitalists, though, have evolved into a powerful and wealthy
elite with an enormous stake in the status quo. Truly private capital
markets would strip officials of their power to reward cronies with bank
loans and stock market listings. Copyright enforcement might do wonders
for China's software industry, but it's blocked at the local level by
cadres more interested in safeguarding the jobs and profits that flow
from knock-offs. Although Beijing gives provinces funds for schools and
health clinics, much of that money winds up elsewhere. The National
Audit Office has reported that 10%% of audited central government
funds―including money allocated for pensions, health care, and
unemployment―are diverted into illegal loans to companies, construction
of posh government buildings, and other questionable investments. "All
the things we see as competitive advantages for China now are
translating into disadvantages," says Rosen.

Beijing is doing what it can to rein in rogue players. On July 10, Zheng
Xiaoyu, the former commissioner of the State Food & Drug Administration
(SFDA), was executed for accepting bribes of about $850,000 from eight
drug companies seeking quick product approval. Worse, on his watch the
agency gave the green light to many flawed drugs, including an
antibiotic that killed more than 10 people. The Shanghai party
secretary, Chen Liangyu, was fired last year after being accused of
plowing $400 million in pension funds into real-estate projects and toll
roads. And last September, authorities discovered that two senior
executives at a state-owned insurer had deposited $4 million-worth of
premiums in the bank accounts of friends and family.

These high-profile punishments serve as a warning, and enforcement is
improving. But the central government still struggles to impose its will
on local officials nationwide. China's State Environmental Protection
Agency employs about 300 people at its headquarters in Beijing, while
some 60,000 employees are scattered at environmental protection bureaus
across the country. Those numbers may look impressive compared with the
U.S. EPA, which has a payroll of 17,500. But those 60,000 environmental
watchdogs report to provincial and local governments, which tend to
favor economic development over green considerations. A 2006 OECD study
says that while pollution fines are rising, they're usually far below
the cost of installing equipment to cut pollution. And authorities often
negotiate down the charges. "For the sake of their own political
scorecards, some local officials have joined forces with businesses
seeking windfall profits," Pan Yue, SEPA's deputy chief, told the China
Daily on July 3.

To understand how bureaucrats and business leaders flout SEPA's rules,
take a trip to Lake Taihu, the source of drinking water to 2.3 million
residents of the city of Wuxi. In the 1990s, as industry sprang up on
the lakeshore and Taihu grew more polluted, authorities ordered local
factories to clean up their waste water. Then in 1999, local officials
said the problem had been licked as factories installed treatment
plants. But those new facilities were often idled as companies refused
to shoulder the cost of operating them, and factories continued to dump
untreated waste into the lake. The situation worsened, until this spring
the lake turned an iridescent green. "I'm angry with the government
because it can't solve the pollution problem," says Lydia Li, an
executive assistant at a foreign-owned manufacturer in Wuxi. In May, she
says, she had to buy nearly 50 gallons of bottled water after yellowish
water smelling of sulfur started running from her tap.

Oversight of food production in China is similarly troubled. The SFDA
employs 1,700 people, but 80%% of China's food producers―some 350,000
enterprises―have fewer than 10 employees and often lack any real
understanding of safety standards. And again, there's little local
incentive to crack down on scofflaws. "If local governments close all
the companies that violate food safety regulations, a lot of workers
will lose their jobs," says Luo Yunbo, dean of the food and nutrition
college at China Agricultural University in Beijing.

The misplaced economic priorities explain the decrepit state of social
services. Top leaders have been pledging to provide basic public
health-care and retirement plans since they began downsizing giant state
enterprises in the '80s, dismantling the "iron rice bowl" of
cradle-to-grave benefits. But responsibility was divided among different
ministries, and funding social programs was delegated to local
governments. Compared with spurring growth, social services got short
shrift. It would cost Beijing around $40 billion―a sum it could easily
afford―to set up a national primary health care system similar to
Britain's, figures Huang Yanzhong, director of the global health studies
program at Seton Hall University. "But I'm not optimistic," Huang says.
Responsibility is fragmented among too many competing ministries in
Beijing, and at the local level, cadres still are judged on GDP growth.
"If you try to tackle this with policies rather than deep changes in
political institutions, the government won't be able to bring
accessible, affordable health care," he says.

So, many people go without. Huang cites government surveys showing that
nearly half of Chinese say they can't afford to visit a doctor when ill,
70%% lack health insurance, and 30%% refuse hospitalization due to cost.
And the system is corrupt. Hospitals earn most of their revenue selling
drugs, and get kickbacks from pharmaceutical suppliers―creating an
incentive to overprescribe. Chinese media are filled with stories such
as that of a 75-year-old cancer patient in Harbin who was billed over
$500,000 for imported medicines, many of which were found to be unnecessary.

Meddling by party officials is hobbling China's stock markets, too. The
booming Shanghai Stock Exchange, started in 1990 to raise funds for
state enterprises, boasts first-rate facilities, and shares have nearly
tripled since 2005. In the first five months of this year, companies
raised $17 billion, and issues that will likely fetch tens of billions
more are in the pipeline. But despite some improvements in oversight,
trading remains volatile, weakly regulated, and driven by rampant
speculation. That's in large part because the exchange has evolved
little from its original mission. Markets are supposed to allocate
capital efficiently to the best companies. But in China, notes Carl E.
Walter, managing director at JPMorgan Chase & Co. (JPM) in Beijing, "the
primary function remains funneling money to state-owned companies."

Again, it comes down to the cozy relationship between government and
industry. Some 95%% of the stocks on the Shanghai bourse are state
enterprises, and last year no private companies were permitted to list
there. But 14 state enterprises did. The reason: By floating 10%% to 30%%
of their shares, state companies can ease their dependence on bank loans
without ceding any real control, while insiders make windfalls on the
stock offering. Although regulators occasionally fine companies that
don't disclose key data, delistings or prosecutions for governance
lapses are rare. "The central government wants a healthy stock market,"
says finance professor Chang Chun of the China Europe International
Business School in Shanghai. "But companies are owned by strong local
and provincial governments, and they have more connections within the
party. [Regulators] are either afraid of going after them or may not
have the power to go deeper."

Misguided government policy isn't the exclusive preserve of the local
party structure. Beijing is in charge of the Chinese drive to become a
power in science and technology. China already boasts superbly equipped
labs in everything from life sciences to nanotechnology to optics,
churns out over 60,000 masters and doctoral degrees in science and
technology each year, and has made big strides in military technology
and manned space flight. And Chinese scientists publish an impressive
number of papers in international journals.

Writing scientific papers, though, doesn't necessarily equal innovation.
"China is spinning its wheels," says Zhu Jian-Gang, director of Carnegie
Mellon University's electrical engineering department and an adviser to
China's national optical lab in Wuhan. While government and university
labs have first-rate facilities, Zhu says most of the work is
unimpressive. These institutions are focused on turning technologies
into money-making products rather than discovering breakthroughs. "They
do a lot of research, but it isn't important," Zhu says. One problem is
that promotions are too often based on seniority and connections rather
than on merit. "That does not create an environment that attracts young
people," he says.

REWARDING REPETITION

Another problem is that state agencies press for quick results. "The
bureaucratically driven process in China creates a strong incentive to
push R&D money into product development," says Anne Stevenson-Yang, a
former head of the U.S. Information Technology Office in Beijing and
current president of Twin Poplars, a startup focusing on incubating
innovative Chinese enterprises. The result? "Companies are rewarded for
replicating existing technologies."

Witness Beijing's drive to produce homegrown alternatives to
technologies pioneered elsewhere. While Beijing can proudly say it has
its own technologies for DVD, Wi-Fi, and superfast third-generation (3G)
cellular service, the cost to Chinese companies has been high. Even
though Beijing also plans on using the two global standards already in
existence, regulators have delayed the launch of all 3G services because
the Chinese technology is years behind schedule. That has hobbled
telecom equipment makers such as Huawei Technologies and ZTE and handset
producers TCL and Ningbo Bird. "The continued delay of 3G in China is
hurting the whole industry," says Jing Wang, Qualcomm Inc.'s (QCOM) Asia
chief. "If China had already embarked on 3G, these vendors would be more
important players."

The list of shortcomings in China's economic model is long, but is it
fair to expect any different? After all, China's many defenders are
quick to note, the mainland has come a long way in just three decades.
Its growth record is unparalleled in history, and it took the U.S. and
Europe centuries before they developed modern financial systems and
methods for ensuring food safety, providing pensions, and protecting the
environment. "Americans tend to think China should be held to the same
standards that we have today, disregarding that we had these problems
ourselves in the not-too-distant past," says United Technologies Corp.
(UTX) CEO George David.

But the West ultimately implemented social reforms after upheavals that
led voters to elect new governments. And South Korea and Taiwan tamed
crony capitalism following traumatic democratic transitions. The Chinese
Communist Party, in contrast, appears to be nowhere near tolerating
political change. In fact, it's clamping down on dissent.

It is just as fair, then, to ask a different question: After decades of
efforts by reformers, why assume China will build the financial, legal,
and administrative systems required to become a modern industrial
society? The only way up is to tame the unregulated, raw self-interest
that flows from Deng's historic compromise with the party and the
people. That would require a legal system that doesn't let local cadres
circumvent regulations, grading officials on metrics that go well beyond
simple GDP growth, and capital markets that nurture and reward
entrepreneurs. In short, it means getting the party out of business. At
this stage, such revolutionary change seems politically impossible. So
it's just as plausible that the flawed China we see today is basically
what we will have a decade from now, after all.

Engardio is an international senior writer for BusinessWeek. Roberts is
BusinessWeek's Beijing bureau chief. Balfour is Asia Correspondent for
BusinessWeek based in Hong Kong. Einhorn is a correspondent in
BusinessWeek's Hong Kong bureau .

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