> The Chinese Saga of Olympic Shame Continues.... Broken China/BusinessWeek
>
> 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 .
>
> http://www.businessweek.com/print/globalbiz/content/jul2007/gb2007071...