China’s governance tightrope
China's leaders are right that the country's governance must be modernized. But, to succeed, they may need to take a risky step, loosening their control over the activities of local governments – and thus over the economy – and introducing greater downwar
Five years ago, China's leaders decided to target modern state governance as a top reform priority. The goal of such reform is to improve the state's capacity to adapt to the sheer size and increasing complexity of the Chinese economy, and to mitigate risk. Achieving this objective will not be easy.
To understand why, and what it will take to succeed, consider how Chinese governance has worked in recent decades. Overall, governing the country involves a combination of political centralization and economic decentralization. In particular, China's spectacular income growth has been enabled by a delicate balance between the concentration of political power in the hands of the central leadership and the delegation of economic management to local authorities.
This balance has often proved difficult to maintain. For example, when China still had a fully planned economy, Mao Zedong had to delegate the management of stateowned enterprises (SOEs) to local authorities for some time in order to boost production, as local governments were in a better position than the industrial ministry in Beijing to manage local suppliers. But, within a few years, this system had become so disorganized, due to economic chaos in the wake of decentralization, that the central government reasserted its control.
Nonetheless, in 1978, Deng Xiaoping not only delegated authority to local governments, but also increased their revenue through a system of fiscal contracting, in an effort to maximize their contribution to overall GDP growth. Again, the plan worked for a while – until China's leaders confronted the downside of fiscal decentralization: the central government's declining revenue share under this system limited its capacity to assert its authority and manage macroeconomic stability. As a result, in 1994, the central government had to revise the intergovernmental fiscal relationship. It reverted from fiscal contracts to a system in which the central government acquired the majority of tax revenues and the revenue share of local governments was substantially reduced.
But while this change strengthened the central government's hand, it undermined
local governments' ability to sustain their spending, which still amounted to some 80% of total government expenditure. In other words, revising the intergovernmental fiscal relationship did not calibrate the expenditure responsibility between central and local governments. To this day, local governments have to raise extra-budgetary funds to finance the rising deficit between revenues and expenditure.
Understandably, Chinese local leaders have not negotiated a reduction in their share of total expenditure responsibility, not least because the central government has appointed provincial leaders over whom it maintains substantial control. Meanwhile, since 1994, the central government has implemented a performance-based system for assessing and promoting local leaders, thereby fuelling competition among local authorities. This point is the key to a better understanding of Chinese governance today, which the economist Chenggang Xu aptly describes as a “regionally decentralized authoritarian system.”
It is not easy to assess this system, because competition among local authorities has always had both good and bad outcomes. While this horizontal competition has helped China to reach growth targets, central leaders must be supportive of local leaders' discretionary powers, authority to raise funds, and capacity to attract investment.
In most cases, however, local officials would abuse such powers and do more than needed. For example, local authorities have long had a perverse incentive to improve their own standing by allocating resources to image-building projects that serve no genuine economic need or purpose. This might boost growth in the short term, but unproductive investments can also threaten macroeconomic stability in the longer term.
Another difficulty in assessing Chinese governance arises from the complicated relationship between politics and business in different regions. Decentralization rewards local officials who are competent and devoted to supporting economic growth. But it also creates opportunities for these officials to forge surreptitious ties with business owners, and this undermines growth in the long run. Because of the strong competition to stand out in terms of growth, especially at the provincial level, many lower-level officials use their authority more to advance their personal interests. At the same time, business owners seek illicit relationships with local officials to gain protection, privileges (such as contracts), loans, a blind eye to safety standards, and regulatory exemptions – activities that generate financial risks and undermine competition by raising entry barriers for more efficient enterprises.
The delegation of discretionary power to the bottom of the system could therefore create a dilemma for the central leadership: exercising more control would hurt growth, but so would the rampant corruption that results from not exercising it.
Yet the solution is not as simple as cracking down on graft. Since President Xi Jinping launched his anti-corruption campaign in 2012, China's overall economic performance has not improved, partly owing to local officials' increased reluctance to take bold steps to boost growth.
The crux of the problem may lie in China's system of upward accountability in governing its officials. While Chinese governance undoubtedly has its advantages – in particular, it enables the central government to mitigate risks, including preventing debt and financial weakness from triggering crises – it can hamper the kind of policy experimentation needed to sustain economic progress.
Given the system of upward accountability, de-emphasizing GDP growth in assessing the performance of local officials would help reduce these officials' incentive to abuse decentralized powers and make unproductive investments. But if Chinese leaders do not abandon the system of upward accountability, how would they measure and assess local officials' relative performance? A step toward introducing downward accountability into the governance system is perhaps necessary.
China's leaders are right in the sense that the country's governance must be modernized. To succeed, however, they may have to revise their approach to managing local governments and introduce greater downward accountability in assessing their performance. This shift undoubtedly carries risks, but ultimately they are worth taking in the course of adapting governance for continued economic development.
Zhang Jun is Dean of the School of Economics at Fudan University and Director of the China Centre for Economic Studies, a Shanghai-based thinktank. Copyright: Project Syndicate
Decentralization rewards local officials who are competent and devoted to supporting economic growth.