"Special deals" and capitalism with Chinese characteristics

China satisfies none of the classical requirements for sustained high economic growth rates - it has not clear formal legal protection of private property, there is no independent judiciary for contract enforcement, formal rules and laws for private businesses are opaque, foreign companies have market access blocked for no apparent reason, the ease of starting a business is roughly at the same level as countries like Iraq and Congo, and so on.

If formal institutional arrangements are so weak/poor, how does the economy grow at such rate for so long? 

In a new working paper Chong-En Bai, Chang-Tai Hsieh, and Zheng Michael Song write,

The answer, we suggest, lies in the set of informal institutions that emerged in China in the early 1990s. The key feature of these informal institutions is that special deals are readily available to private firms... Chinese private firms succeed, in part, by obtaining a special deal from a local political leader which enables them to either break the formal rules or obtain favorable access to resources. The prevalence of special deals is common in countries with poor formal institutions, and China is no different. The essence of a special deal is that they are only available to some firms, and there is abundant evidence in many settings that the benefits of firms with special deals are out-weighted by the costs borne by firms that are left out.

In the case of China however, there are three reasons why the benefits of special deals may have exceeded the cost. First, Chinese local governments have enormous administrative capacity and use it to provide a “helping hand” to favored firms. This “helping hand” ranges from exemptions to regulations, lobbying the central government for the right to break rules, improving local infrastructure, providing land (and to a lesser extent credit) at below market prices, and blocking entry of other firms that threaten the profits of the favored firms. Some of this help – such as blocking competitors – lowers welfare, but much of it – such as exemptions to inefficient regulations – is probably growth enhancing.

Second, local political leaders have high powered incentives to provide special deals. For example, the largest car company in China is a joint venture between General Motors and the City of Shanghai. Dunne, a long time observer of China’s automobile market, describes Shanghai’s support for General Motors in the following way: “The commercial goal of selling more GM Buicks and Chevrolets in China becomes a political and economic campaign to enhance the power and might of the City of Shanghai. Think of it as Shanghai Inc. with the Mayor as the Chairman and CEO.” Local leaders may support private firms simply out of a sense of duty or because local leaders that show competence in supporting private business are recognized and promoted. The benefits can also be entirely monetary, ranging from tuition payments for their child to (hidden) equity stakes in favored private firms held by family members. Because of the high powered incentives to support private firms, a large and increasing number of Chinese firms benefit from the special deals. So the Chinese system is best described not simply as regime of special deals but one where there is almost “free entry” into special deals.

Third, a large number of local governments actively support private firms. Moreover, they compete ferociously with other local governments to attract and support their businesses. As described by McGregor (2010) (pg. 175-176), “What is obvious for anyone who travels around the country is how much of the economy is driven by another factor altogether, a kind of Darwinian internal com- petition, that pits localities against each other....each Chinese province, city, county, and village furiously compete to gulp down any economic advantage they can lure their way.” Competition between local governments is crucial in limiting the predatory power of protected firms. A local government can block competitors of favored firms in its locality but has no ability to do so in other cities. Competition also gives firms options when faced with incompetent or predatory local governments.

In other words,

China has “extractive economic institutions”... where political elites extract rents from the rest of society. But our hypothesis is that “extractive economic institutions” in China come with unique “Chinese characteristics” that has made all the difference. First, local political elites extract rents by enabling favored firms to generate more profits in the first place. They can do this because of the enormous administrative capacity of local governments, and the resulting growth of local businesses enables local elites to extract even more rents. Second, local elites get personal benefits from these rents, and thus the local administrative apparatus is laser-focused on supporting favored firms. Third, thousands of local governments compete ferociously to attract and support firms, thus limiting the ability of an individual local government to harm other businesses... 

Our narrative of special deals with Chinese characteristics is closely related to Yasheng Huang’s account of “Capitalism with Chinese Characteristics” and Chenggang Xu’s description of China as “Regionally Decentralized Authoritarianism.” Huang documents the emergence of special deals in China in the early 1990s and argues that such deals are harmful to economic growth. Xu argues that powerful local governments are behind the growth of private firms, but is silent on the key fact that local support for private firms almost always takes the form of special deals. Our hypothesis is that it is precisely the combination of special deals and powerful local governments that underpinned China’s economic success over the last 30 or so years and, at the same time, has created risks for the future. 

And this is important in the context of the ongoing trade confrontation with the US,

Special deals are at the root of the tension between China and its trading partners. Companies based in countries that do not have access to special deals find themselves disadvantaged when they compete with Chinese companies that do. Foreign companies in the Chinese market either have to make their own special deal or, as is the case with a Chinese firm that does not have a special deal, find that their intellectual property and contracts are not well respected. An important and still unresolved question is how the world trading system can accommodate countries based on rules as well as those based on access to special deals.