Wade Shepard
Forbes
Oct. 24, 2016

China is a country that rose to the top on the back of vibrant markets with weak institutions, and the lack of enforced regulations led to a very dynamic business climate where deals were not hamstrung by red tape and money feverishly cycled between both the white and black spheres of the economy.

“The first step of development is always to build markets with weak institutions,” said Yuen Yuen Ang, the author of How China Escaped the Poverty Trap, a book which flipped the conventional wisdom about emerging markets on its head. “Meaning, it may look corrupt, it may look like you have the wrong types of practices and the wrong types of property rights, but it’s all about people making use of the existing institutions they have to stimulate market activities.”

Ang related how in the early 80s, when China was searching for ways to initially spark its economic renaissance, virtual armies of bureaucrats were directed to use their personal relationships to find investors for development-related projects.

“They make use of expenses that would strike us as kind of a corrupt system, because these bureaucrats are unleashed to go out to do development, look for investors, and they are given very powerful monetary incentives. . . There are explicit rules, sometimes even written down in documents, where as a bureaucrat you can collect five percent of the value of investments that you bring in, for example.”

China has developed economically and infrastructurally faster and more extensively than any other country in history, and this was partly due to an under-regulated, grassroots business environment that was built by networks of social connections and peppered with monetary incentives for decision-makers to engage in large-scale development. Many of the measures which are generally the firm foundations and safeguards of developed economies are often little more than economic barriers in emerging markets — things like due bureaucratic processes, fair practices, transparency, property rights, and even personal rights. And China was able to rise so successfully in large part due to the fact that it didn’t hamstring itself by following the rules set forth by more developed countries.

As Ang pointed out, emerging markets often find themselves in a chicken or egg scenario in terms of what should come first, getting rich or establishing strong institutions. China chose to get rich first. For all of the obvious drawbacks, when looking at the bottom line — i.e. economic growth and development at a time when the country was severely deficient of both — China’s under-regulated business and political environment ultimately worked. But now that China has developed more mature markets that are producing at a higher capacity and are more integrated in the international sphere, these same weak institutions and seemingly corrupt practices are now eroding the economy from the inside out.

“At first you can make use of things like corruption, informal institutions, connections to kick-start markets, but at some point when you actually start having a market some things are going to have to change, and China on a national level is now at this point,” Ang continued.

In late 2012, President Xi Jinping very publicly stepped up and declared an end to the era of weak institutions in China, vowing to fight corruption at all levels and demanded a more austere trajectory for government officials. While the campaign that followed was initially written off and even mocked by some foreign observers as merely a purge of political opponents, in theory it was exactly what the country needed at the time it was needed.

Throughout the four years that the anti-graft campaign has been active, both officials high and low have had their professional and personal practices more closely monitored, and many ended up being purged. According to government information, nearly 300,000 officials were punished last year alone, which piles on top of the 400,000 who were punished in years previous. While not long ago government officials were encouraged to attract investors and reap the personal spoils as a normal part of business, now this was grounds for going to jail.

The result, as could be expected, was less economic dynamism, stalled development, and seas of abandoned infrastructure and investment projects.

“It’s definitely had a dampening effect on the economy,” said James Roy, a principal at China Market Research Group.

Entire consumer and service sectors that were once the beneficiaries of an environment where gift giving, lavish dining, high-end boozing, and premium entertainment were an everyday part of the business experience, suddenly found themselves in a customer vacuum. Faced with the very real prospect of being punished for these types of engagements — or even sporting too fancy of a watch, a common “gift” — government officials and entrepreneurs rapidly began altering the way they did business.

“You saw a very dramatic drop off at around the exact same time [as the beginning of the corruption crackdown] for a lot of Swiss watch brands as well as the designer brands, Louis Vuitton and Gucci . . . going from fairly consistent double digit annual growth to very flat to slightly negative growth,” said James Roy. “It’s caused a shift in the way the consumers are making purchasing decisions, there’s less of a desire to have too high or flashy a profile.”

The high-end F&B sector has also been hit hard, as dining and boozing were once common ways to spin the wheels of a deal or to cultivate those all so essential relationships.

“So you really are seeing a lot more closure of restaurants that relied a lot on private parties, private banquet table rooms for a lot of their business,” Roy continued. “Because any government business, any state-owned enterprise, dinner or an event now has to be much more limited in scope.”

The effect of this transition has gone beyond merely not being able to give gifts or throw extravagant banquets to pressure or gain the good graces of business partners, but also shook up some of the fundamental ways that local governments function.

Suddenly, government officials no longer seemed confident as to how to go about their work. The old ways of doling out tenders and other investment opportunities to companies based on personal connections was no longer acceptable, but a new system had yet to be developed. The general fear of being pegged as corrupt — caused mostly by a lack of clarity on the line between acceptable and unacceptable practices — led to some officials simply doing nothing. So rather than having this streamlined system where top officials could get massive projects underway with, almost literally, a flip of their wrist and a nod of their head, a decision-making-by-committee process evolved, with those at the top wanting to maintain as much distance from the action as possible. To put it simply, there was a reason why China was able to develop so quickly, and this hallmark aspect of the country’s era of rapid growth may be coming to an end.

“Basically, no one wants to make a decision anymore, so everything stops in the business world,” explained Richard Brubaker, a professor of sustainability at China Europe International Business School in Shanghai. “You talk about the fact that entrepreneurs are being brought in as part of these investigations. What entrepreneur now wants to actually do much and not hedge their bets? So it’s had a huge impact and I won’t say it’s all for bad. I think there’s quite a bit of good that’s coming from this but it’s certainly creating this hesitancy in the market, and the bad thing is that they don’t know where it’s going to go.”

“I think it has first of all slowed down processes, which is not necessarily bad,” said Daan Roggeveen, the director of MORE Architecture in Shanghai. “Secondly, I think it has caused a slowdown on overarching, in the sense that over-ambitious projects are now easier sidelined. This can be good, so pointless vanity projects don’t get a chance.”

Responding to this slow down, the central government has been punishing and criticizing officials who don’t actively perform their duties or spend the stimulus money that was pumped into the economy last year. This has put some officials in a rather compromising position where they could face a punishment for engaging in business and development or for not engaging in business and development.

The true economic impact from the corruption crackdown is impossible to definitively measure, but a researcher at BNP Paribas estimated that it alone could be taking between 1 and 1.5% off of annual GDP. While this estimate may seem a little high, what it highlights is a raw fact: the corruption crackdown is leaving a big economic footprint – and is further evidence that the decline in China’s annual GDP growth rate is not just about market fundamentals.

However, while shaking up the society from top to bottom, China’s crackdown on corruption has yet to produce much in the way of desired results. According to Transparency International’s Corruption Perceptions Index, China is apparently more corrupt now than before the anti-corruption campaign began. With a ranking system where a score of 0 means most corrupt and 100 least corrupt, China pulled a 37 last year. This is three points worse than in 2013 and two points worse than in 2012. To put it simply, Xi’s crackdown has been more focused on combating the downstream effects of corruption rather than its upstream institutional causes. It is easy to put people in jail, much more difficult to completely reconfigure an entire bureaucracy and develop truly strong institutions — a fact that has not been lost on the Communist Party as they enter the next phase of the anti-corruption campaign.

“[China] is a middle income economy, and if it wants to continue growing it needs to change a lot of its institutions,” Ang said. “If you’d taken this discussion back in the 80s, 90s, even 2000s it was not clear that you need political reform to have development. But I do think that China has now reached a point where it actually does need to change its institutions, including its political institutions, in order to continue this process.”

“Many in China would suggest that corruption is a lubricant to keep the economy turning,” said Mark Tanner of China Skinny, a Shanghai-based marketing and consumer research firm. “In the short-term there is a degree of truth in that, but in the medium to long-term if China can stamp out corruption across all levels the economy will come out stronger, more dynamic, transparent, and sustainable.”