China's political-economic institutions and development.

• Author: Xu, Chenggang
• Position: Essay

After more than three decades of economic reform, China has transformed from being one of the poorest economies in the world to being the second-largest economy measured by nominal exchange rates, or the largest economy measured by purchasing power. As such, it is important to elucidate the determinants of China's future development.

This article will focus on China's institutions. I argue that although the size of China's economy is extremely important in terms of its impact on the global economy, it is misleading to ignore political and economic institutions. Indeed, forecasts based on extrapolating past trends could be erroneous (see Pritchett and Summers 2014). China was the largest economy in the world before the end of the 19th century but then lost ground to Western nations that established the rule of law and free trade. To understand China's past and future development, one has to examine its institutions.

The existing literature presents two contradicting views of China's future: one optimistic, the other pessimistic. The late economic historian and Nobel laureate Robert Fogel predicted that by 2040 the Chinese economy would account for 40 percent of global GDP while the U.S. share drops to 14 percent (Fogel 2010). His prediction is consistent with a standard growth model, which takes market institutions as given. Other authors, such as Gordon Chang (2001, 2011) and Zoe Zhang (2014) are less sanguine. They claim that China faces serious problems and may collapse because of political and economic crises.

Treating China as a monolithic entity can be misleading. Recent research has shown that Chinese counties where privately owned firms are concentrated experienced significantly higher growth rates--and less income inequality--than other counties (Guo et al. 2014). Another recent study found that China's state-owned firms are significantly less efficient than their counterparts in 27 other transition economies, while China's private firms are significantly more productive (Kim, Wang, and Xu 2014). Yet one of the major problems in China is that it is difficult for private firms to enter and to grow in many economic sectors due to institutional barriers and discriminations against the private sector. Meanwhile, state-owned firms obtain most of the resources from the government, which reduces their capital productivity and total factor productivity (TFP). (1)

In the remainder of this article, I first compare China with other countries from a historical perspective and present cross-country data on distance from the "world frontier," measured by the ratio between a country's per capita GDP and that of the most advanced country, such as the United States. (2) This measure indicates the effects of institutions on long-term growth. Next, I provide an analysis of China's institutions and their origin, and illustrate their effects on China's economic performance. The concluding section argues that institutional reform is essential for China's sustainability and stability.

Institutions and Development: Understanding China's History

In the last 30 years, China has been on the path of returning to its historical status relative to other countries. President Xi Jinping has referred to this development as "China's dream," and it has brought positive reactions and hope from the Chinese people. However, will China be able to return to its previous international status? Will China be able to achieve more than merely returning to its historical status? To understand how far China can continue to develop, we should first comprehend the reason China drastically declined since the late 19th century for nearly 100 years, and how China managed to catch up since 1978. We can then evaluate whether the particular catch-up mechanism of China is sustainable. I will argue that the outcome will depend on the underlying Chinese institutions.

China Is Returning to Its Historical Past

China has the second-largest economy in the world by nominal GDP level, but its status remains distant from its global status in 1850, when China was by far the largest economy in the world. Even more strikingly, 200 years ago, China's GDP accounted for one-third of global GDP (Maddison 2003). Table 1 shows that China has returned to its historical status in 1890, as the world's second-largest economy. However, by 1913, the United States far outpaced China in terms of GDP, and the United Kingdom, Germany, and Japan were undergoing rapid industrialization.

In June 1898, China attempted constitutional reform during the Wuxu Restoration, but that effort ended quickly, in September. Enlightened Chinese intellectuals and politicians advocated the so-called Hundred Day Reform. They believed that China's imperial institutions were major obstacles to development and were responsible for its rapid decline relative to the rising world powers. Table 1 shows the stagnation of the Chinese economy from 1890 to 1950, after decades of wars and the collapse of the Chinese empire subsequent to the failures of two constitutional reforms.

Table 2 lists the share of global GDP in 1871 and further elaborates my point. In 1871, one of the most devastating civil wars in Chinese history ended, and the Chinese Empire rapidly declined and eventually collapsed. If we only look at the statistics of 1871 without knowing the institutional background, China's global share of GDP (17.2 percent) looks even more impressive than today's (15 percent).

Development Level of China

Although China is the second-largest economy in the world, China's development level is still significantly below that of the world frontier. Based on per capita GDP, the development level of China is similar to that of Peru and is only about 19 percent that of the United States. (3) The most important message of Tables 3 and 4 is that China has not made any progress since the Industrial Revolution (or since 1850), in terms of per capita GDP ranking and distance from the world frontier, regardless of its high share in global GDP in certain periods.

In 1850, the Chinese economy was the largest in the world and significantly larger than the combined economies of the next three highest-ranked nations. However, China ranked last among the 24 nations based on per capita GDP. Moreover, the development distance of China from the world frontier increased steadily and rapidly from 0.25 in 1850 to 0.05 in 1950 (a lower ratio means more backwardness). If backwardness always has advantages for catching up, then China's economy would have advanced rapidly since 1950, after the wars and the nation reunited. Yet, the gap only marginally narrowed from 0.05 in 1950 to 0.06 in 1980, because of the lack of progrowth institutions--namely, the rule of law and free markets.

Tables 3 and 4 also show cross-country historical data to illustrate the impediment caused by certain institutions to economic growth. A substantial part of China's contemporary institutions stem from the Soviet Union while others are inherited from the Chinese Empire, which may arguably be even worse in terms of fostering growth. The USSR (for the years before the Soviet era, the area is defined by the USSR geography) is included in Tables 3 and 4 to illustrate the extent of Soviet achievement in terms of economic development. The USSR was a super power at an aggregate level.

However, due to its institutions, the USSR's distance from the world frontier has not significantly improved compared with the tsarist Russian Empire. To illustrate this point, an important fact is that the USSR's research and development expenditure as a percentage of GDP was the highest globally at the peak of the Soviet Union's power, and was significantly higher than that of the United States and Japan. However, the Soviet Union failed to narrow technological and economic gaps from the frontier economies. After more than seven decades of Soviet central planning, the country only produced two of the world's 200 most important inventions and innovations (Komai 2014).

An extensive literature explains the adverse effects of Soviet institutions and Chinese imperial institutions on economic growth. Yet, Tables 3 and 4 show that the current development level of China is significantly lower than that of the USSR and far lower than that of the Chinese Empire in 1850 in terms of distance from the world frontier.

Effects of Constitutionalism on Long-term Growth

Empirical evidence indicates that constitutionalism is a determining factor of long-term growth (e.g., North 1990, Acemoglu and Johnson 2005, Acemoglu and Robinson 2012, Acemoglu et al. 2014). I use constitutionalism to refer to institutionalized rules that limit the power of government, particularly its power to violate property and political rights. The key element of constitutionalism is the separation of powers and political pluralism--also known as the rule of law. (4)

Based on a 60-year post-war dataset and a strict definition of democracy as adherence to constitutional rules and the rule of law, Acemoglu et al. (2014) provide cross-country evidence that democracy determines long-term economic growth. This...