Signs point to declining legitimacy of the Communist Party of China, but uncertainty remains on how it will play out.
by Chris Angle
October 29, 2019

As the trade war between the U.S. and China continues with negotiations and an unclear outcome, questions are being asked in certain business circles as to whether China is still a good place to do business. While Western companies have been doing business in China for 40-plus years, the price of doing business has often been Chinese copying of technology and intellectual property. For decades, this was seen as an acceptable cost of doing business, given the size of the Chinese market and apparently stable political-economic system. However, China presents some long-term challenges that makes it advisable for certain businesses to reanalyze their strategic position in regard to whether the risk/reward trade-off is still the same as it has been in the past. This is not to say that a business should necessarily be out of China; only that certain challenges mean that the old risk/reward paradigm may no longer be valid.

In looking at China, it is important to bear in mind a couple of things. The first is that the Chinese government doesn’t see business and economic growth as something worth pursuing for its own sake as do many Western governments or cultures. For China, the growth is seen as a source of political legitimacy and national power. The second, related to the first, is that the fundamental social contract between the Chinese people and the governing Communist Party is that in exchange for submitting to autocratic rule, the party will provide prosperity. This makes a massive, sustained economic downturn extremely dangerous for the stability of the governing system.

In the West when there is an economic downturn, there is an election, often the old government is tossed out, a new one elected, and life goes on. In China, there is currently no mechanism for a peaceful transfer of power. This means that if the system ever loses legitimacy to the point that the Communist Party can no longer coerce compliance, China is likely to experience a violent uprising/revolution of some sort. Regimes that lose legitimacy to this point can experience instability ranging from massive strikes and protests until the government steps down all the way up to armed uprising. It is virtually impossible to tell in advance what path things will take, as much of it depends on actions taken by multiple actors under multiple constantly changing conditions. Suffice it to say that a country going through a wrenching upheaval is not one that is conducive to business-as-usual.

Given this, the primary question is, how likely is it that the political legitimacy of the Communist Party of China (CPC) will deteriorate to a level that would trigger massive civil unrest? There are several indications that the legitimacy of the CPC is on the decline, as well as some challenges in the future that are likely to further erode the autocracy-in-exchange-for-prosperity bargain.

(Note that the recent unrest in Hong Kong indicates a low level of governmental legitimacy. However, Hong Kong has a unique political history, which means that conditions there are not necessarily indicative of conditions throughout the rest of China. The danger for the regime is that the protests would spread to other cities, which could put the party control of the country into serious jeopardy. However, at the time of this writing, this does not appear to be happening.)

Cooked Books
The first indication that things might not be well in China is there is some reason to believe that the economic growth numbers that the Chinese government has been presenting to the world are not completely accurate. Starting from 1989-2018 (according to Wikipedia), the average annual growth rate that the Chinese government has put out is 9.25 percent. Put another way, the Chinese economy is said to be more than 14 times as large as it was in 1989.

For comparison, the U.S. economy is only 3.6 times as large on a nominal basis than it was in 1989. While this by itself is not necessarily cause for skepticism, the fact is that China appears to have a system in which leaders at various levels are judged on the economic numbers that their regions produce. (1) This produces an incentive to get the “right” numbers and further incentivizes numbers falsification when the true numbers come in low. This virtually guarantees distortion of the final economic numbers in a positive direction. Even overstating the number by 1 percentage point over 30 years can have the effect of implying that the size of the Chinese economy is nearly a third larger than it actually is.

Earlier this year, several academics (Wei Chen, Xilu Chen and Michael Song of the University of Hong Kong, and Chang-Tai Hsieh of the University of Chicago) looked into additional (aka, harder to fake) data such as tax receipts, nighttime light intensity from satellites, electricity generation, railway cargo and merchandise exports to name a few. They estimate that China has been overstating its GDP growth rate by 1.7 percentage point since 2008. (2) Even assuming that the 2008 GDP numbers were accurate, this would imply that China’s GDP is roughly 20 percent smaller than what the Chinese government is saying it is.

Whatever the true size of China’s economy, it is clearly smaller than what is being portrayed by the government and the popular press. For a system whose entire legitimacy depends on providing prosperity, high published growth rates can for a time satisfy a population that has been promised prosperity with the image of that prosperity being visible in the near future, even if it isn’t currently here in the present. However, that game can only go on so long. When the people lose faith, the legitimacy of the entire system can be called into question, with resulting civil unrest.