Why China Works

China is the only major economy that is likely to show significant growth this year, because it is the only one that routinely breaks every rule in the economic textbook. There is no truly free market in China, where the state doctors statistics, manipulates the stock markets, fixes prices in key industries, owns many strategic industries outright, and staffs key bank posts with Communist Party members and tells them to whom they should lend, and in what they should invest. In fact, the main reason China is not slowing as fast as the other big five economies is its capacity for what economists ridicule, in normal times, as state meddling: it limited foreign investment in the banking sector and didn't embrace the exotic financial innovations that are the melting core of the global credit crisis.

Why does China's brand of command capitalism work? The question has long intrigued economists, who tend to cast the state as hopelessly stupid, the market as naturally brilliant. Now that the United States and Europe are moving toward state control—by nationalizing the banking and car industries, and imposing heavy new regulation on the financial industry—the question has a new urgency. China, the poorest and most chaotic big economy, looks like the one best positioned to navigate what may be the worst global downturn in seven decades.

In a time of crisis, China's bureaucrats can pick from traditional market tools, like their Western counterparts, and from the arsenal of command capitalism. Early last year, as the housing market was overheating, they simply ordered bankers to cut back on housing loans: then as home sales began to fall, they offered market incentives, like lower taxes on home purchases. In recent weeks they launched economic rescue efforts similar to those in the west, including a huge ($600 billion) plan to ramp up government spending and big interest-rate cuts. But they've also issued orders that would be seen as improper "intervention" in the West—for example, calling last week on state industries, including steel and construction, to "actively increase" their roles in the economy by buying up new assets at home and abroad.

Once seen as the bad habit of an immature economy, China's state meddling is now seen as a bulwark of stability. "Government control of the most capital intensive sectors leaves me optimistic about China's prospects," says CLSA economist Andy Rothman. "The government can say to companies in these sectors, 'Continue to spend, don't defer your investment plans'." Despite the falls in its biggest export markets and its own stock markets, China's economy looks likely to grow more than 7 percent in 2009—down from the double-digit pace of recent years, but stronger than most. Corporate loan rates are actually up, as state banks loosen credit. In a nation where investment is "the backbone of sustainable growth," accounting for 40 percent of GDP, the state is once again ramping up investment to fight serious threats to growth, says Morgan Stanley Asia chief Stephen Roach. "What we're seeing is that the Chinese command-and-control system can actually work more effectively than other market based systems in times of economic stress," he says.

When the original capitalist roader, Deng Xiaoping, said "It doesn't matter if a cat is white or black, as long as it catches the mouse," he put economic growth above ideology purity. Now Chinese leaders quote Deng to defend the basic deal he offered the Chinese people: autocratic capitalism would provide economic growth, while the Communist Party would retain absolute political power. Many of these leaders now argue that a democratic China couldn't have survived—let alone flourished—in a global recession. "China isn't ready for a democratic free-market system," says Fang Xinghai, the Western-trained director of the Shanghai Financial Services Office. "Think about what happened in the U.S. elections in 2000—if that had happened in China, there would be a war. The genius of Deng is that when he put China on the path to a market economy 30 years ago, he knew the country needed a stable political system [to withstand the changes of reform]. Whatever our system is, it is suitable for China."

China works because it is governed by a radical pragmatism that has focused on a slow but steady shift toward freer markets. Deng called it "crossing the river by feeling for the stones." The state still exerts a strong and stabilizing hand, but it has unleashed a private sector that now controls at least half the economy, and as much as 70 percent if you include state-owned companies that are in fact allowed to operate as private firms. That's up from around 17 percent in the early 1990s. Some 60 percent of GDP growth, and two thirds of new job creation now come from the private sector, according to CLSA.

In 1995, China began a revolutionary dismantling of state-run industry, laying off 46 million state workers—the equivalent of the entire workforce of France and Italy—over the next six years alone. In the years following, the streamlining has continued, sharply raising profitability at state-run firms (it was up 38 percent between 2004 and 2005, for example), and the private sector was allowed to play an increasingly important role in the economy. Rothman calls it "radical change, but over an extended time period." During this period numerous books on Russia's transition to capitalism were translated into Chinese. Above all, the Chinese wanted to avoid the chaos that followed Russia's "big-bang reforms" of the early '90s, which created a corrupt, Kremlin-sponsored economic oligarchy that still haunts Russia today.

China's crackdowns on political dissent have obscured the daring risks it takes on economic reform, even in crises. China opened to Western investment at an earlier stage of development than either Japan or South Korea—in the early 1980s, when its average yearly income was only 760rmb ($500), because Deng recognized that global trade was the way out of national poverty. He also freed peasants to seek jobs in cities, a risky move in a nation with a long history of mobile peasant rebellions. Even after the Tiananmen massacre of 1989, Deng continued to push economic reform. During the Asian financial crisis of the late 1990s, China joined the World Trade Organization, committing itself to a wider opening of its domestic markets. Around the same time, the government allowed laid-off workers to start businesses and buy up state-owned housing for a song, founding an ownership society almost overnight, and setting the stage for a middle-class society, in what Rothman calls "the biggest one-time transfer of wealth in the history of the world."

Now, as a worse crisis gains momentum, Beijing continues to push market reforms in key sectors, even as it reasserts control in others. Banks are one main target of reform. "Capital markets are still dominated by bank lending. We have too few products and we need to get more institutional investors into the market," says Fang Xinghai. To that end, China is boldly moving beyond stocks into new types of complex securities, including stock index funds, corporate bonds and other debt products, and even options and futures trading—albeit simple oil futures, rather than the complex credit derivatives that tanked Western markets. The fact that Chinese leaders understand even in the midst of the credit crisis that more sophisticated forms of securitization can play a stabilizing role is a sign of strategic thinking, and great skill at learning from others' mistakes. Asked what he admires most in Western counterparts, Jiang Jianqing, chairman of China's largest state bank, ICBC, says, "Innovation. Americans have an endless passion for it. Perhaps in the past, it hasn't been so well regulated, but you can't stop it. It's one of the most important ways to push enterprise forward."