Guest post: Corruption may undo China’s economic miracle | beyondbrics | News and views on emerging markets from the Financial Times – FT.com

According to details released by the Chinese media, the Jing’an government invited bids for a project to insulate a teachers’ dormitory. Not surprisingly, a company wholly owned by the Jing’an District Government, the Jing’an Construction Company, “won” the bid, but then gave the Rmb30m project to its wholly owned subsidiary Jiayi Company, which had little experience in this kind of project.After paying government officials bribes to obtain this contract, Jiayi proceeded to farm out various aspects of this project to sub-contractors who paid Jiayi management the highest bribes.In some cases, the work was further sub-contracted to foremen, who also had to pay sub-contractors bribes. At every level, guanxi and the amount of bribes determined who received the contract, not quality, safety or track record. In the end, a welder, hired precisely because he was inexperienced and therefore cheap, accidentally dropped his torch, which set off the fire.

Given the dominance of the state at every level of government, government officials learned long ago that the best way to make some money on the side was to form their own companies, which “bid for” and often won lucrative contracts from the government and from state-owned enterprises.

In many cases, these parasitic companies do not do the contracted work themselves but instead farm out the work to the highest bidders. The owners of these connected companies, often officials themselves or their close friends and relatives, can make money without doing anything. It is rent-seeking in its most naked form.

As this “unspoken rule” way of business proliferates to every corner of the Chinese economy, quality, safety, and basic trust all go out the window, replaced by the subcontractors who could pay the highest bribes.

Although a small number of people are enriched by the system, the vast majority suffers from its consequences. This corrupt system of subcontracting may be partially responsible for the high-speed train crash last month; it is also responsible for the prevalence of radioactive material in China’s homes, as noted by an earlier piece on beyondbrics.

In the mean time, this corrupt system deadens incentives for real innovation and customer service in many sectors. After all, why innovate when a company can bribe government officials for contracts or a guaranteed monopoly? Despite occasional crackdowns, it is hard to see how this logic can be reversed.

At minimum, two major reform needs to be carried out to reverse the corruption. First, the state economy continues to be sprawling and continues to enjoy soft-budget loans from the banks. This creates ample opportunities for connected insiders to set up dummy companies to take advantage of government contracts. Because senior managers of SOEs are not remunerated according to profit (and profit not tied to capability), they are only weakly incentivised to maximise profit but strongly incentivised to take advantage of rent-seeking opportunities, which allow them to privatise state wealth.

If large SOEs, including state banks, were genuinely privatised, owners of firms would be more interested in generating profit and even building the reputation for their own firms, instead of taking advantage of rent-seeking opportunities.

Of course, China’s weak regulatory environment is also to be blamed. With more transparent public oversight, a free media, and accountable officials, the tragedy in Shanghai could also have been avoided.

via Guest post: Corruption may undo China’s economic miracle | beyondbrics | Newsand views on emerging markets from the Financial Times – FT.com.

Unspoken rules, subcontracting, dummy firms, corruption. Nothing is new for these. However, what should be new is the causal links under all these: is corruption causes people losing incentives to innovate, or is there something deeper? I would argue that the real driver behind all these is the family upbringing: kids are taught with respect to results rather than the processes; when they are driven only by the tunnel of light, cutting corners is no big deal; when we look at those corrupted today, do not forget that they are just normal people in China. 

 

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