The Chinese economy is in trouble, but not because of COVID-19

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After months of draconian COVID-19 lockdowns, the Chinese economy seems to be catching a break. In May, China’s exports surged due in large part to strong demand overseas. Inflationary pressure stayed mild, raising hopes for Beijing to stimulate lackluster growth.

But observers should curb their enthusiasm about China’s economic recovery, and not just because of the lingering pandemic. A cornerstone of China’s state capitalism, local governments’ strong incentives to grease the economic wheel, is broken, which started before the current wave of lockdowns swept the country.

China has been perhaps the most cited example of an economy making great strides despite a lack of political freedom and civil liberty — at least for a good while. The main reason for such success has been that the Chinese government, particularly at the local levels, has a vested interest in pro-growth policies. In a 2019 co-authored paper in the Journal of Institutional and Theoretical Economics, I explained how this could happen when an autocracy has the incentive to pursue public capital.

Where you stand sometimes depends on where you sit, and for local governments in China, a large part of their fiscal income sits on land sales. Until recently, local authorities had derived nearly half of their dough for years by auctioning off long-term land-use rights — a way around China’s constitutional requirement that land is publicly owned.

When land is so dear to a government’s heart, it should come as no surprise when the government spares no effort to keep land prices high, for example, by building infrastructure and improving the local business environment. Hangzhou, home to Alibaba Group, derives about 60% of its government revenues from land sales, and the funds are known to be responsible for ambitious projects, such as hosting the 2022 Asia Games.

England, after Henry VIII’s break with Rome in 1534, had a similar experience. As he separated the Church of England from papal authority, the king dissolved monasteries, convents, and the like and seized the massive amounts of land they sat on. According to University of Chicago historian John Nef, for about a century, a significant fraction of crown revenues in England came from such land sales, and the English government was considered business-friendly for its efforts to build national markets and encourage commerce.

But this driver for China’s economic success faltered last year, when a little-noticed change in Beijing’s heart took much of the local governments’ incentives away.

In June 2021, China’s central government announced it would take control of the collection of land-sales revenues from local land departments. From then on, property developers would make land-purchase payments to Beijing, which would then let local authorities use the funds attributed to them. While, technically, the funds still belong to local governments, the policy put local authorities under Beijing’s microscope, making them less free to manage their economies.

To understand why that matters, imagine that you still make a living the way you want, but suddenly the federal government controls your paychecks. Now, imagine it’s China’s government. Local governments’ land sales revenues started to slump in July 2021, foreshadowing the property market crisis later that year and the continuing economic struggle to this day.

There’s no question that the way Beijing handles COVID’s spread is deeply destructive to the world’s second-largest economy. But it’s misguided to think that the end of lockdowns will solve China’s economic problems. As long as local governments lack the incentives to promote growth, China’s economy won’t be out of the woods.

Weifeng Zhong is a senior research fellow with the Mercatus Center at George Mason University and a core developer of the open-sourced Policy Change Index project, which uses machine-learning algorithms to predict authoritarian regimes’ major policy moves by “reading” their propaganda. He is also the curator of the Wei To Think Again newsletter on U.S.-China competition.

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