Perhaps the most important problem, one not easily corrected because of strong political opposition, is that close to one half of manufacturing output is produced by state owned enterprises (SOEs). These enterprises are less efficient on the whole than private companies, they often have monopolies in their sectors, they are not important innovators, and they get privileged access to capital from state-owned banks.
The China 2030 report argues that the SOEs must operate more like commercial companies, but that is not easy since officials from the Communist Party usually have high positions in these enterprises, and many of the larger SOEs are closely related to the Communist Party and the military. The ideal solution would be to privatize most SOEs, but that does not seem likely in the near future. This is partly because government officials would lose power if SOEs were privatized, and partly because the government fears that privatized companies would greatly cut employment and increase social unrest.Unfortunately for China, it would not be possible to close rapidly the per capita income gap with rich countries as long as a large fraction of manufacturing output in China is produced in over-manned and inefficient state enterprises.
Private companies in China have great difficulty borrowing from state banks since most of their lending goes on favorable terms to the SOEs. The financial crisis in the West has increased the reluctance of Chinese leaders to open their capital markets to competition from foreign banks and funds. Yet greater private banking access to Chinese companies and households seems essential for China's continued rapid growth.
China is very worried about social unrest, as it observes the Arab Spring and other unrest toppling governments. Many protests in China originate in rural areas where farmers complain about their inability to sell the land they farm, and about local governments that arbitrarily take their land to build factories or infrastructure. The Chinese government also fears the 150 million migrant workers who complain about their low wages, and about the discrimination against them in gaining access to housing, schools for their children, and health services. Unrest also arises from non-migrant factory workers who complain about working conditions, and arbitrary differences in wages between workers with similar productivities. Basically, most of the unrest in China is due to the fact that much of the increase in inequality is not grounded in productivity differences, but rather in discriminatory government rules and behavior.
As China continues to grow, households will demand that a larger fraction of national income goes into consumer goods and services at the expense of investments and the accumulation of foreign reserves. Spending on consumer goods accounts for only 35% of China's GDP compared to over 70% in the US. Chinese enterprises would be induced to look more to its domestic market if the Renminbi was allowed to float and appreciated a lot relative to the dollar and other currencies. For then Chinese companies would have more trouble exporting their outputs to other countries.
Ultimately, the challenge for China is to move more toward a private enterprise economy with flexible and competitive labor and capital markets, where assets like land can be bought and sold rather freely, and where workers are free to move around the country without discrimination, and to take whatever jobs they want. I confess I do not know if China will make these reforms quickly enough to prevent a sizable slowdown in their drive to becoming a rich country. The experiences of both the Soviet Union and Japan shows both that it is very hard for countries to change their ways when they have had considerable economic success, and that the slowdown in growth rates is abrupt once it happens. Still, I would not bet against the ability of Chinese leaders to radically change their economic ways once again if that becomes necessary to continue to grow rapidly.
