The hype on the Chinese market has reached deafening levels. “If you want to be the world leader in your industry, you must be the leader in China,” said G.E.’s Jack Welch. But a rising chorus of dissenters argue the country’s economy is headed for crisis. So which is it?

A specter is haunting China – the specter of communism. Or rather, the specter of the country’s transition from communism, and the unorthodox path China took to make this transition at world-beating rates of economic growth.

First acknowledge the sheer improbability of what China accomplished. Economies without private property rights are not supposed to grow. And the Chinese economy had poorly protected property rights, excessive and arbitrary regulation, haphazard enforcement of contracts – a recipe for failure. Yet the Chinese economy expanded at nearly ten percent per year between 1980 and 2001. At the end, the average Chinese was 800 percent richer than he had been just over two decades before.

One does not violate the basic laws of economics without doing something a bit unusual. And China’s growth was surely that. As China scholar Yingyi Qian points out, between 1979 and 1993, most of the new firms created in China were not private businesses, they were state-owned enterprises run by local governments. By 1993, these local state-run firms produced 42 percent of China’s national output, against only 15 percent for the private sector.

Certainly, it is an odd “market reform” program that creates more state-owned companies. But China’s leaders knew that most private businesses could not survive the country’s predatory bureaucrats and uncertain property rights. So local governments were authorized to set up their own, public, enterprises. Any “profits” these generated could be kept as local government revenues. (A powerful incentive for tax-starved local officials eager to fund local projects, as well as their own salaries.) China’s leaders surmised, correctly, that local state-run enterprises, selling into competitive national markets, would be both efficient and – backed by local governments – able to protect their own property rights and contracts, even if the legal system was not yet up to the task.

This was a tremendous success. But the catch is that such unorthodox strategies have created a deeply politicized economy in China. Far from the ideal of an unbiased referee – embodied by America’s Federal Reserve Chairman Alan Greenspan, immune to political influence – China’s policymakers frequently step onto the economic playing field.

A recent example: as China’s growth rate has neared ten percent, the country’s leaders have tried to slow an economy they worry is out of control. But this has proved difficult. Local officials, determined to boost growth, simply ignore orders to slow things down. In the first two months of 2004, investment projects at the local level shot up by over 60 percent from the same period a year ago. As a Chinese official explained to the Financial Times – “The local governments are too powerful. If they want a loan, then local banks can’t really refuse.”

To be sure, highly interventionist governments can deliver rapid growth. Especially in export-oriented economies. Backing individual businesses does little harm when what these businesses want is to succeed in competitive foreign markets.

But the Achilles heel of such regimes is their performance in economic downturns. No business wants a recession, so interventionist policymakers try to prevent them – in the process creating imbalances that can turn a downturn into a full-blown crisis. Beholden to well-connected financial firms, the Thai government held its currency peg until the country’s foreign reserves were all but wiped out – sparking the Asian financial crisis. The Korean government allowed influential business conglomerates to continue borrowing until debt-to-equity ratios reached unsustainable levels and disaster ensued. In the wake of these debacles, the fast-growing “Asian Tigers” were redubbed “crony capitalists.”

Certainly, the extreme pessimists are wrong. China’s growth is no mirage. And, despite recent problems, slowing the overheating economy should be possible.

But when China approaches its next real downturn the true test will come. The levers of political intervention in the economy, held by local governments and others, are many and powerful. If the economy does slow, these levers will be thrown. Rather than the “hard landing” which concerns many commentators, the danger for China is a landing that is too soft. Interventionist efforts to force growth, and defy the business cycle, will produce inefficient investment, excessive lending – in sum, imbalances that could easily turn the country’s next cyclical downturn into a true economic crisis.

This article was originally published on, before I sold the website to Roubini Global Economics.