Over the past few decades, China’s economic transformation has been miraculous. The country has risen from dire poverty to become the world’s second-largest economy, driven by rapid industrialisation, export-led growth, and strategic infrastructure investments. Despite this impressive trajectory, however, China faces significant challenges that threaten its continued economic ascent. The issue mainly lies in a systemic contradiction: China’s market liberalisations are halted by the grip of its extractive political institutions. While China could spur economic growth in the past with its unique model, the system’s inherent bipolarity is unsustainable. This contradiction between partially inclusive economic practices and a centralised political structure impedes China’s long-term economic success. To understand China’s success story, its current woes, and its likely future trajectory, one must distinguish between inclusive and extractive institutions.
Inclusive institutions are characterised by market openness, a high degree of secure property rights, and a level playing field between market players. An example of this in the history of China would be the introduction of Special Economic Zones in the 1980s where the local economy was handed over from state control to market forces. This shift enabled local populations to pursue their own interests within the economy. Hence, new businesses could be created, enter or leave markets, and did not suffer from artificial competitive advantages that might be enabled by an interventionist state favoring certain firms and markets over others. Overall, markets operating under inclusive institutions are distinguished by creative destruction, where people pursue their own talents and interests, leading to high levels of productivity, investment, and innovation driven by technological change.
Extractive institutions, on the other hand, are characterised by a substantial concentration of power and wealth in the hands of an elite that centralises control and excludes the broader population from power. These elites exploit the economy for their own gains. Examples of this are Chinese State-Owned Enterprises, which receive preferential treatment via financial support by the state over private companies, creating an unlevel playing field. Under such institutions, markets are not fully open, property rights are insecure, and innovation is stifled. The features of inclusive economic institutions appear only in a limited fashion or within a constrained time frame. Instead of free markets driving economic growth, it is the political elite that allocates resources to various sectors and that determines the degree of inclusivity in political and economic affairs. It is precisely this latter scenario that characterises China’s economic development over the past few decades.
To illustrate this situation, in their book Why Nations Fail, Daron Acemoglu and James A. Robinson use the analogy of a bird caught in a cage: the bird represents the Chinese economy while the cage constitutes the state’s control. For example, with Deng Xiaoping’s rise to power, the Chinese economy was gradually liberalised. Private property was introduced, the price mechanism was handed over to the market, and industries were partly privatised. Hence, inclusive economic institutions were established to a limited degree—or to utilise the metaphor, the cage was enlarged so that the bird had more room to fly. However, it was never genuinely set free. This partial opening of the Chinese economy led to an influx of foreign capital and technology, which were predominantly channelled into state-led investments in infrastructure and real estate.
Despite these limited reforms, however, China’s economy remains coercive due to the weak protection of property rights and the state’s near-total control over strategically important sectors, such as banking and finance. China’s rise was remarkable, yet it came with significant contradictions. The partially inclusive economic institutions exist under a framework of extractive political institutions. This bipolarity is not sustainable in the long run: either the extractive political institutions must transform into inclusive ones or economic institutions will revert to a high degree of extraction. The latter scenario is more likely and, in fact, is currently unfolding in China.
For the past 40 years, China leveraged cheap labour stemming from its economic opening to transform itself from a low-income country to a global power with high competitiveness. Now, however, China is stuck in the middle-income trap, meaning that the effectiveness of the factors that initially spurred its development, namely the cheap production of goods and state-led infrastructure investment, has waned. Why is that? China’s economic model depends on international trade through massive export volumes of cheaply produced and subsidised goods. As general incomes in China have increased, labour costs have risen as well, which diminishes China’s competitiveness over other countries.
To escape the middle-income trap and sustain economic growth, China must transition from an economy dependent on cheap exports to one driven by domestic consumption and innovation. Nevertheless, Chinese consumption levels remain too low—so low, in fact, that the economy frequently faces deflation. This reflects the impact of the Chinese Communist Party’s (CCP) disincentivising institutional framework, which undermines individual freedom, entrepreneurship, and technological development.
The inability and unwillingness of the Chinese Communist regime to attempt to escape the middle-income trap by introducing more fundamental market reforms prompted Xi Jinping to enact far-reaching interventionist measures. These are not solely intended to resuscitate economic growth but also to secure the CCP’s grip on Chinese society by rolling back some of the major reforms of the past decades. This strategy involves 1) providing massive fiscal stimuli through infrastructure construction projects and industry subsidies and 2) the Communist state taking control of vast parts of the economy by re-nationalising companies, cracking down on critical industries like the tech and financial sectors, and extending coercive regulation throughout the economy.
Instead of improving the Chinese economy, these interventionist policies have contributed to further declines in growth rates due to the misallocation of resources caused by the state’s assertive role in the economy. For example, the Chinese government’s mismanagement of the economy led not only to the overproduction of certain goods and services but of entire cities. State-sponsored real estate investments led to the construction of so-called ghost cities and huge building projects that are practically empty due to the low demand and artificially high supply of apartments. The construction of huge real estate projects might indeed grow the economy in the short run. But crucially, the discrepancy between low demand and high supply constrains capital and resources to unproductive assets which prevents the continuation of long-term economic growth.
Consequently, the CCP’s interventionist economic policies have left the Chinese economy more vulnerable to severe financial bubbles, especially in the real estate sector, as illustrated by the collapse of the Evergrande Group, one of China’s largest real estate developers. While China’s economic development has been impressive, it is underpinned by the insoluble conflict between market openness and extractive political control. Without significant institutional reforms within its economy, China’s growth prospects remain constrained, making it increasingly difficult to achieve long-term economic growth.
If China wants to sustain its economic prosperity, it must not roll back but build on its past reforms, which entails handing over more power to the private sector instead of conducting massive state intervention schemes in the economy. Herein lies the systematic contradiction of a CCP- led China, and its quest for complete control over the country.
