China’s Economic Puzzle: Unlocking the Secrets with Lan Xiaohuan’s “In the System”

Lan Xiaohuan’s “In the System: China’s Government and Economic Development” (置身事内：中国政府与经济发展) isn’t just another dry economics book; it’s a captivating deep dive into the often-mystifying world of China’s economic miracle. Since its release in January 2021 by Shanghai People’s Publishing House, “In the System” has become a phenomenon, igniting passionate debate across Chinese social media about the role of the government in the nation’s economic success story.

What makes this book so compelling? Lan, an economics professor at Fudan University and the Chinese University of Hong Kong (Shenzhen), masterfully breaks down complex economic theories into an engaging and accessible narrative. Drawing from his own lecture notes, he provides a clear and compelling explanation of how the Chinese government actively shapes the country’s economic landscape. Think of it as a backstage pass to the inner workings of China’s economic engine, revealing the gears, levers, and often-hidden hands guiding its trajectory.

The book’s impact is undeniable. Lauded by influential figures like Luo Yonghao, Liu Gesong, Zhang Jun, Zhou Li’an, and Wang Shuo, “In the System” has resonated deeply with readers eager to understand the forces driving China’s economic ascent. Its popularity is reflected in its stellar 9.1 rating on Douban, amassed from a staggering 80,000 reviews, and its impressive ranking at #54 on Douban’s Top 250 book list.

“In the System” challenges conventional economic wisdom, arguing that to truly understand China’s economic rise, one must look beyond simple market forces and delve into the government’s intricate involvement in resource allocation, investment, and even the day-to-day operations of businesses. Lan provides a unique and insightful lens through which to view China’s economic puzzle, making it an indispensable read for anyone seeking to grasp the nuances of this economic powerhouse.

The Power of the Purse: Local Governments and Fiscal Reform

“In the System” paints a vivid picture of the financial dance between China’s central and local governments, a dance that has undergone dramatic shifts since the era of economic reforms. Chapter 2 delves into this dance, focusing on the pivotal 1994 “fiscal responsibility system” that reshaped the financial landscape.

Imagine China in the 1980s, a country experimenting with the intoxicating elixir of market forces after decades of rigid central planning. This was the era of “fiscal contracting” (财政包干), a system that empowered local governments to keep a portion of their revenue exceeding a pre-determined target. Think of it as a profit-sharing arrangement, incentivizing local governments to grow their economic pie, fueling the rise of “township and village enterprises” (TVEs) that became the engine of early industrialization.

While seemingly beneficial, this financial decentralization had unintended consequences. As local economies boomed, central government revenue dwindled, leading to a phenomenon termed “decline of the two proportions” (两个比重). This referred to the shrinking share of central government revenue in the national total and the overall decline of national budget revenue as a percentage of GDP. This fiscal squeeze left the central government with limited resources to support crucial reforms, social welfare programs, and national projects.

Moreover, “fiscal contracting” inadvertently fostered a culture of off-budget revenue (预算外收入). Local governments, keen on retaining more of their earnings, devised creative ways to circumvent central oversight. Tax breaks for local businesses, coupled with a surge in administrative fees and other less-transparent sources of income, became commonplace. This resulted in a parallel “second fiscal system” operating outside the purview of national budgetary control.

By the early 1990s, the limitations of “fiscal contracting” were becoming increasingly apparent. The central government, starved of funds, faced dwindling authority and struggled to guide national development initiatives. The need for reform was undeniable.

Enter the 1994 “fiscal responsibility system” (分税制). This landmark reform introduced a clear division of tax revenues, categorizing them as central taxes (中央税), local taxes (地方税), and shared taxes (共享税), with the lion’s share going to the central government. This shift aimed to restore the central government’s financial muscle and its ability to steer the national economy.

However, implementing this reform proved far from straightforward. Many local governments, accustomed to the financial autonomy of “fiscal contracting,” fiercely resisted the changes, fearing a significant loss of revenue. Lan vividly recounts the tense negotiations, led by then-Vice Premier Zhu Rongji, who embarked on a nationwide tour to persuade local leaders to embrace the new system. The story of Zhu’s negotiations with Guangdong, a province that had reaped significant benefits under the old system, offers a fascinating glimpse into the complex political maneuvering required to navigate China’s unique bureaucratic landscape.

To ease the transition, the central government implemented a “tax rebate” (税收返还) mechanism, guaranteeing local governments a minimum level of revenue based on their “base year” (基年) tax income. This seemingly technical detail, however, opened a Pandora’s box of “base year speculation.” Local governments, anticipating the change, engaged in a frenzy of tax collection in the final months of 1993, artificially inflating their baseline and securing larger future rebates. This “base year speculation” not only distorted economic data but also highlighted the strategic maneuvering that often accompanies major policy shifts in China.

Faced with shrinking budgetary resources, local governments needed to find alternative ways to finance their ambitious development agendas. This, coupled with the 1998 housing reform that ignited the commercial real estate boom, gave birth to “land finance” (土地财政). This ingenious yet controversial system empowered local governments to capitalize on their control of urban land, generating revenue through land sales and development. “Land finance” became the lifeblood of China’s rapid urbanization, fueling infrastructure investment and economic growth.

Lan’s analysis of this crucial period unveils the intricate interplay of fiscal reforms, political maneuvering, and the rise of “land finance,” providing a nuanced understanding of the forces shaping China’s economic trajectory. The story of China’s fiscal reform serves as a powerful reminder that economic reforms are rarely smooth sailing. They involve complex negotiations, unexpected consequences, and creative adaptations by local actors seeking to maximize their interests.

Building the Machine: Local Government Investment and the Rise of “Land Finance”

Imagine a city in China undergoing a rapid transformation, with gleaming skyscrapers piercing the skyline, sprawling industrial parks buzzing with activity, and sleek high-speed rail lines connecting it to the rest of the country. This breakneck development, characteristic of China’s urbanization drive, demands massive capital infusions, often exceeding the capacity of traditional government budgets. Lan Xiaohuan, in chapters 3 and 4 of “In the System,” pulls back the curtain on the ingenious yet controversial mechanisms behind this development, focusing on “local government financing platforms” (LGFPs) and the emergence of “land finance.”

Picture a cash-strapped local government eager to fund ambitious projects, but facing strict limitations on direct borrowing from banks. This is where LGFPs come into play. These government-backed entities, often dubbed “Urban Investment Companies,” operate as financial intermediaries, leveraging their unique relationship with the state to secure loans and investments. Think of them as the financial arms of local governments, tasked with building the infrastructure and attracting the businesses that drive economic growth.

The linchpin of this system is “land finance” (土地金融), a uniquely Chinese model that capitalizes on the government’s control over urban land. LGFPs, often endowed with vast tracts of land by local governments, use this land as collateral to secure loans from banks or issue bonds, known as “Urban Investment Bonds” (城投债). The repayment of these loans is typically tied to future land sales revenue or other government-backed sources. It’s a financial alchemy of sorts, transforming land, an immobile asset, into a dynamic source of capital that fuels urban development.

Lan illustrates this complex dance with compelling case studies. Take, for instance, the restoration of the historic “Wide and Narrow Alley” district in Chengdu. This project, fraught with challenges of preservation, demolition, renovation, and reconstruction, demanded significant financial resources and a long-term vision, making it unattractive to private investors. Enter Chengdu Cultural Tourism Development Group (成都文化旅游发展集团), a wholly state-owned LGFP that undertook this ambitious project, showcasing how LGFPs can play a crucial role in preserving cultural heritage while driving urban renewal.

Another compelling example is the Suzhou Industrial Park, a sprawling economic zone home to a plethora of multinational corporations. Here, the development model took a slightly different path. While a state-owned LGFP, Suzhou Industrial Park Zhaorun Investment Holding Group (兆润集团), spearheaded the initial land preparation and infrastructure development, another state-owned enterprise, China-Singapore Suzhou Industrial Park Development Group (中新集团), took the reins for attracting investors and managing the park’s operations. This two-pronged approach highlights the adaptability of the “land finance” model, demonstrating how LGFPs can collaborate with other entities to manage different phases of development.

However, “land finance” isn’t solely the domain of state-owned LGFPs. Private companies like China Fortune Land Development (华夏幸福), have entered the arena, showcasing the “industry-city integration” model. Under this model, local governments grant vast tracts of land, encompassing both industrial and residential zones, to private developers, who then shoulder the responsibility of transforming this raw land into thriving urban centers.

China Fortune Land Development, famously dubbed a “city builder” by the Chinese media, epitomizes this approach. Their landmark project, the Gu’an New Industry City in Hebei province, encompasses a staggering 170 square kilometers. While these private developers are tasked with attracting industrial investment and creating jobs, their primary source of profit often comes from developing and selling residential real estate. The proceeds from these sales are then used to subsidize the often less-profitable industrial development, effectively mirroring the government’s “land finance” playbook, albeit with a private sector twist.

This blending of public and private interests in land development underscores the unique nature of China’s economic model. The line between government and market actors can often blur, particularly in large-scale urban development projects where both public and private capital are essential.

This entanglement also extends to the “Public-Private Partnership” (PPP) model, a globally recognized approach to infrastructure development. While PPPs are not a Chinese invention, they have taken on distinct characteristics in China. First, the sheer scale and number of PPP projects in China are unparalleled. Second, despite the “private” component in PPPs, the dominant players are often state-owned LGFPs or other government-affiliated companies, highlighting the lingering influence of the state in economic affairs.

Lan’s insightful analysis of these various models sheds light on the creative and often-controversial mechanisms that have propelled China’s rapid urbanization. By understanding the role of LGFPs, “land finance,” and the complex interplay of public and private interests in land development, one can gain a clearer picture of the forces shaping China’s urban landscape, and the challenges and opportunities that lie ahead.

Navigating the Debt Maze: Challenges and Reforms

China’s economic miracle, built on a foundation of relentless investment and rapid infrastructure development, has come at a price: a mountain of debt. Lan Xiaohuan, in “In the System,” doesn’t shy away from this thorny issue. He dissects the intricate web of debt that entangles local governments, state-owned enterprises, and banks, and explores the government’s efforts to navigate this treacherous financial landscape.

The reliance on “land finance,” while initially a boon for development, has become a double-edged sword. Local governments, fueled by the seemingly endless well of land sales revenue, embarked on ambitious construction projects, often outpacing real economic growth and accumulating a heavy debt burden. This debt-fueled growth model, reminiscent of a speeding train, faces the risk of derailment if not carefully managed.

As Lan points out, the cracks in the system began to appear around 2010, as the global financial crisis and subsequent European debt crisis exposed the vulnerabilities of China’s debt-laden economy. The “four trillion yuan” stimulus package, while successful in staving off a severe economic downturn, further amplified the debt issue, pushing the total debt-to-GDP ratio to alarming levels.

To address the looming debt crisis, the central government initiated a series of reforms, akin to a delicate surgery on the nation’s financial system. One key intervention was the implementation of “debt swaps” (债务置换), a clever financial maneuver aimed at alleviating the debt burden on LGFPs. Imagine a local government struggling to repay high-interest loans taken out by its financing platform. Debt swaps offered a lifeline, replacing these costly loans with lower-interest government bonds, easing immediate repayment pressures and reducing overall interest payments.

Furthermore, the government embarked on a mission to reform the LGFPs themselves, pushing for their transformation into more sustainable entities. The aim was to wean them off their role as government financing conduits and instill greater financial discipline. This involved clarifying their relationship with the government, pushing for greater transparency in their operations, and most importantly, eliminating the implicit guarantees that had shielded them from market forces. Breaking this “too big to fail” mentality was crucial in forcing LGFPs to operate more responsibly.

However, tackling the debt problem required more than just reforming the borrowers; the lenders also needed a dose of discipline. The government introduced regulatory measures to rein in banks and other financial institutions from reckless lending to LGFPs. This included stricter lending guidelines, closer scrutiny of loan applications, and a crackdown on creative accounting practices used to circumvent lending restrictions.

Recognizing that reckless spending by local officials had contributed to the debt buildup, the central government introduced a powerful tool: lifelong accountability for excessive borrowing (终身问责). This sent a clear message that officials who prioritize short-term gains over long-term sustainability would face serious consequences, even after leaving office. This accountability mechanism aimed to curb the “spend now, worry later” mentality that had permeated some levels of government.

Yet, the most fundamental reform lay in overhauling the very structure of China’s financial system. The government recognized the need to shift away from a system dominated by bank loans, an “indirect financing” system with inherent risks, towards a more diversified system that embraced “direct financing” through capital markets.

Think of it as diversifying China’s financial portfolio. Direct financing, through stock and bond markets, allows businesses to raise capital directly from investors, reducing reliance on bank loans and creating a more robust and resilient financial system. This shift not only reduces the concentration of risk in the banking sector but also introduces greater market discipline, as investors demand accountability and transparency from companies seeking their funds.

However, transitioning to a direct financing system is a monumental task, requiring extensive reforms to enhance market transparency, investor protection, and regulatory oversight. China’s capital markets, while growing rapidly, are still relatively young and lack the depth and sophistication of their counterparts in developed economies.

Moreover, as Lan astutely observes, the success of capital market reform hinges on a fundamental shift in the very role of the government in economic affairs. For direct financing to flourish, the government must relinquish some of its control over investment decisions, allowing market forces to play a greater role in allocating capital. This implies a shift away from a system where government-backed entities dominate investment towards a more open and competitive market where private investors bear a greater share of the risk and reward.

In essence, China’s debt challenge is more than just a financial puzzle; it’s a reflection of the country’s complex economic structure and the lingering influence of the state in resource allocation. The government’s multifaceted reforms, while commendable in their ambition, will require continued fine-tuning and adaptation as China’s economy matures and integrates further into the global financial system. Navigating this debt maze demands a delicate balance between preserving financial stability, promoting economic growth, and empowering market forces to play a more decisive role in shaping China’s economic future.

Why “In the System” Is Your Guide to China’s Economic Reality

“In the System” isn’t just a book for economists; it’s a must-read for anyone who wants to understand the real China, the China beyond the headlines and tourist snapshots. Lan Xiaohuan accomplishes something rare: he makes complex economic issues clear, engaging, and even exciting, like watching a high-stakes game unfold.

For Americans used to a clearer separation of government and business, “In the System” is eye-opening. It takes you inside the world of Chinese local officials, showing their immense power over land, investment, and even the success or failure of individual businesses. You’ll see how this power fueled China’s boom, but also created its challenges: ghost cities, mounting debt, and a reliance on exports that’s now causing global friction.

What makes this book so valuable is its honesty. Lan doesn’t shy away from the downsides of China’s model, but he also doesn’t offer simplistic solutions. He helps us grasp the tough choices China faces as it transitions to a new phase of growth, one that’s more sustainable, more equitable, and less reliant on the old playbook.

If you’re a businessperson eyeing the Chinese market, a policy wonk trying to make sense of China’s global ambitions, or simply a curious reader fascinated by this rising power, “In the System” is your guide. It’s more than just an economics lesson; it’s a window into the soul of China’s economic engine, its strengths, its flaws, and the forces that will shape its future.