Middle-income countries, for a variety of reasons, cannot sustain GDP growth rates of 9–10 per cent per year decade after decade, even if they do ‘everything right’.

Doing ‘everything right’ in the Chinese case, however, is going to be a particular challenge. Fundamental changes in many of the institutions governing the Chinese economy and society are likely to be required. This short essay will briefly describe some of these needed changes and then focus on one of the most difficult: the interrelated challenges of eliminating excessive regulation at all levels of the economy, strengthening and fundamentally reforming the legal system, and greatly reducing the corruption and rent-seeking that now undermines the productivity of the economy and threatens the stability of the political system.

Many of the reforms required are well understood, but are either technically or politically difficult to implement. The need to make major changes in the financial system has been accepted, and many changes are underway. Some, such as making the Shanghai and Shenzhen exchanges efficient and fair reflections of underlying economic forces, are technically difficult, and have not been fully solved even by exchanges in the highest-income nations. Wringing political influence out of lending decisions by the banks, in contrast, is technically easy but politically difficult. The problems of state-owned enterprises, particularly those with large political clout and/or monopoly power over their sectors, is mostly politically difficult, but not impossible – as Premier Zhu Rongji demonstrated in the late 1990s, with the use of World Trade Organization accession as a club to force fundamental changes on these enterprises.

More complex reforms that are partially understood include the interrelated reforms of eliminating the household registration (hukou) system, completing the transformation of China into a mainly urban society, setting market prices for rural land, dealing with the rapidly aging population, and general welfare reform that includes all citizens, including rural-to-urban migrants. This combination of related reforms has major financial implications for both central and local governments.

Then there is the need to rely more on domestic household consumption demand to propel the economy forward. Government leaders have been calling for greater reliance on the domestic market for years, but the only increases in the share of domestic demand were achieved through the massive infrastructure and housing construction programs – which have now run into sharply diminishing returns. Household consumption as a share of GDP remains at a low level, although there is considerable controversy over just how low. The problem is that the main vehicle for increasing household consumption is for wages to rise faster than GDP for a good many years, something that is not really under the government’s control.

The challenge of controlling corruption is one of the best ways to illustrate the complexity of the reforms required in both the economic and political systems. China ranks 80th out of 176 total countries surveyed in Transparency International’s Corruption Perception Index for 2012. That said, China’s score of 39 out of a possible 100 is an indicator of the pervasive corruption that it is perceived to have. This level of corruption has not prevented high economic growth in the past but it is likely to become a bigger economic problem in future as China has to depend more and more on productivity growth to maintain a high rate of GDP growth. Social stability may also become more difficult to sustain as the population becomes better educated and its access to information continues to rise through the internet and other sources.

The problem is that China’s approach to corruption is to apply stiff penalties to those who are caught and convicted and, more recently, to put restrictions on the conspicuous consumption of government officials. Relatively little is being done to eliminate the underlying structures that foster much of the corruption and rent-seeking that occurs. In essence, there are two major structural contributions to corruption and rent-seeking in China. One is the enormous number of licenses and procedures that a prospective investor or producer must go through; procedures that, for the most part, involve discretionary decisions by officials from local levels up on through the government hierarchy. The other is the conflict of interest built into a system where the same body – namely, the Communist Party – appoints the heads of all state companies, their regulators, and the heads of bodies – most notably, judges in the legal system – whose job is to resolve conflicts between companies or between regulators and companies.

In the World Bank’s ease of doing business index, China ranks 91st out of 185 countries. Although this doesn’t seem particularly bad, only 5 or 6 of the 94 countries ranked below China are achieving any growth at all. China ranks an abysmal 151st in the subcategory ease of ‘starting a business’. Given its size and diversity, it is reasonable for local officials to have considerable discretion to adjust rules to local conditions, but the number of rules that must be met, together with the discretion of local officials, provides hundreds of millions of opportunities each year to exact payments from businesses if the officials are so inclined – a number that would overwhelm any country’s enforcement effort. The only way around this problem is to greatly reduce the number of rules that require discretionary decisions by officials, make the process as transparent as possible (for example, by putting the process online), and removing discretion of remaining decisions where possible. Everything else should be left to market forces that are likely in most cases to better reflect real local conditions and so be more efficient.

Finally, the built-in conflicts of interest inherent in the current system need to be greatly reduced. Many problems – the advantages of state enterprise management in bidding for contracts, for example – can only be addressed by having regulatory bodies that are truly independent of the companies. The party must get out of the business of appointing company heads and confine its role to appointing regulators. More importantly, there must be a body independent of both the regulators and businesses that can resolve disputes, and that normally means a legal system where the judges are not beholden to the same political authorities as the regulators and businesses. Politically, this is clearly the biggest challenge to reformers, and none so far have been willing to address the issue. In the absence of fundamental changes of this sort, individuals with political connections will continue to receive very large rents – some of them quite legal, but no less undesirable – by lending their names (and implied influence) to the highest bidders.

Dwight H. Perkins is the Harold Hitchings Burbank Professor of Political Economy, Emeritus, at Harvard University. A more in-depth discussion of these issues can be found in Ross Garnaut, Cai Fang and Ligang Song (eds), China: A New Model for Growth and Development (ANU E Press, 2013), presented at China Update 2013.