Perils of decentralisation with Chinese characteristics
India must note that decentralisation, once celebrated as a reason for China’s economic miracle, has turned counter-productive.
India is closely observing China’s model of decentralisation, once celebrated as the driving force behind its economic miracle. However, recent developments show that this decentralisation may now be counterproductive. During his Independence Day speech, India’s Prime Minister urged states to compete with each other to attract investments. While this is a strategy that worked well for China in the past, extreme subnational competition there has reached its limits, raising important lessons for India.
(i) The Nature of China’s Decentralisation
In China, decentralisation has meant that local governments handle an overwhelming 51% of total government spending, in stark contrast to India where city-level administrations account for less than 3% of government expenditure. Chinese local governments also manage a much broader range of services, from unemployment insurance to pensions—tasks typically handled by national governments in countries like India.
However, despite the high degree of decentralisation in China, the country does not operate under a federal system. Unlike in federal countries where the powers of lower-level governments are constitutionally protected, in China, the central government retains the authority to override and extinguish the powers of local governments. A clear example of this was seen after Deng Xiaoping’s reforms in the early 1990s when local governments went on a spending spree, prompting the central government to limit their financial autonomy through the Tax-Sharing Reform of 1994.
(ii) The Overcapacity Trap
Local governments, eager to promote economic growth, began focusing on industrial development at the expense of public services. They offered industrial land at discounted prices to attract investors, hoping that increased industrial output would drive regional economic growth and, in turn, boost tax revenues. Firms, benefiting from these cost advantages, produced goods at lower prices and exported them globally. This investment-led model worked well for many years but was structurally prone to overcapacity—creating more goods and services than the market could absorb.
This competitive growth model is akin to a car with two accelerators but no brakes. While it generated significant wealth during the tenure of leaders like Hu Jintao, it also resulted in wasteful investments, overproduction, and loss-making industries. The central government’s broad policy directives allowed local governments the freedom to experiment with different economic models, which helped stimulate growth. For instance, Guangdong Province pioneered special economic zones, while other regions pursued alternative growth strategies. This local autonomy fostered innovation and contributed to China’s economic rise.
Additionally, the global geopolitical climate at the time was favorable. International markets were willing to absorb China’s surplus production, particularly in industries like steel. Between the early 2000s and 2010, China went from being a net importer of steel to the world’s largest producer and exporter. Although overcapacity in the steel sector became a major issue by the 2010s, many Chinese companies thrived, creating significant value for both employees and the government.
(iii) The Tipping Point
The cracks in this model began to show around the time Xi Jinping came to power. A 2014 report by China’s National Development and Reform Commission (NDRC) estimated that nearly half of all investments made between 2009 and 2013 were “ineffective,” resulting in an estimated $6.9 trillion in wasted resources. To address this problem, Xi Jinping’s administration tightened central control over the economy, establishing stricter regulations on how and where investments should be made.
Under Xi’s leadership, central directives became much more specific and focused, leaving local governments with less room to experiment. The push for self-sufficiency led to an emphasis on certain key sectors, such as the semiconductor industry, where the government sought to localize the entire supply chain. The “Big Fund,” established in 2014 to develop China’s domestic chip-making capabilities, encouraged local governments to pour money into semiconductor firms. However, after a decade of investment, China still struggles to produce advanced chips. Many of the firms receiving government funding have not lived up to expectations, and local governments continue to funnel resources into loss-making industries.
As of mid-2024, 30% of China’s industrial firms were reporting losses, marking the worst performance since the Asian financial crisis of the 1990s. This downturn can be attributed to the overcapacity problem, where local governments, driven by competitive pressures, continue to support industries that produce more than the market demands. This overproduction has now become a liability, especially as international markets increasingly view China’s economic policies as a national security threat.
(iv) Geopolitical Challenges and Overcapacity
China’s overcapacity issue is not just a domestic concern; it has become a global one. Other countries now see Chinese overproduction in industries such as electric vehicles and telecommunications equipment as a threat to their own industries. These geopolitical tensions have been exacerbated by China’s aggressive foreign policy and its pursuit of self-sufficiency in sectors like technology. This has led to growing mistrust of Chinese products and investments on the global stage.
In response to these challenges, Xi Jinping’s government has tried to shift the focus from exports to domestic demand. However, this transition has proven difficult. China’s economy, long driven by supply-side investments, is ill-equipped to pivot to a demand-driven growth model. Additionally, efforts to find new international markets through the Belt and Road Initiative (BRI) have been less successful than anticipated. Many of the countries involved in the BRI are not economically strong enough to generate the demand that China’s overcapacity requires.
(v) Lessons for India
China’s decentralisation model, once hailed as a success, now shows signs of strain. Overcapacity, wasteful investment, and a lack of effective governance have created a situation where decentralisation has become counterproductive. This should serve as a cautionary tale for India, where the central government is encouraging states to compete for investment. While competition can drive innovation and growth, extreme decentralisation without the right checks and balances can lead to inefficiencies and economic imbalances.
One of the key differences between India and China is that India operates within a federal framework, where the powers of state governments are constitutionally protected. This means that state governments in India have more autonomy than their Chinese counterparts, which could make India’s decentralisation efforts more sustainable in the long run. However, India must be careful not to repeat the mistakes of China, where unchecked competition among local governments led to overcapacity and waste.
(vi) The Future of China’s Economy
China now faces a critical juncture. The country’s decentralisation model, which once drove its rapid economic growth, is no longer sustainable. If China continues down this path, it risks further economic decline. Overcapacity and a failure to adapt to changing global conditions have already hurt key industries, and without significant reforms, the situation could worsen.
China’s aggressive push for self-reliance in sectors like technology, combined with its overproduction in industries like steel and telecommunications, has alienated key international partners. To avoid further economic isolation, China will need to recalibrate its political and economic relationships with major global powers. Without a shift in strategy, the country’s economic prospects could continue to deteriorate.
(vii) Conclusion
The decentralisation model that once underpinned China’s economic success is now a source of significant challenges. Overcapacity, wasteful investment, and strained geopolitical relationships have exposed the flaws in China’s approach. For India, the lessons from China’s experience are clear: decentralisation must be balanced with effective governance and a focus on sustainable, long-term growth. If not, the risks of decentralisation turning counterproductive, as seen in China, are all too real.
