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"As long as human rights are violated, there can be no foundation for peace. How can peace grow where speaking the truth is itself a crime?"

The Great Fall of Chin

May 18, 2012

Qi hu nan xia, goes a Chinese proverb: When one rides a tiger, it is difficult to dismount. For the leaders of China’s 1.3 billion people, the import is clear. Stay on the tiger’s back, issue commands, and hope like hell the beast doesn’t turn on you. Over the last quarter-century that approach has served the mandarins of the Communist Party well. China became an economic marvel and staked a claim as the world’s next superpower. Civil liberties, social development, environmental husbandry, and political transparency were subordinate to the imperatives of growth. Increasing complaints about the avarice and gangsterism of government officials could be dismissed as local problems as long as an  enlightened elite was thought to be guiding the state with a steady hand. Even when under pressure to reform, China’s leaders could reassure themselves that their grip on power remained secure.

Not anymore. The Communist Party faces the most serious threat to its authority since the Tiananmen Square uprising of 1989. The case of Bo Xilai alarms China’s leadership precisely because it weakens the impression of strength and competence they have labored so hard to maintain. A tough-on-crime princeling about to be welcomed into the ruling elite is suddenly accused of being corrupt; his wife is implicated in the murder of a British business associate; the family’s fortune, totaling over a hundred million dollars, exposes the wealth high-ranking bureaucrats have amassed at the public’s expense.

These episodes have revealed to the world—and to a sizable portion of the Chinese people—a culture of greed, violence, and deceit at the highest levels of government. The Communists’ power is not in imminent danger, but their legitimacy is.

Already on the defensive, China’s leadership was left sputtering with indignation on May 2 after a blind dissident, Chen Guangcheng, left the protection of the U.S. Embassy in the company of Ambassador Gary Locke. Chen has suffered years of persecution for challenging forced abortions and sterilization. In another era Chen might have disappeared the moment he left the embassy, where he sought refuge a week earlier. The circumstances of his departure from U.S. custody remain murky, and it’s impossible to know whether Chen and his family will be protected from harassment in the future. But China is in the spotlight now. Secretary of State Hillary Rodham Clinton, visiting Beijing for the the annual Strategic and Economic Dialogue, announced that China had committed to let Chen “pursue higher education in a safe environment.”

For China’s partners in commerce, this is a time of confusion and risk—and also opportunity. Western companies such as Hewlett-Packard (HPQ), Caterpillar (CAT), General Motors (GM), and Siemens (SI) have bet big on the continuation of China’s economic miracle. No sensible CEO dares to kick the Chinese leaders when they’re down. With the outcome still uncertain, no one wants to pick sides, either.

Finesse is called for, along with a clear focus on what really matters. Western governments and businesses benefit if China moves in the direction of free markets and democracy. They lose if China’s leaders try vainly to keep the lid on the pressure cooker. While Western leaders don’t have much influence over what happens next, they can at least keep the lines of communication open while quietly appealing to the enlightened self-interest of China’s would-be reformers. “Thinking people understand the need for change,” says Duncan Clark, chairman of Beijing-based consulting group BDA China. “China is the Pragmatic Republic of China; ultimately pragmatism drives everything.”

All of which is to say that it’s a mistake to stop doing business with China. Just as it’s a mistake to think this is business as usual.

The Bo Xilai case is rocking China and shaking the West because it has revealed the breakdown of a contract between the leaders and people of China. The unspoken deal is that the colorless chiefs of the Communist Party will deliver prosperity, keep low-level graft under control, and ensure a smooth transition of power every 10 years. In return, the Chinese people will work hard and tolerate their lack of say in how their country functions.

Until recently the skids appeared well greased. This fall the 18th Party Congress is expected to name the reform-minded Vice President Xi Jinping, 58, as president and Party secretary. Li Keqiang, 56, executive vice premier in charge of the economy, is in line to be premier. Those appointments are still on track. What’s now in play is who else will sit on the nine-member Politburo Standing Committee, the group that collectively runs China. Bo won’t get his once-expected seat. Who ascends is the subject of a multi-directional struggle among forces including those of current President Hu Jintao and of his 85-year-old predecessor, the still-active Jiang Zemin. The 2,000 or so delegates who will vote are being selected now in backroom bargaining that’s undoubtedly brutal.

Bo’s disgrace has thrown into question the leadership’s ability to groom its successors, a key aspect of its promise to the people. For China’s rulers, the scandal comes at a bad time. Touting their stewardship of the economy, the sine qua non of Party legitimacy, is no longer an easy sale. They’re caught between trying to deflate a real estate bubble and trying to prop up the real economy, whose 8.1 percent rate of growth in the first quarter was the slowest since 2009. Even after a recent rally, the Shanghai Composite stock index remains 60 percent below its frothy 2007 high. (America’s Dow Jones industrial average is just 6 percent off its 2007 high.)

For China and its foreign investors alike, there’s a risk that a fearful leadership will retreat further from democracy and free markets. “People are trying to save themselves. Nobody wants to have their flank exposed during this period, so there tends to be a move toward conventional policies, conservative policies,” says BDA’s Clark

Such a retreat would buy China’s leaders only a superficial calm. So-called mass incidents—riots, strikes, and protests—doubled in five years, to 180,000 in 2010, according to Sun Liping, a sociologist at Beijing’s Tsinghua University. Last year’s Wukan village uprising over land grabs and the death of a protester suggested that local party officials are losing control over their jurisdictions. “They have kept society stable by bribing the society, in effect by buying the people,” says Jean-Pierre Cabestan, head of the department of government and international studies at Hong Kong Baptist University. “But how long is that sustainable now?”

China already has inequality comparable to the Philippines and Russia and is far less egalitarian than Japan, the U.S., and even Eastern Europe, according to Li Shi, an economist at Beijing Normal University. The top 10 percent of urban Chinese earn about 23 times that of the poorest 10 percent, according to official figures—which are almost certainly understated. Even those whose lives have improved resent those who have climbed even higher by milking the system.

The country’s political order resists change. Hu’s “Harmonious Society” campaign, which he initiated in 2005, has curdled into something unwholesome. Harmony has become a synonym for uniformity, obedience, and censorship. In a dig at Hu’s slogan, Chinese whose electronic communications have been blocked or bleeped joke that they have been “harmonized.”

Repression works, until it doesn’t. In a new book called Why Nations Fail, economist Daron Acemoglu and political scientist James Robinson predict that China’s economic miracle will fade because the security-obsessed government will continue to resist the creative destruction that is crucial to innovation, and because the concentration of power at the top will produce spasms of instability as factions fight for victory and its spoils.

Western investors care less about political repression in China than about state encroachment on private enterprise. Guojin mintui, the expression goes—the state advances, the private sector retreats. Some firms with full or partial state ownership are world-class, like China Mobile (CHL), the world’s largest mobile phone company in terms of subscribers, with 660 million users. But too many mediocre state-owned enterprises still beat out private players with below-market-rate financing and special access to government contracts. “How do you compete on big deals if your competitor is one of China’s favored children?” asks Howard Chao, a senior partner in the Asia practice at law firm O’Melveny & Myers.

That’s not foreign executives’ only peeve. Of about 300 U.S. companies surveyed last November and December by the American Chamber of Commerce in China for its 2012 annual report, 79 percent said enforcement of intellectual property rights was ineffective, up from 70 percent in last year’s report. Some of their complaints were beyond the government’s control: 89 percent said China was losing competitiveness because of rising costs, up from 78 percent in the 2011 report.

Investors are starting to act on their words. In March, foreign direct investment into China fell about 6 percent from a year earlier, the fifth straight month of decline. That was the longest streak of monthly declines since 2009, when the financial crisis caused multinationals to slow overseas investment. China doesn’t depend on money from abroad, but it does require the technology and know-how that foreign multinationals bring.

China and its investors need each other. Ford Motor (F) Chief Executive Officer Alan Mulally has built Chongqing into Ford’s biggest manufacturing center outside of southeastern Michigan. Ford’s latest foray was announced after Bo Xilai was ousted as Chongqing’s Party secretary. In a visit to Bloomberg Businessweek on May 1, Mulally said, “I really enjoyed working with him.” But he made clear that Ford did not rely only on Bo. “We maintain productive relationships with the present leaders and future leaders,” he said. “China is very supportive of the auto industry and of our partnerships.”

Bo, son of a Mao-era revolutionary hero, had cast himself as a neo-Maoist in opposition to officials pressing a capitalist agenda. In Chongqing—a heartland city of 30 million styling itself as the Chicago of China—he favored a strong government hand and redistribution to the poor. Seen in that light, his downfall should be good for foreign investors.

But Bo was also that rare character in China who was willing to challenge the status quo by trying new things, a valuable quality in a country suffering from leadership sclerosis. In Chongqing, Bo was reforming the hukou, or household registration system, which controls rural-to-urban migration. He was also experimenting with a property tax, a rarity in China, as a way to raise more revenue from the rich and suppress real estate speculation. His fall could stall those initiatives.

On a more elemental level, Bo’s fall may have sent a message to other would-be disrupters: Lie low. “The biggest victim of what is happening now is any notion of systematic reform,” says Northwestern University political scientist Victor Shih. “This has sent a very strong signal to all in government that any attempt to carry out systematic changes that harm the interests of other interest groups and factions will result in serious political trouble for the instigator of those changes.”

The optimists’ case is that the scandal could catalyze change. “The reformers have the upper hand now,” says Alaistair Chan, an economist who covers China with Moody’s Analytics (MCO) in Sydney. “The reformers hope this whole Bo incident shows the downside of having the government too much in the economy.”

With the downfall of Bo, Wang Yang, now Party secretary of Guangdong, is seen as having a better chance to win one of the top spots in Beijing. His record in China’s southern export powerhouse is encouraging to many. Wang has opted to rely mainly on private businesses, encouraging their growth with tax breaks and by squeezing out lower-margin industries with tighter labor and environmental regulations—what Wang has dubbed “emptying the cage and changing the bird.”

This isn’t the first time China’s leaders have seemed vulnerable. The government survived the turmoil of the Tiananmen crackdown in 1989, and then made it through the big restructurings of state enterprises in the 1990s without serious problems. “Remember, this is a society that between 1994 and 2001 laid off 60 million workers,” says David Zweig, a professor in the social science division of Hong Kong University of Science and Technology. “They laid off the population of France. And they managed it.” Huge numbers of Chinese are happy members of the ownership society, with cars and title to their homes.

Still, China’s leaders are making a mistake if they conclude that purges, repression, and state capitalism will work again. When the People’s Liberation Army retook control of Beijing’s Tiananmen Square in June 1989, the protester who blocked a column of tanks was captured by a single Associated Press photographer named Jeff Widener. He had to smuggle the film out of a Beijing hotel in his underwear. China is far less isolated today. Despite Hu’s attempts at “harmonization,” repression cannot hide.

Democracy and openness are values Western governments and business leaders need to press for, however tactfully. Lacking democratic legitimacy, China’s leaders retain support only by delivering a steadily rising standard of living. Jason Mann, head of China healthcare equity research at Barclays (BCS) in Hong Kong, updates the tiger-riding proverb to surfboard-riding. “As long as you stay in front of the wave,” he says, “it’s fine.” The flip side is that you are in constant danger of being swallowed up. That’s no way to live, or to run a country. —With reporting from Bloomberg News.

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