While it might sound an abstract, dusty issue, the importance of objective, robust laws to protect property and contracts cannot be overstated. For all its prowess, China needs to embrace it.

A clear and reliable legal system, particularly around enforcement of contract and property rights is a bedrock of a successful economy and yet for large parts of the world, ill-defined, or non-existent, property rights and robust legal structures are a serious barrier to growth. The Peruvian economist, Hernando de Soto, for example, in his book The Mystery of Capital, famously highlighted the crucial need for robust property rights. In China, a country that is still under Communist rule, an important question for its future is how to ensure legal protections develop in a way that can be trusted by domestic and foreign investors alike. In this article, Andy Rothman, who is investment strategist for Matthews Asia, the US-headquartered firm, gives his views. The article has been republished with the firm’s permission.

China’s rulers recently missed an opportunity to begin dealing with what I consider the most important long-term obstacle to the country’s continued growth and stability – the rule of law. A recent meeting of senior Communist Party officials concluded with lofty rhetoric about the rule of law, but did not alter a system that still places the Party above the law.

Why the rule of law is important
Regular readers of Sinology know that I am optimistic about China’s medium-term economic prospects, within the context of expecting gradually slower year-on-year growth rates. This optimism is based in large part on the continuing evolution of government policy designed to embrace private enterprise and markets. My biggest concern, however, is that there has been little parallel evolution in China’s governance and institutions.

China’s economy and society are increasingly based on property rights: private companies employ 80 per cent of the workforce, create almost all new jobs and are responsible for most investment and industrial sales; entrepreneurs and artists are creating new intellectual property daily; 85 per cent of urban families own their home; and farmers have land-use rights. Yet the country lacks the rule of law, which is needed to effectively protect these property rights and ensure a fair, rules-based commercial environment.

This is already the source of many of problems. Corruption, weakness in industries dependent on intellectual property rights and the widespread theft of land from farmers - the main cause of protests across the country - are all consequences of the lack of rule of law.

In the near term, China can continue to thrive, as people find ways to navigate corruption and the opaque system, and as the [Communist] Party works to reduce interference in the legal system by local officials. But as the pace of economic growth inevitably slows over the coming decades, China’s unique form of authoritarian capitalism is unlikely to provide the necessary institutional support for a modern, market-based society.

What is the rule of law?
There are many definitions of the “rule of law,” but the World Justice Project provides one based on four principles: the government, as well as individuals, are accountable under the law; the laws are clear, stable and just, are applied evenly and protect property rights; the law-making and law-enforcement processes are accessible, fair and efficient; and justice is delivered by competent, ethical and independent authorities.

“In a society governed by the rule of law, the government and its officials and agents are subject to and held accountable under the law,” according to the World Justice Project. “Modern societies have developed systems of checks and balances, both constitutional and institutional, to limit the reach of excessive government power . . . These checks and balances take many forms in various countries around the world: they do not operate solely in systems marked by a formal separation of powers . . . What is essential, however, is that . . . no single organ of government has the practical ability to exercise unchecked power.”

I would summarise the rule of law as such: Rather than being a power to be wielded by officials, the rule of law is a structure designed to limit the power of officials.

Embraced by the party, at least in theory
The Communist Party has, in theory, embraced the concept of the rule of law. Several years ago, then-Premier Wen Jiabao said, “The most important aspect of building a harmonious society is strengthening democracy and the legal system to promote social fairness and justice.” And last month’s Party meeting endorsed the concept of “ruling the country according to the law”.

The Chinese constitution already calls for a system of rules and procedures to make the government accountable to the people. Article 5 of the constitution states: “No organisation or individual may enjoy the privilege of being above the Constitution and the law.” It is, however, clear that in practice, the law is a tool the Party uses to achieve its political objectives.

One key aspect of the rule of law is an independent judiciary, and Article 126 of the constitution calls for the courts to exercise judicial power independently and without interference by the Party. But the high degree of Party interference in the criminal justice system, and the almost complete absence of due process, is illustrated in Criminal Justice in China, a detailed study led by Mike McConville, a law professor at the Chinese University of Hong Kong, and published in 2011:

“In China’s criminal justice system, the verdict of those cases which are prosecuted in court is never in real doubt. There may be an occasional finding of not guilty, but we did not encounter any such case and reports of such events are rare. Courts operate on a presupposition of guilt based upon the prosecution case file. What happens in the court hearing is largely incidental to verdict and the ‘trial’ is a trial in form only or, occasionally, functions to serve a wider social or political purpose,” it said.

Progress but not fundamental change
The recent Party meeting was billed as an opportunity to advance the rule of law, and there was one significant step in that direction. China’s leaders pledged to reduce corruption and interference by local Party officials in the judicial system. I do expect to see progress here, which should make resolution of basic civil cases more transparent and equitable, reducing the risks of near-term instability.

But the Party leadership also reaffirmed the primacy of the Party over the legal system, meaning that in any case, civil or criminal, Party leaders in Beijing will continue to have the power to intervene to achieve their political aims.

A communique summarising the results of last month’s meeting stated that “the leadership of the Party and Socialist rule of law are identical. . . We must strengthen and improve Party leadership over the rule of law work . . . [and] construct a line of Socialist rule of law work teams who are loyal to the Party, loyal to the country, loyal to the people, and loyal to the law.” It was not random placement that “loyalty to the Party” came well before “loyalty to the law” in that sentence.

Does China need the rule of law?
“Countries with greater constraints on politicians and elites and more protection against expropriation by those powerful groups have substantially higher income per capita, greater investment rates, more credit to the private sector relative to GDP and more developed stock markets,” according to a study by economists Daron Acemoglu and Simon Johnson.

But this conventional wisdom among political scientists and legal scholars is challenged by the extraordinary success of China’s authoritarian capitalist system. Without the rule of law, the Chinese have experienced rapidly rising income growth, booming investment, falling poverty, higher grain yields and lower infant mortality.

“In sum, the experience of the reform era in China seems to refute the proposition that a necessary condition for growth is that the legal system provide secure property and contract rights,” according to scholars Donald Clarke, Peter Murrell and Susan Whiting. “Passably secure property rights . . . were a product of the political-economic equilibrium, in which important ingredients were the central government’s transparent desire for a growing economy rather than class struggle . . .”

It is, however, far from certain that the status quo can survive the challenges of a society that now enjoys greater personal freedom and wealth, and is increasingly aware of how the rule of law protects property rights in other countries. The current system will surely be stressed by the continued deceleration in economic growth rates, and that stress level will rise further when China experiences its first recession to occur when most of its people are working in the private sector and are homeowners. While I do not believe that a recession is on the horizon, it is inevitable over the long run.

As Acemoglu and Johnson point out, “When property rights institutions fail to constrain those who control the state, it is not possible to circumvent the ensuing problems by writing alternative contracts to prevent future expropriation, because the state, with its monopoly of legitimate violence, is the ultimate arbiter of contracts.”

This problem is already visible in rural China, where local officials often violate the property rights of farmers, leading to frequent protests and periodic violence. Changing China’s legal system and institutions to prevent this problem from becoming more widespread, and to support continued economic growth, is the Party’s chief challenge in the coming decades.

Will China get the rule of law?
There are, at this moment, no signs that the Party is preparing to establish the rule of law. The Party appears to want to continue to use the legal system to exercise its political control over the population, rather than to move toward a system that is designed primarily to protect the rights of individuals by limiting the government’s power.

We do need to acknowledge, however, that back in the mid-1980s, when I first worked in China, it was not apparent that the Party was prepared to significantly relax its control over people’s daily lives. But, a decade later, the Party stopped telling its citizens where to live and what to farm. In the mid-1990s, we did not expect the Party to dramatically shrink the state sector and pave the way for private firms to become the engine of growth. Private home ownership was not on the horizon. Today, most urban Chinese work for private companies and own their homes.

During the past two decades, the Party has surprised in many ways. It has taken a path that is unique among authoritarian regimes: relaxing day-to-day control over people’s lives and commercial activities while strengthening the Party’s control over the political and legal systems. This is a key reason why the Chinese Communist Party has outlived other authoritarian regimes. Constant, pragmatic reform of economic policy is also why GDP growth averaged 10 per cent for two decades before cooling to an average of 8.5 per cent over the last four years.

Establishing the rule of law would require the Party to take another unique and dramatic step: to cede to its citizens some of the Party’s control over the political and legal systems. Failure to take this step is not a short-term risk for investors, but I believe it will be key to China’s economic prospects over the next 10 to 20 years.