CHINAS ECONOMIC REFORM: AN OVERVIEW* Introduction China completes 60 years since the founding of the PRC in October 2009,

but now, 29 years of the struggle for socialism (1949-78) under very unfavourable conditions have been eclipsed by 30 years of capitalist reforms. The new China that has emerged is an economic powerhouse. China stands out as an outstanding success among transition economies. Even as others, especially those in Eastern Europe, experience negative growth, falling living standards and hyperinflation, Chinas dramatic growth rates and rising living standards have been outstanding even when compared to the tigers of South-East Asia. India and China have always been compared and this comparison is inevitable because of striking similarities amidst differences. There is little doubt as to who has performed better. China outperforms India by any yardstick except on the inflationary front. This is accepted by almost all the observers. However, there is unanimity regarding the reasons for Chinas superior performances. This is a far cry from the sixties, when China, despite high investment rates, was racked with economic stagnation and famines that claimed the lives of millions of people. With the buildup of social infrastructure in the pre-reform period and physical infrastructure in post reform, China has advanced rapidly with superior performance. Economic Reform In the first two decades of post-Mao period during 1978 and 1998 China transformed itself from a centrally planned economy to an emerging market economy. During this period growth averaged 10 percent a year, and per capital GDP more than quadrupled. Chinas transition to a market economy has taken place in two stages. In the first stage (1978-93), reformers introduced incentives, hard budget constraints, and competition by decentralizing government, allowing non-state (mostly local government) enterprises to develop and expand, maintaining financial stability, and adopting a dual-track approach to market liberalization. In the second stage (199498), China aimed to develop best-practice market institutions. It allowed convertibility of the current account, overhauled the fiscal system, reorganized the central bank, downsized the government, and began to privatize state-owned enterprises. China did not adopt a conventional model which contains stabilization, liberalization, privatization, and democratization. She has succeeded despite the lack of complete market liberalization, privatization and secure private property rights, or democracy. In the first stage she has been undergoing highly dynamic and profound yet smooth internal institutional changes in an unconventional manner. China started the reform in 1978 with a clear desire to increase productivity and raise living standards by reforming its economic system and structure. Although China did not establish uniform rules or international bestpractice institutions during its first 15 years of reform, it nevertheless underwent dynamic and fundamental institutional changes in four main areas.

The note prepared by Prof. K.G. Sahadevan, IIM Lucknow for classroom discussion.

Regional decentralization of the Government: China devolved government authority from central to local levels. Local government supervised about three-quarters of the state industrial firms. Township and village governments directly controlled township and village enterprises (TVEs). Local governments were given significant regulatory authority over the local economy, issuing business licenses, coordinating business plans, resolving business disputes, and attracting foreign investments. They were responsible for local public goods such as schools, health care, utilities, and so on. The devolution of authority was accompanied by fiscal incentives. Under the fiscal contracting system, local governments entered into long-term fiscal contracts with higher level governments. Many were allowed to retain 100 percent at margin so that they kept any revenue above a target amount. The fiscal contracting and eating from separate kitchens system were against the conventional wisdom which holds that economic reform means liberalization of markets and autonomy of enterprises and households, not decentralization within the government organization. Entry and expansion of non-state firms: Growth of the non-state sector is the key to understanding reform in China. Between 1978 and 1993 the share of non-state enterprises increased from 22 to 57 percent. The change occurred without any privatization of state owned enterprises and was entirely the result of fast entry and expansion of new local government enterprises. Most of these local government firms are TVEs. The ownership rights give the government control over firms financial accounts and thus make it less costly to extract revenues from them than taxing private firms. In 1993 such enterprises accounted for 72 percent of rural industrial output and 58 percent of rural employment. They promoted local industrialization and moreover, after-tax profits of TVEs were used largely for reinvestment and provision of local public goods. The local government control over TVEs proved very effective because of three reasons viz., insecure property rights, imperfect capital markets and the particular feature of Chinas fiscal system. Financial dualism: The third institutional pillar of reform in China is financial dualism. Although government fiscal revenue declined sharply, it was accompanied and partially compensated for by an increase in quasi-fiscal revenue from impressive financial deepening. This deepening provided the basis for Chinas macroeconomic stability and helped it avoid a financial crisis. China promoted two important institutional arrangements in financial system viz., financial repression and anonymous banking. Anonymous banking provided an effective commitment device for limiting the governments predatory behavior and creating private incentives. When transactions are made with cash rather than through bank transfers, it is difficult for the government to monitor business transactions and thus to take away the generated revenue. When bank deposits are anonymous, the government does not know the identity of depositors and is thus unable to target individuals and confiscate their financial wealth. While government could acquire some quasi-fiscal revenue through financial repression, the anonymous banking allowed it to achieve a credible commitment for creating private incentives. Market liberalization through the dual-track approach: China took a dual track approach to price liberalization under which the market was first liberalised at the margin. Under the plan track, economic agents were assigned rights to and obligations for fixed quantities of goods at fixed plan prices, as specified in the plan. Under the market track, economic agents participated in the market at free market prices, provided that they fulfilled their obligations under the plan.
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With this approach real market prices and markets as a resource allocation institution were created in China during the very early stages of reform. The dual track approach to market liberalization could liberalise markets without creating losers and is thus politically appealing. It provided the opportunity for economic agents to be better off; maintenance of the plan track provided implicit transfers to compensate potential losers from market liberalization by protecting status quo rents under the plan. Assessing Reform The four pillars of institutional change contributed to Chinas reform success because they changed the functioning of the government, firms, the financial system, and markets to unleash the forces of positive incentives, hard budget constraints, and competition, but in novel ways. The Chinese experience has demonstrated that reforming the government and providing it with incentives is as crucial as reforming the economy, that non-private and non-state ownership can be an engine of growth, that financial stability can be maintained for an extended period through quasi-fiscal revenues from the banking system, and that dual-track liberalization provides one mechanism for minimizing the number of losers from reform. Despite impressive achievements many problems occurred. First, decentralization of the banking system went too far; e.g., allowing local governments to gain substantial control over the credit supply. It caused inflation. Second, many difficult reforms were delayed. No state enterprises were privatized. No effort was made to establish property rights protected by the rule of law or to set up legal mechanisms for contract enforcement. Third, the achievements up to 1993 were made through institutional innovations that either were ad hoc responses to particular constraints in the planning system or took advantage of loopholes in the system. Although they were effective in breaking the central command, such ad hoc practices were subject to frequent renegotiation and change. Reform: stage II Replacing the system: 1994-98 The second phase of the reform has aimed to replace the planned system with a market system. In 1993, the Chinese Community Party approved a document that supported major advances in coordinating reform policies, establishing a rule-based system, building market-supporting institutions, and reforming property rights and ownership. First, it advocated a coherent package and an appropriate sequencing of reform, known as combining a reform package with breakthroughs in key areas. Second, the new strategy called for a rule-based market system to create a level playing field. Third, the new strategy focused on building market-supporting institutions, such as formal fiscal federalism, centralized monetary system, and a social safety net. Finally, the new strategy addressed enterprise reform in terms of property rights and ownership. The intent was to transform state owned enterprises into modern enterprises with clarified property rights, clearly defined responsibility and authority, separation of enterprises from the government, and scientific internal management. Some of the key accomplishments of this period are as follows. First, in 1994 dual track approach was abolished and unified forex rates and convertibility of the current account was introduced. Second, China introduced current account convertibility of it currency in 1996. Third, major tax and fiscal reform introduced in 1994. Value added tax became the major
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indirect tax. In 1995, the new budge law took effect by which the central government was prohibited from borrowing from central bank and from running a deficit on its current account; deficit financing of capital account was permitted as long as it was financed with government bonds. The law also imposed restriction on local governments from borrowings from financial markets. Fourth, in 1993, the central bank was centralized. The move was intended to reduce the influence of local government over the credit policy of the central bank. In 1995 the central bank law gave exclusive responsibility for controlling monetary policy. These reforms substantially reduced local government influence over monetary policy and credit allocation decisions. Fifth, downsizing and reform of government began in 1998. Most industrial ministries were abolished trimming the number of ministries in the central government from 45 to 29 and number of civil servants was halved from 8 million to 4 million. Finally, large scale privatization of state owned enterprises and layoffs of state workers began in 1995 with the slogan of grasping the large and releasing the small. By the end of 1996, 70 percent of small state-owned enterprises had been privatized. Two institutions accompanied the mass layoffs. Xiagang provided some payments to laid-off workers and Zaijiuye helped displaced workers find new jobs. Completing Chinas transition: Challenges ahead Before China becomes a market economy and realizes its full potential it needs to adopt secondgeneration reform strategies especially in three important areas: the financial system, stateowned enterprises and corporate governance, and the rule of law. Major problems remain in each of these areas and deeper institutional changes are still needed. Transforming the financial system: The institutions underlying Chinas financial system remain primitive and weak. Moreover, the banking system has become more and more fragile because of the growing stock of NPAs in state banks. Estimates indicate that NPAs are more than 30 percent of GDP. This shows that Chinas current financial system is not sustainable in the long run. However, it is pointed out that the fragility of banks in China cannot be compared with that of other Asian countries or Russia which faced financial collapse in late 1990s. First, banks in China are owned by the state; their bad debts thus represent government, not private, debt. The total government debt including NPAs of state commercial banks in China is estimated to be around 30 percent of GDP which compares favorably with the 70 percent in the US and more than 100 percent in Japan. Second, Chinas bad debts are domestic, not foreign. As long as the state continues to control the international capital flow and restrict domestic interest rates and the entry of domestic and foreign banks, it will have the instruments of financial repression at its disposal needed to reduce the costs of financing its domestic debt. Third, neither exchange rate nor political instability seems likely in China in the immediate future. Although a financial crisis in China is not imminent, drastic financial reform is needed. Policy makers will have to deal with both the stock and the flow of bad loans. China needs to introduce a bankruptcy procedure. As major creditors they should have rights of receivership and the responsibility for reorganizing the bankrupt firms. Restructuring state-owned enterprises and corporate governance: Although new private firms are being formed and small state-owned enterprises are being privatized, large state-owned enterprises still constitute the backbone of the Chinese economy. Such enterprises represent the
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main revenue source and financial burden for the government and are ultimately responsible for the financial sector problem. Transformation of these enterprises is thus critical. Managers of state-owned enterprises are political appointees. The party intervention in enterprises resulted in high agency costs and political costs. Corporatisation and depoliticisation are difficult tasks for China because they necessitate political reform. Establishing the rule of law: The big challenge of China is establishment of the rule of law. The economic advantages of the rule of law over ad hoc arrangements are transparency, predictability, and uniformity. Establishment of the rule of law reduces idiosyncratic risks, rentseeking, and corruption, which in turn reduces transaction costs. It establishes the relationship between the government and markets that is needed to make credible commitments. It provides a foundation for secure private property rights against government intrusion. Second, the rule of law protects private property rights, enforces contracts, and creates a level playing field for market competition. Therefore, government must become a neutral third party, a regulator rather than a manager. A completely independent judiciary though impossible under a one-party system, it is very necessary for Chinas transformation. Lessons from Chinese reform Chinas transition path has been so unusual that it casts doubts on some the conventional thinking on reform and system changes. Three important conclusions can be drawn from Chinas reform experience. First, reforming a planned economy can be successful. Second, the system change from a planned to a market economy can occur without a political revolution. Third, transition to markets can be achieved without following the same path to reform. Policy makers must accommodate country-specific conditions. Chinas experience provides several important lessons about reform in particular and institutional change in particular. First, considerable growth is possible with sensible but imperfect institutions. Second, removing one distortion may be counterproductive in the presence of another distortion. Third, transition economies lack basic market-supporting institutions and the people and human capital to operate them. It means that some existing institutions can be useful to market-oriented reform before they eventually vanish. Fourth, institutional changes that create incentives, impose hard budget constraints, and introduce competition should apply not only to firms but also to governments. Fifth, successful reform depends on political support, which in turn depends on delivering tangible benefits to a large majority of the population. A reform without many or large losers can be politically acceptable and sustainable. Finally, successful institutional change requires appropriate, though not necessarily optimal, sequencing. Chinas experience suggests that existing institutions should be dismantled only after new institutions are in place, or new institutions should be allowed to emerge from the old. To conclude the gap between conventional economic thinking and the realities of Chinas transition shows that our knowledge about institutional change and transition process is limited. There is difference between the final destination and the process of transition; even if we have perfect knowledge about the destination, the appropriate route may still be unclear. As Robert Solow has said, There is not some glorious theoretical synthesis of capitalism that you can write down in a book and follow. You have to grope your way.
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