China's Transition to a Market Economy

Chinas Transition to a Market EconomyYingyi QianDepartment of EconomicsUniversity of MarylandandJinglian WuDevelopment Research CenterThe State Council of the Peoples Republic of ChinaRevised: May 2000AbstractChinas two-decade reform since 1979 has evolved in two stages with the November 1993decision marking a turning point. The essence of this decision is to replace the planning systemwith a modern market system. We examine the process of change in the mind-set of theleadership and analyze its political, economic, and intellectual basis. We then evaluate theprogresses made during the first five years (1994-98). To investigate the remaining challenges,we choose to focus on what we regard as the core issue: establishment of a free and competitiveenterprise system by changing the government-business relationship to an arms-length type.Three necessary tasks are: (i) transforming state-owned enterprises; (ii) promoting privateenterprises; and (iii) establishing the rule of law. In each, we assess the current status and analyzethe opportunities and difficulties for future development.Paper prepared for the Conference on Policy Reform in China at the Center for Research onEconomic Development and Policy Reform (CEDPR), Stanford University, on November 18-20,1999. The findings, interpretations, and conclusions expressed in this paper are entirely those ofthe authors. They do not necessarily represent the views of the Chinese government. The authorsare grateful to Pieter Bottelier, Nicholas Hope, T.N. Srinivasan, and other conference participantsfor helpful comments and discussions.It was the best of times, it was the worst of times, it was the age ofwisdom, it was the age of foolishness, it was the epoch of belief, it was the epochof incredulity, it was the season of Light, it was the season of Darkness, it was thespring of hope, it was the winter of despair, we had everything before us, we hadnothing before us, we were all going direct to Heaven, we were all going direct theother way, .- Charles Dickens, A Tale of Two Cities1. IntroductionBy the end of 1998, Chinas economic reform has gone through two full decades. Chinastransition from a planned to a market economy has often been portrayed as a gradual andexperimental process, or in Deng Xiaopings widely quoted phrase: crossing the river by gropingfor stones. But how far has China progressed across the river? How tough is the remainingjourney? And how will China navigate to the other side of the river? This paper will give someassessment of these important questions.We view Chinas transition to markets as an evolutionary process in two stages, where thefirst stage spanned about fifteen years between 1978 and 1993 and the second stage began in1994. Although the two stages had much continuity between them, the division is quite clear: thewatershed being the historic decision of November 1993, Decision on Issues Concerning theEstablishment of a Socialist Market Economic Structure, adopted by the Third Plenum of theFourteenth Congress of the Chinese Communist Party.To better understand the significance of this decision, we need to first review the nature ofthe first stage reform, which is the topic of section 2. In that stage, while the basic institutionalframework of central planning remained intact, the reform was carried out incrementally toimprove incentives and to expand the scope of the market for resource allocation. The2incremental reform achieved most success outside the state sector rather than inside the statesector. It was actually a big success: it generated high growth, dramatically improved peoplesliving standards, and eliminated shortage, the common symptom of all planned economies. Itssignificance can only be understood when compared with the seemingly similar reforms in EasternEurope prior to 1990. The most remarkable example is Hungary, which pioneered a seriouseconomic reform by abolishing mandatory planning targets for enterprises as early as in 1968 andbecame a role model for the Chinese reformers in the early 1980s. However, the Hungarianreform failed to eliminate shortage and the Hungarian economy stagnated in the 1980s (Kornai,1986). Similar stories might be told for Poland and the Soviet Union. The failures of economicreform in Eastern Europe provided an impetus for a more radical approach to reform, which onlybecame possible and put into practice after the fall of the Communist Parties from the poweraround 1990. Against this background, the Chinese success in its incremental reforms between1978 and 1993 was a big surprise, and has pioneered an alternative way of transition from plan tomarkets.The November 1993 decision is a historic document because it represents a strategic shiftin the course of Chinas reform. For the first time and in essence, it decides to abolish theplanning system altogether and set the goal of reform to be the establishment of a modern marketsystem eventually to incorporate international institutions recognized as best practice. Thismade the second stage of Chinas reform beginning 1994 comparable to that in Eastern Europeafter 1990 and in the former Soviet Union countries after 1992, although the political andeconomic background leading to such reforms are quite different. As well known, in all countriesof Eastern European and the former Soviet Union, transition to markets began after political3democratization. In contrast, China entered the transition stage without such a political reform.In section 3 we will examine the process of change in the mind-set of the leadership and itspolitical, economic, and intellectual basis.In the first five years since 1994, China attempted several radical reforms according to theNovember 1993 decision. The major ones include unification of exchange rates and convertibilityunder the current account; the overhaul of the tax and fiscal systems with the separation ofnational and local tax administrations; and reorganization of the central bank, includingestablishing cross-province (i.e., regional) central bank branches. China also started to privatizesmall-scale state-owned enterprises, to lay off excess state employees, and to establish a socialsafety net. In section 4 we will provide a critical evaluation of the progresses in these areasbetween 1994 and 1998.Despite of the great achievement, China still has a long way to go on its progressiontoward the other side of the river - a modern market economy. To investigate the remainingchallenges, one is often tempted to prepare a long and comprehensive menu covering many issuesand all of them seem important. But what is the core issue? In section 5, we argue that the coreissue is the change of the government-business relationship to an arms-length type with anestablishment of a free and competitive enterprise system. This is a foundation of any modernmarket system. No one would deny the importance of tax reform, financial reform, or externalsector reform, for example, but without this foundation no tax or financial system can functionwell. To fundamentally change government-business relationship, we consider three tasksnecessary: (i) transforming state-owned enterprises (SOEs); (ii) promoting private enterprises;and (iii) establishing a rule of law to govern the government-business relationship. In each, we4describe the current status, analyze the opportunities and the difficulties, and examine possibledevelopment trends.We conclude in section 6. To be sure, there is no precedent for a country under the ruleof a Communist Party to make a successful transition to a fully-fledged market economy. Nor isthere a precedent under which a centrally planned economy reformed successfully in anincremental way before China did it in its first fifteen years of reform. No existing theory wouldpredict either success or failure in Chinas second stage of reform. China faces many difficultchallenges, but it also has many opportunities. One new favorable factor is Chinas imminentaccession to the World Trade Organization (WTO), which we argue will provide an importantand timely impetus for its further and faster reform. We are cautiously optimistic for China tomake a quantum leap in the next decade in its transition to a modern market economy.2. The Nature of the Reform in the First Stage (1978-93)Compared to the dismal economic performance of the Eastern European reforms in the1970s and 1980s, Chinas incremental reform between 1978 and 1993 was a remarkable success.During this period, Chinas GDP grew at an average annual rate of about 9 percent, or 7.5 percenton a per capita basis. The living standard of ordinary Chinese people improved significantly. Forexample, an average Chinese consumer increased his/her consumption about three times for ediblevegetable oil, pork, and eggs. The per person living space has doubled in urban areas and morethan doubled in rural areas, and total household bank deposits, measured against the GDP,increased from less than 6 percent in 1978 to more than 40 percent in 1993. The number ofpeople living in absolute poverty was substantially reduced from over 250 million to less than 1005million in this period as well. By the end of 1993, reform was supported by people in all walks oflife simply because almost everybody benefitted from it. This was in sharp contrast with thefrustration of Eastern European reformers in the late 1980s, when they saw only a dead end totheir reform efforts of decades (Kornai 1986, 1992).Why was China able to avoid the failure of Eastern European reform? The answer isdeeper institutional changes than those in Eastern Europe (Qian, 1999; Wu, 1999). Thesechanges take the form of incremental reform (zengliang gaige), that is, introducing dramaticchanges outside, rather than inside, the existing core of central planning. The most significant isthe rapid rise of a sector outside the state sector, known as the non-state sector (Qian and Xu,1993; Wu, 1999). In agriculture, nearly 100% activities have been organized by householdfarming by the early 1980s. In non-agriculture activities, the non-state sector includes a variety ofownership forms of enterprises, such as collectives, cooperatives, private businesses, jointventures with foreign firms, and sole foreign invested firms. Unlike SOEs, non-state enterprisesoperated outside of the scope of central planning, and they were subject to harder budgetconstraints and faced more competition than SOEs. The non-state enterprises soon became theengine of growth and industrialization. In 1978, the share of the state sector in industrial outputaccounted for 78 percent of the national total; by 1993, it was down to only 43 percent. Theshare of the state sector in commerce was 55 percent in 1978, and it was down to 40 percent by1993. Because of the absence of privatization of SOEs during this period, the changes of therelative weight of the non-state sector were entirely due to its very fast growth. In contrast, inEastern European countries, despite decades of reform, in the late 1980s, the state sectorcontinued to dominate the economy and their second economy (that is, the non-state sector)6remained insignificant, especially in industry (Kornai, 1986). However, it is worth noting thatduring this period foreign direct investment in China was not significant yet, accounting for lessthan 5 percent of total investment by the early 1990s. Furthermore, domestic private firms werenot significant either, and most of non-state firms were actually local government controlledcollective enterprises, such as rural Township-Village Enterprises (TVEs).Accompanying the rise of the non-state sector was the development of markets. Pricereform started in the way known as dual-track mechanism, that is, prices were free up at themargin while the planned prices were maintained for planned quantities freezed for some time(Wu and Zhao, 1987; Lau, Qian, and Roland, 2000). Again, this is a form of incremental reform.As a result, true domestic market prices for all goods were established quickly and as early as inthe mid-1980s. The planned track was largely phased out in the early 1990s, and by 1993, morethan 90 percent of prices (in terms of industrial output values) were determined by market forcesrather than by the government. In contrast, in Hungary, despite the fact that mandatory planningtargets were abolished as early as in 1968, most prices continued to be administered bybureaucrats and not determined by the market by the late 1980s (Kornai, 1986). Chinas marketdevelopment was also pushed by its fast expansion of foreign trade. Due to the opening policy,both export and import increased much faster than GDP. For example, export to GDP ratioincreased from less than 5% in 1978 to more than 20% by the early 1990s. The expansion offoreign market interacted with domestic market development, which helped push the convergenceof the two tracks.In essence, achievements up to 1993 were made through clever incremental reforms,which differed significantly from the Eastern European reforms up to 1989. On the other hand,7these reforms were often ad hoc responses to particular constraints of the planning system or tookadvantages of the loopholes in it. For example, contracting between different levels ofgovernment and between government and enterprises/households prevailed. Although such acontracting was effective in eroding central planning, these contracts were ad hoc and subject tofrequent renegotiations and change. In the final analysis, by the early 1990s, the core of centralplanning remained.Lenin, in his famous book State and Revolution, has characterized a centrally plannedeconomy as a State Syndicate and a Party-State, Inc. Lenins original description referred to thesituation where the entire society becomes one factory and all the people becomes employees ofthe Party-State. In its narrow sense, this description does not apply even to pre-reform China(nor the former Soviet Union), because of the complex of internal organizational structureinvolving both state and collective sectors. But the essential point of Lenins Party-State remainedvalid for both pre-reform and post-reform China. The Party-State is reflected in the followingthree areas. First, state-owned enterprises are still controlled by the State and the Party in an oldfashion way, if not for daily operation, but certainly for strategic decisions. No single stateenterprise was privatized and almost none went bankrupt. No state employees were ever laid offfor economic reasons. The Party appoints top managers in state enterprises. Although the statesector shrank significantly in relative terms, it expanded in absolute terms in employment, output,and assets. Second, truly private enterprises did not develop at a healthy pace. Truly privateenterprises accounted for less than 15 percent of industrial output by the end of 1993, and almostall of the domestic private enterprises had less than 8 employees. Most non-state enterprises,such as TVEs, were collective or joint ventures which were essentially local government8controlled and not truly private. Local government is, of course, part of the State. Third, newmarket-supporting institutions were not built to replace the old planning institutions. China didnot have a market-supporting fiscal system, financial system, system of corporate governance,social security system, and a modern legal system, for example. Fundamentally, there was no ruleof law, and the State and the Party, not laws, were governing the economy.3. The Essence of the November 1993 Decision and Why the ChangeThe November 1993 decision marks a watershed change, indicating the beginning of anew direction of economic reform. To understand the significance of this turning point, we startby discussing the main contents of this decision and several follow-up decisions. We then analyzethe political and economic basis for the leadership to make such a strategic shift as well as theintellectual inputs contributing to the change.A. The Essence of the November 1993 Decision and Subsequent Ideological ChangesAt the outset of reform, China desired change in order to increase productivity andimprove living standards, but at no time did the leadership think of introducing a full-fledgedmarket system (Perkins, 1994). During the first fifteen years of reform, the official ideology wasthe one of combining plan and market together.In the early 1990s, the mind-set of the leadership started to change. In the spring of 1992,Deng Xiaoping made his famous Southern tour to mobilize local support for further and moreradical reform. The big ideological breakthrough occurred afterwards at the Fourteenth PartyCongress held in September 1992 when the Party, for the first time, endorsed the socialist market9economy as Chinas goal of reform. It is important to distinguish the Chinese socialist marketeconomy from market socialism as advocated by some Eastern European reformers in the1970s and 1980s. In market socialism, the market is a simulated one to serve the purpose ofsocialism based on public ownership (Kornai, 1992). In contrast, in a socialist market economy,the word socialist is an adjective and the goal is market economy. Therefore, a socialistmarket economy differs from market socialism in a fundamental way.The contents of transition to a socialist market economy became clearer one year later. In1993, the Communist Partys Economics and Finance Leading Group, headed by Party SecretaryGeneral Jiang Zemin, worked together with economists to prepare a grand strategy of transitionto a market system. Several research teams were formed to study various aspects of transition,ranging from taxation, the fiscal system, the financial system, and enterprises, to foreign trade.The final output was the Decision on Issues Concerning the Establishment of a Socialist MarketEconomic Structure adopted by the Third Plenum of the Fourteenth Party Congress inNovember 1993 (China Daily, November 17, 1993).The essence of the November 1993 decision is to replace Chinas centrally planned systemwith a modern market system eventually to incorporate international institutions recognized asbest practice. This landmark document represented a turning point on Chinas road to a marketeconomy. This document, together with several subsequent decisions, is a very significant historicevent.The decision made two major breakthroughs. First, the decision called for building ofmarket-supporting institutions, such as formal fiscal federalism, a centralized monetary system,and a social safety net. For example, separation of central and local taxes and their administration10was a critical step in moving toward formal fiscal federalism. Revenue transfers between thecentral and provincial governments were to be based on a fixed formula rather than bargaining. Itrepresents the beginning of a rule based system.Second, the decision addressed the enterprise reform issue in a more fundamental way -property rights and ownership. It decided to transform SOEs into modern enterprises withclarified property rights, clearly defined responsibility and authority, separation of enterprisesfrom the government, and scientific internal management. Also, for the first time, it left the dooropen regarding the privatization of SOEs: As for the small state owned enterprises, themanagement of some can be contracted out or leased; others can be shifted to the partnershipsystem in the fo