The Institutional Foundations of Market Transition in the People's Republic of China

Qian, Yingyi Working Paper The Institutional Foundations of Market Transition in the People's Republic of China ADBI Research Paper Series, No. 9 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Qian, Yingyi (2000) : The Institutional Foundations of Market Transition in the People's Republic of China, ADBI Research Paper Series, No. 9, Asian Development Bank Institute (ADBI), Tokyo, https://hdl.handle.net/11540/4116 This Version is available at: https://hdl.handle.net/10419/111100 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/3.0/igo/ ADB I NSTITUTE W ORKING P APER 9 The Institutional Foundations of Market Transition in the People’s Republic of China Yingyi Qian May 2000 ADB INSTITUTE TOKYO ASIAN DEVELOPMENT BANK INSTITUTE ASIAN DEVELOPMENT BANK INSTITUTE For the past 20 years, PRC’s economic reform has succeeded without complete market liberalization, without privatization and secure property rights, and without democracy. This suggests that considerable growth is possible with sensible but not perfect institutions, appropriate but not optimal sequencing and that some “transitional institutions” can be more effective than “best practice institutions” at certain stages due to second-best principles. This important paper challenges conventional wisdom by showing that (i) planned economies can be reformed, (ii) such reform can be deepened into a full-scale transition to market, and (iii) there may be diverse paths for successful transition depending on country-specific conditions. The author improves our understanding of PRC’s unique reform path and advances a new paradigm for the study of reform and institutional changes in general. ADB Institute Working Paper Series No. 9 May 2000 The Institutional Foundations of Market Transition in the People’s Republic of China Yingyi Qian II ADB INSTITUTE WORKING PAPER 9 This paper is part of the Institute’s research project on development paradigms. Additional copies of the paper are available free from the Asian Development Bank Institute, 8th Floor, Kasumigaseki Building, 3-2-5 Kasumigaseki, Chiyoda-ku, Tokyo 100-6008, Japan. Attention: Publications. The Working Paper Series primarily disseminates selected work in progress to facilitate an exchange of ideas within the Institute's constituencies and the wider academic and policy communities. An objective of the series is to circulate primary findings promptly, regardless of the degree of finish. The findings, interpretations, and conclusions are the author's own and are not necessarily endorsed by the Asian Development Bank Institute. They should not be attributed to the Asian Development Bank, its Boards, or any of its member countries. They are published under the responsibility of the Dean of the Asian Development Bank Institute. The Institute does not guarantee the accuracy or reasonableness of the contents herein and accepts no responsibility whatsoever for any consequences of its use. The term "country", as used in the context of the ADB, refers to a member of the ADB and does not imply any view on the part of the Institute as to sovereignty or independent status. Names of countries or economies mentioned in this series are chosen by the authors, in the exercise of their academic freedom, and the Institute is in no way responsible for such usage. Copyright ©2000 Asian Development Bank Institute and the author. All rights reserved. Produced by ADBI Publishing. ABOUT THE AUTHOR Yingyi Qian is currently Professor of Economics at Maryland University. His research interests include comparative institutional economics, economies in transition, and PRC’s economic reform and development. After receiving his doctorate from Harvard, Professor Qian taught economics at Stanford University throughout the 1990s. During this period he has been awarded a number of fellowships, including the McNamara Faculty and Hoover National. He also holds a Masters in statistics from Columbia and a M. Phil. in management science and operations research from the Yale School of Management. III PREFACE The ADB Institute aims to explore the most appropriate development paradigms for Asia composed of well-balanced combinations of the roles of markets, institutions, and governments in the post-crisis period. Under this broad research project on development paradigms, the ADB Institute Working Paper Series will contribute to disseminating works-in-progress as a building block of the project and will invite comments and questions. I trust that this series will provoke constructive discussions among policymakers as well as researchers about where Asian economies should go from the last crisis and current recovery. The conference version of this paper was presented on 10 December 1999 at the HighLevel Dialogue on Development Paradigms, on the occasion of the second anniversary of the establishment of the ADB Institute. Masaru Yoshitomi Dean ADB Institute IV ABSTRACT This paper intends to properly account for the People’s Republic of China’s (PRC) two decades of market transition by examining its institutional foundations. The journey of transition is analyzed as a two-stage process. In the first stage (1978-93), the system was reformed to unleash the standard market forces of incentives, hard budget constraints, and competition. The underlying institutional forms and mechanisms, however, were far from conventional: reforming government through regional decentralization; entry and expansion of non-state (mostly local government) enterprises; financial stability through “financial dualism;” and a dual-track approach to market liberalization. In the second stage, PRC aimed to build a rule-based market system incorporating international best practice institutions but proceeded in its own way. Major progress was made in the first five years (1994-98) on the unification of exchange rates and convertibility of the current account; the overhaul of the tax and fiscal systems; reorganization of the central bank; downsizing of the government bureaucracy; and privatization and restructuring of state-owned enterprises (SOEs). To complete its transition to markets, however, PRC still faces serious challenges, especially in transforming its financial system and SOEs and in establishing the rule of law. The paper concludes by reflecting on the economics of reform and institutional change from the PRC experience. The main lesson learned is that considerable growth is possible with sensible but not perfect institutions, and that some unconventional “transitional institutions” can be more effective than the “best practice” institutions for a period of time because of the second-best principle. Specific lessons include: incentives, hard budget constraints, and competition should apply not only to firms but also to governments; reforms can be implemented without creating many or big losers; and successful reforms require appropriate, but not necessarily optimal, sequencing. V TABLE OF CONTENTS Preface iii Abstract iv Table of Contents v 1. Interpreting PRC’s Transition to Markets: The Institutional Perspective 1 2. Reforming the System: 1979-93 5 A. Regional Decentralization of the Government 5 B. Entry and Expansion of Non-State (Mostly Local Government) Firms 7 C. “Financial Dualism”10 D. Market Liberalization through the Dual-Track Approach 12 E. An Assessment 13 3. Replacing the System: Since 1994 14 A. Strategic Move: Setting the Goal for a Market System 15 B. Major Accomplishments in the First Five Years (1994-98) 18 C. Political Economy of Reform and the Dynamics of Transition 21 4. Completing PRC’s Transition: Challenges Ahead and Priority Research Agenda 23 A. The Financial System 23 B. State-Owned Enterprises and Corporate Governance 25 C. The Rule of Law 27 5. Reflections on the Economics of Reform and Institutional Change: Lessons from PRC 29 A. Reflections on the Principles of System Change 29 B. Reflections on the Process of Reform 30 C. Reflections on the Theory and Practice of Transition 31 References 33 1 The Institutional Foundations of Market Transition in the People’s Republic of China Yingyi Qian† 1. Interpreting PRC’s Transition to Markets: The Institutional Perspective In the two decades between 1978 and 1998, the People’s Republic of China (PRC) has transformed itself from a centrally planned economy to an emerging market economy and at the same time has achieved nearly a 10 percent average growth rate. During this period, PRC’s per capita GDP has more than quadrupled and the living standard of ordinary Chinese people has improved significantly. For instance, per capita consumption has increased four times for eggs and eight times for poultry, the per person living space has more than doubled in the urban areas and nearly tripled in the rural areas, and total household bank deposits, measured against the GDP, increased from less than 6 percent in 1978 to more than 60 percent in 1998. The benefits of the reform were also shared by people on a broad basis. The number of people living in absolute poverty has been substantially reduced from over 250 million to about 50 million in two decades, a decline from one-third to a twenty-fifth of PRC’s population. Life expectancy on the other hand has increased from 64.37 years in the 1970s to 70.80 years in 1996 (68.71 for men and 73.04 for women), with infant mortality falling from over 50 per thousand in the 1970s to less than 30 per thousand in the 1990s (China Statistical Yearbook, 1997; Almanac of China’s Population, 1997). In 1998, the World Bank moved PRC’s ranking up from a low-income to a lower-middle-income country.1 Such a performance appears more impressive when compared with the average performance of the transition economies in Eastern Europe and the former Soviet Union. By 1998, with only a few exceptions, the great majority of these countries still have not recovered to their 1989 output levels according to official statistics. The PRC performance looks even more impressive when considering the fact that transforming large countries is much more complicated than transforming smaller ones; conceivably, the tasks of transforming Russia or PRC are more challenging than those of transforming Poland or Viet Nam. At the outset, PRC’s reform went against all odds. Coming out of the disastrous decade of the Cultural Revolution, it was poor, over-populated, lacked human capital and natural resources, and was constrained by adverse ideology and political opposition. Two decades ago few economists would have bet on today’s outcome of reform in PRC. † I appreciate the comments of Masahiko Aoki, Nicholas Hope, Lawrence Lau, Boris Pleskovic, Gérard Roland, Andrew Walder, and three reviewers. Original paper first presented at the World Bank’s Annual Conference on Development Economics, Washington, D.C., 28-30 April 1999. The conference version of this paper was prepared for the ADB Institute’s High-Level Dialogue on Development Paradigms, Tokyo, 10 December 1999. The findings, interpretations and conclusions expressed in this paper are entirely those of the author. 1 Centrally planned economies also had a high growth period (such as the Soviet Union in the 1930s and 1950s, Eastern European countries in the 1950s and 1960s, and PRC in the 1950s). However, it is well known that such a growth rate was based on heavy industry expansion at the sacrifice of consumer industry and thus the people’s living standards, and it was always associated with chronic shortages (Kornai, 1980). PRC’s high growth in the past two decades was different: consumer and export industries boomed, the people’s living standards improved, and chronic shortages disappeared. 2 Even so, PRC’s reform experience has been always viewed as an anomaly in terms of transition to a market economy, and it has not been properly accounted for by mainstream economics and thus appreciated by mainstream economists. For example, From Plan to Market: World Development Report 1996 on transition economies (World Bank, 1996) gave PRC short shrift because it could not figure out where to put PRC on the various measurement parameters, and instead illustrated the PRC experience mainly in boxes rather than in the text. PRC simply does not fit the general description of the report. However, the data point of PRC is too important to ignore: it has been one of the most successful transition economies, it produced more than all other transition economies combined in 1998 in terms of GDP, and, moreover, its per capita GDP is very likely to surpass that of the 15 former Soviet Union countries in the next decade, which was unthinkable a decade ago.2 Still, economists tend to underestimate the significance of PRC’s reform experience. The most popular argument is that PRC was a poor agricultural country and thus reform was easy. Of course PRC was much less developed than Eastern Europe and the former Soviet Union at the outset of reform and the latter faced some difficulties that PRC did not have, such as problems of excess industrial capacity and comprehensive welfare coverage. However, this argument does not explain how and why PRC’s reform was successful, especially considering that it faced double difficulties. As a planned economy, PRC faced many problems similar, although not identical, to Eastern Europe and the former Soviet Union, such as a lack of property rights and markets, persistence of a predatory government, and the difficulty of maintaining financial stability. In addition, as an underdeveloped country, PRC also faced many problems that do not exist in Eastern Europe and the former Soviet Union, such as enormous population pressure, severe shortages of human capital and natural resources, very poor industrial and infrastructure bases, and a lack of democracy. The fact that PRC faced the double problem of transition and development presented a bigger challenge and it is far from clear how PRC managed to succeed. After all, there are many poor countries that do not grow. The reasons why PRC’s reforms are not properly understood and thus appreciated by mainstream economists are profound. There are strong prior beliefs, based on the existing knowledge of economics, about the formulation that a transition should use. Furthermore, such beliefs are supported by the strong evidence from the failed economic reform in Eastern Europe and the former Soviet Union prior to 1990 which did not follow that formulation. The theory and evidence together formed a powerful “conventional wisdom” about a set of necessary and sufficient conditions for a successful transition; that is, stabilization, liberalization, privatization, and democratization. Leaving aside the issue of whether they are sufficient to the experts on Eastern Europe and the former Soviet Union, the PRC path of reform and its associated rapid growth seemed to defy the necessary part of conventional wisdom: although PRC has adopted many of the policies advocated by economists, such as being open to trade and foreign investment, and enforcing macroeconomic stability, violations of the standard policy prescriptions are also striking. For most of the past two decades, PRC’s reform succeeded without complete market liberalization, without privatization and secure private property rights, and without democracy. One might have thought that in the absence of these “essential” factors reform would fail. 2 According to Maddison’s (1998) calculation based on purchasing power parity, without taking into account the 1998 Russian economic crisis, PRC’s per capita GDP will surpass that of the 15 former Soviet Union countries by 2010. 9 community government can make use of its political connections with the state banks to channel loans to TVEs, and the state banks are also more willing to lend to TVEs because discrimination against private enterprises makes lending to the latter politically more risky. On economic grounds, the community government is able to reduce the risks borne by the banks through cross-subsidization among its many diversified enterprises (Byrd, 1990), or it can use accumulated collective assets as collateral or as co-investment funds to reduce potential hazards in the lending-borrowing relationship (Che and Qian, 1998a). Also, the community government can reduce information asymmetry involved in market transactions by integrating a number of investments, since market observations drawn from these transactions are much more informative than they are when drawn from transactions resulting from unorganized private investments (Che, 1998). Insecure property rights and imperfect capital markets are also the common features of other transition and developing economies, but why do we not see TVEs or similar types of firms elsewhere more often? The regional decentralization in PRC described above appears to have played a central role, because local governments at township and village levels are empowered with comprehensive authority for local economic development, and they are also provided with the incentives to do so since they can keep the revenues generated (Byrd and Gelb, 1990; Oi, 1992). Elsewhere, the tasks of government bureaucrats are simply collecting taxes and passing them up to the higher level governments. But a deeper question is: why cannot the local government get more revenue by taxing private firms than by developing their own firms? Che and Qian (1998b), using the incomplete contracting framework, argue that ownership rights give the government control over the firms’ financial accounts and thus make it less costly to extract revenues from them than taxing private firms. For the same reason, when local governments control firms, it is also harder for the central government to extract revenue from them, and thus revenue is more likely to stay in the local areas. Therefore, ownership and control make the difference. Econometric studies on the data from PRC’s rural industry provides some evidence to support the above theoretical arguments. Using panel data from 28 provinces in PRC between 1986 and 1993, Jin and Qian (1998) found that the share of TVEs relative to private enterprises in rural industry in a province is higher if the initial collective assets under the control of community government is larger, or if the local political strength to resist pressure from higher level government (appropriately measured) is higher. This evidence is consistent with the theory that local government ownership of firms is related to the institutional environment. They also examined the consequence of ownership of firms on the revenue distribution among the national government, community government, and households. They found that a one percent increase in the share of TVEs relative to private enterprises is associated with a 0.11 percent increase in the shares of revenue accrued to the national government and a 0.24 percent increase in the shares of revenue accrued to the township/village governments. These results confirm the fiscal incentives of the local governments in developing TVEs, and also show that government control of firms plays an important role of substituting for taxation institutions. C. “Financial Dualism” PRC has generally managed macroeconomic stability well, except for the periods of 1988-89 and 1993-94. PRC, no less than Russia, experienced a sharp government tax revenue decline. What, then, are the microeconomic and institutional foundations for its financial stability? The third institutional pillar of reform is “financial dualism” (McKinnon, 1993; Bai et al., 1999). 10 There are two aspects of financial dualism. One aspect concerns government revenue: although tax revenue sharply declined, it was accompanied, and thus partially compensated, by an increase of “quasi-fiscal” revenue from impressive financial deepening. This provides a basis for PRC’s macroeconomic stability and avoids a financial crisis like Russia’s (McKinnon, 1993). In PRC, consolidated government budgetary revenue as a share of GDP declined from 31 percent in 1978 to 13 percent in 1993. Taking into account the extra-budgetary and offbudget revenues, total tax revenue also declined dramatically, from 40 percent of GDP in 1978 to about 19 percent in 1993 (Bai et al., 1999). On the other hand, cash in circulation as a percentage of GDP was less than 6 percent in 1978, and increased to 16 percent in 1993. Total household bank deposits were less than 6 percent of the GDP in 1978, and they increased to about 50 percent in 1993 and further to 62 percent in 1997. The M2 to GDP ratio continued to climb, from less than 50 percent before the reform to more than 100 percent in the 1990s (Almanac of China’s Finance and Banking, 1996). What seems to be surprising is that the financial buildup lasted much longer than most economists expected. The result has been that the government reaped substantial benefits. By one estimation, between 1986 and 1994, the government collected quasi-fiscal revenue from the banking sector, averaging about 9 percent of the GDP, or more than one half of the budgetary revenue (Bai et al., 1999). Bai et al. (1999) go one step beyond the macroeconomic issue of government revenue and study more fundamental microeconomic implications of fiscal-decline-cum-financialdeepening. They highlight the coexistence of two institutional arrangements in PRC’s financial system. The first is the well-known one of financial repression, that is, a combination of government control on international capital flows with restriction on domestic interest rates and private financial activities. The second is what they called “anonymous banking,” which is a combination of the government’s relaxed regulation on the use of cash for transactions and permission to use anonymous household savings deposits. They argue that anonymous banking together with financial repression implies some major advantages over direct taxation in the institutional environment of PRC. The conventional wisdom holds that taxation is less distortionary than revenue extraction from financial repression. But this view ignores the government behavior on taxation. In PRC, as in many developing and transition economies, because there is a lack of rule of law, the government has difficulties committing itself to fixed tax rates, let alone to low tax rates. Such a commitment problem undermines private incentives and is often regarded as a major obstacle to economic development as well as reform (North, 1997; Williamson, 1994). Bai et al. (1999) argue that anonymous banking provides a simple and effective commitment device to limit the government’s predatory behavior and create private incentives. When transactions are made through cash rather than bank transfers, it is difficult for the government to monitor business transactions and thus to tax away the generated revenue. When bank deposits are anonymous, the government does not know the identity of depositors and thus is unable to target a particular person and confiscate his financial wealth. Although the government can still “tax” financial savings through inflation or regulating the interest rate, this method of revenue extraction is indiscriminate. In their model, Bai et al. show that revenue extraction from the financial system can be costly to the government and thus it imposes a limit. Therefore, through anonymous banking, the government is able to achieve a credible commitment for creating private incentives. Through financial repression, although the government can acquire some quasifiscal revenue, it is more limited than discretionary taxation.5 They conclude that indirect 5 As a result, financial repression in PRC was “mild” because the real interest rate was not too negative. Indeed, during the past two decades, inflation was generally below 10 percent. In two periods of 1988-89 and 1993-94 11 revenue extraction through the banking system has not just prevented revenue collapses, but more importantly, it has bound the government’s hands and limited its ability for revenue extraction and thus is conducive to private incentives. The other aspect of financial dualism concerns the lending side of the financial system. There was an asymmetry: state enterprises received the most credit from the state banks and faced soft budget constraints, while non-state enterprises received only limited credit and faced much harder budget constraints. For example, the total size of the SOE industrial output was about twice that of TVEs in the late 1980s and early 1990s. However, loans to rural enterprises (mainly TVEs) accounted for only about 8 percent of all non-agricultural loans, while loans to SOEs accounted for about 86 percent (Almanac of China’s Finance and Banking, 1993). While credit discrimination against non-state firms was often criticized, such discrimination became a blessing because when the non-state sector was subject to a hard budget constraints, it was more disciplined and performed better. An intriguing question is why the state sector is subject to soft budget constraints and the non-state sector is subject to hard budget constraints. One main reason concerns the political benefits of the government. Historically, the government has been committed to the welfare of workers in the state sector in exchange for their political support, but not to those in the nonstate sector. Therefore, the government will bail out state enterprises when performing badly since they value workers’ employment. Another main reason concerns the government’s financial objective. In Bai et al. (1999) the government requires state firms to conduct transactions through state banks so it can conveniently observe them and tax them accordingly. In comparison, non-state firms often use cash for transactions and the government finds it hard to monitor and tax them. Given this difference, the government would prefer to provide credits to state firms rather than to private firms because of its own revenue concerns. The downside of providing credit to state firms is their productivity, which implies a lower potential tax revenue. In Che and Qian (1998a), the difference comes from the control structure. In the case of an SOE, the government controls both the enterprise and the state bank. It therefore receives all the benefits from refinancing a project after sunk investments. This is ex post efficient, but makes less credible an ex ante commitment to no further financing. In the case of TVEs, the community government controls only the TVEs but not state banks. This separation of control over firms and funds induces information asymmetry between the creditor (the state bank) and borrower (the community government on behalf of TVEs). Following the logic of Dewatripont and Maskin (1995), this information asymmetry reduces the benefits the state bank receives from refinancing a project after sunk investment. This in turn increases the ex ante credibility of no refinancing. Therefore, limited authority of a community government becomes a good thing and it serves as a commitment device to harden budget constraints. D. Market Liberalization through the Dual-Track Approach By the mid-1990s, prices of most products in PRC were completely liberalized. But the way the Chinese achieved this result is quite different from the way it was done by the Eastern Europeans. In Hungary, for example, after the 1968 reform, although all mandatory planning was abolished, prices were still determined administratively by bureaucrats subject to political bargaining. There was no real market, only a simulated market (Kornai, 1986). After 1990, on the other hand, prices were swiftly liberalized in one stroke. PRC took a “dualwhen inflation rose to more than 20 percent per year, the government quickly indexed time deposits (over a three-year maturity) to ensure a non-negative real interest rate. 12 track” approach to price liberalization under which the market was first liberalized at the margin while (inframarginal) planned prices and quotas were maintained and then phased out later. 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 pre-existing plan. In addition, a market track was introduced under which economic agents participated in the market at free market prices, provided that they fulfilled their obligations under the pre-existing plan. With this approach, real market prices and markets as a resource allocation institution were created in PRC in the very early stages of reform, which clearly differed from the Eastern European experience prior to 1990. Again the dual-track approach was often criticized by the economists who view it as a partial reform lacking the completeness of liberalization. But Lau, Qian, and Roland (1997, 1999) argue that such a perception is not correct, and that the dual-track approach to market liberalization in fact has two advantages: it can liberalize markets without creating losers and thus is politically appealing, and it can also achieve efficiency under certain conditions. They show, in both partial and general equilibrium models, that independent of the initial conditions concerning supply and demand (such as whether planned prices or quantities are above or below the market equilibrium), as long as the pre-existing feasible plan continues to be enforced appropriately, the dual-track approach to market liberalization is always Paretoimproving. In addition, it also achieves efficiency under usual conditions such as profit maximization and perfect competition, provided market resales and market purchases for redelivery are all allowed. Efficiency-enhancing economic reform should potentially allow winners to compensate losers, thereby making the reform, Pareto-improving. However, in practice, it seems very difficult to find mechanisms that make economic reform Pareto-improving, and even more difficult for reform to be simultaneously Pareto-improving and efficient, because of the distortionary costs of compensation or a lack of credibility in its implementation. The dualtrack approach provides one mechanism for the implementation of efficient Pareto-improving reform. The introduction of the market track provides the opportunity for economic agents who participate in it to be better off, whereas the maintenance of the plan track provides implicit transfers to compensate potential losers from market liberalization by protecting the status quo rents under the pre-existing plan. Thus, the dual-track approach is, by design, Pareto-improving. Moreover, as the compensatory transfers are inframarginal and thus lump sum in nature, the dual-track approach can be efficient too. While single-track (or “big-bang”) market liberalization will lead to efficiency under the usual conditions (such as profit maximization and perfect competition), Pareto-improvement cannot be assured. Furthermore, with the presence of some market imperfection (such as search frictions or imperfect competition), single-track liberalization may cause a decline in aggregate output, as shown in the models of Blanchard and Kremer (1997), Roland and Verdier (1999), and Li (1999), but the dual-track approach can avoid this. It is clear that enforcement of the plan track is crucial for preserving the pre-existing rents. However, sufficient state enforcement power is needed not to implement an unpopular reform, but to carry out one that creates no losers, only winners. One desirable feature of the dual-track approach is its minimal, additional informational and institutional requirements: it utilizes the existing information contained in the original plan and enforces the plan through existing planning institutions. No new information and no new institutions are necessary. Agricultural market liberalization illustrates how the dual-track approach can be both Pareto-improving and efficient. The commune (and later the households) was assigned the obligation to sell a fixed quantity of output to the state procurement agency as previously 13 mandated under the plan at predetermined plan prices and to pay a fixed tax to the government. It also had the right to receive a fixed quantity of inputs, principally chemical fertilizers, from state-owned suppliers at predetermined plan prices. Subject to fulfilling these conditions, the commune was free to produce and sell whatever it considered profitable, and retain any profit. Moreover, the commune and households could purchase grain (or other) outputs from the market for resale to the state to fulfill its responsibility. Under the dual-track, the state procurement of domestically produced grains between 1978 and 1988 remained essentially fixed, while there was almost a one-third increase in grain output. Industrial liberalization also shows how markets could grow out of plans (Byrd, 1991; Naughton, 1995). For coal, PRC’s principal energy source, the planned delivery was increased somewhat from 329 million tons in 1981 to 427 million tons in 1989 (mainly because new state coal mines were opened), but the market track increased dramatically from 293 million tons to 628 million tons in the same period. The increments came mainly from small rural coal mines run by individuals and TVEs. For steel, another of PRC’s major industrial material, the plan track in absolute terms was quite stable, but the share of plan allocation fell from 52 percent in 1981 to 30 percent in 1990. Unlike coal, the supply response in steel came mainly from large SOEs rather than small non-state firms. In the cases of both coal and steel, because the plan track was basically “frozen,” the economy was able to grow out of the plan on the basis of the market track expansion by state or non-state firms. E. An Assessment PRC’s first fifteen years of reform was a remarkable success, judging by the results of fast GDP growth, elimination of shortages, and dramatic improvement in the living standards of ordinary people. By the end of 1993, reform was supported by people in all walks of life simply because everyone benefitted from it. This was in sharp contrast with the frustration of Eastern European reformers in the late 1980s, when they saw only a dead end to their reform efforts of decades. Central planning has long been criticized as an inefficient resource allocation mechanism compared with the market, but its failure has deeper institutional problems than simply planning mistakes or rushed development strategies. Fundamentally, the system is unable, in a credible way, to provide positive incentives to economic agents and to impose financial discipline upon them, and it also fails to create genuine competition. This had remained the case in Eastern Europe even during the economic reform in the 1970s and 1980s (Kornai, 1986). PRC was able to avoid the fate of Eastern European reform prior to 1990 because of its deeper institutional changes. Each of the four pillars of institutional change analyzed above contributed to PRC’s reform success since 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. For example, positive incentives were provided through a variety of means, such as fiscal contracting under regional decentralization, local government ownership, and information decentralization through the relaxation of the regulation on cash and permission of anonymous bank accounts. Harder budget constraints were imposed in circumstances where there are constraints imposed on the government, for example through control rights and information structures. Finally, competition was created not only among firms (both state and non-state) but also among local governments at provincial, city, county, township, and village levels. The PRC experience has demonstrated that reforming the government and providing it with incentives is as crucial as reforming the economy; non- 14 private and non-state ownership can be an engine of growth; financial stability can be obtained for an extended period through quasi-fiscal revenues from the banking system; and dual track liberalization provides one mechanism to minimize the number of losers from reform. Interestingly, none of these methods were recommended by economists; to the contrary, all of them were criticized. Despite these impressive achievements, there were many serious problems during this stage of reform. First, some mistakes were made. For example, decentralization of government went too far in the areas of monetary policy: local governments gained substantial control over the credit supply, and at one point, the bonuses of the central bank’s local branches were even linked to the amount of credit they extended. This was a source of soft budget constraints of local governments and SOEs and of inflation as well (Qian and Roland, 1998). Second, many difficult reforms were delayed. For example, no single state enterprise was privatized and almost none went bankrupt. This is in turn because of the delay of establishing a social safety net. There was also no effort made in establishing property rights protected by the rule of law and contract enforcement mechanisms. Although establishing a rule-based tax system was attempted, it was delayed and failed (Shirk, 1993). Third, and most important, the achievements up to 1993 were made basically through institutional innovations which were either ad hoc responses to particular constraints in the planning system or took advantage of the loopholes in it. The varieties of contracting practices between different levels of government and between government and enterprises were good examples. Although they were effective in breaking the central command, they were ad hoc and subject to frequent renegotiation and change. In their empirical investigation, Jin, Qian, and Weingast (1999) found evidence of the “ratchet effect” over time under the fiscal contracting system: during 1982 and 1992 and on average, a 1 yuan increase of revenue collection this year leads to a 0.24 yuan increase of revenue remittance (or decrease of subsidies) in the next year. They also found that a majority of provinces received extra, though limited, subsidies beyond contractual stipulation, an indication of some soft budget constraints. While the adverse incentive effect of these problems in the case of inter-governmental relationships might be modest, it could be much more serious in the case of the managerial contract responsibility schemes in the SOE reform (Wu, 1995; Qian, 1996). 3. Replacing the System: Since 1994 Since 1994, PRC’s transition has moved into the second stage which aimed to replace the planned system with a market system. I will address three issues in this section. First, I will show that PRC set a goal, becoming clearer over time, to establish a rule-based market economy incorporating international best practice institutions as we know them. In fact, PRC has become the first and the only country in which the ruling Communist Party voluntarily shifted its official ideology to embrace a market system and private ownership. Because many people outside of PRC are still unaware of it, I will provide some detailed evidence to show that this is indeed the case. Second, I will examine advancement in several major areas toward this goal in the first five years of the second stage (between 1994 and 1998). The evidence shows that significant progress has been made, which should clarify many doubts over whether PRC’s reform is continuing. Finally, I will provide an analysis of the political economy of reform and the dynamics of transition, focusing on how the early reforms created constituencies and momentum for further reform without generating obstacles to block it. 15 A. Strategic Move: Setting the Goal for a Market System At the outset of reform, PRC desired reform in order to increase productivity and improve living standards, but at no time did the leadership think that it was going for a full market system (Perkins, 1994). This started to change in the early 1990s. However, establishing that goal in PRC was an evolutionary process, and in that aspect, PRC is unlike some Eastern European countries whose goal was very specific at the beginning of transition, that is, to build a market economy like their neighbors and join the European Union. I will highlight four consecutive milestone events in September 1992, November 1993, September 1997, and March 1999, respectively, to show how this strategic move has evolved progressively over time. The Fourteenth Party Congress of September 1992. During much of the first stage of reform, the official ideology was the one of “combining plan and market together.” A more conservative version of it was “planning supplemented by market” and a more liberal version was “planned commodity economy.” Clearly, the goal of reform was not a market system. In the spring of 1992 Deng Xiaoping made his famous Southern tour to mobilize local support for further and more radical reform. The big ideological breakthrough occurred afterwards at the Fourteenth Party Congress in September 1992 when the Party, for the first time, endorsed the “socialist market economy” as PRC’s goal of reform. It is important to distinguish the PRC socialist market economy from “market socialism” as advocated by some Eastern European reformers in the 1970s and 1980s. In market socialism, market is a simulated one to serve the purpose of socialism based on public ownership (Kornai, 1992). In contrast, in a socialist market economy, “market economy” is the goal and the word “socialist” in an adjective. Therefore, a socialist market economy differs from a market socialism in a fundamental way while it is closer to the “social market economy” of Germany. The Decision of November 1993. The contents of transition to “socialist market economy” only became clearer one year later. In 1993, the Communist Party’s Economics and Finance Leading Group, headed by Party Secretary General Jiang Zemin, worked together with economists to prepare a grand strategy of transition to 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 Market Economic Structure” adopted by the Third Plenum of the Fourteenth Party Congress in November 1993.6 With the objective of a market system in mind, this landmark document made four major advances in the areas of reform strategy, a rule-based system, building market-supporting institutions, and property rights and ownership respectively. It was the turning point on PRC’s road to markets. First, unlike the previous strategy of “groping for stones to cross the river,” the “Decision” emphasized the importance of coordination among various aspects of reforms. It advocated a coherent package and an appropriate sequencing of reforms, known as “combining package reform with breakthrough in key areas.” Second, in the first stage of reform, particularistic contracting played a dominant role, such as fiscal contracting, managerial contracting, and household contracting. For the first time, the “Decision” called for a rule-based market system to create a level playing field. This included the decision to unify the foreign exchange rate and tax rates among all enterprises 6 For the full text of the “Decision,” see China Daily, Supplement, November 17, 1993. 16 regardless of ownership. Shortly before the “Decision,” PRC had already adopted Western accounting rules in its enterprises. Third, the “Decision” focused on the building of market-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 administration was a critical step in moving toward formal fiscal federalism. Revenue transfers between the central and provincial governments were to be based on a fixed formula rather than bargaining. Another example was centralization of the operation of the central bank to minimize the local government’s influence on monetary policies. Finally, the “Decision” addressed the enterprise reform issue in terms of property rights and ownership, rather than, as before, one of “expanding enterprise autonomy.” It intended to transform SOEs into “modern enterprises” with “clarified property rights, clearly defined responsibility and authority, separation of enterprises from the government, and scientific internal management.” It has also, for the first time, left the door open regarding the privatization of SOEs: “As for the small state owned enterprises, the management of some can be contracted out or leased; others can be shifted to the partnership system in the form of stock sharing, or sold to collectives and individuals.” But the major breakthrough on ownership issues had to wait a while longer. The Fifteenth Party Congress of September 1997. In the “Decision” of November 1993, state ownership was still regarded as a “principal component of the economy” while private ownership was a “supplementary component of the economy.” The Fifteenth Party Congress held in September 1997 made a major breakthrough on ownership issues: State ownership was downgraded to a “pillar of the economy” and private ownership was elevated to an “important component of the economy.” In PRC politics, these subtle changes of rhetoric mean a big change in ideology. The document recognized that “varieties of ownership should develop together,” but because private ownership was discriminated against for decades, the major new information here was that private ownership had gained legitimacy. Furthermore, although the rhetoric of public ownership was maintained, its meaning was redefined, because public ownership may have many “different realization forms,” such as joint stock corporations with investment by many owners. At this time, the official ideology toward private ownership finally became “friendly.” The second major breakthrough of the Fifteenth Party Congress was its emphasis on the rule of law. The rule of law is not the same as democracy. For example, the two most free market economies, Hong Kong, China; and Singapore, have the rule of law but are not democracies, by Western standards. PRC seemed to decide to give priority to the rule of law rather than democracy in its sequencing of political reforms and to consider the rule of law crucial for a modern market economy to work well.7 As always in PRC, the content of the rule of law will evolve over time. The Constitutional Amendments of March 1999. Private ownership and the rule of law were incorporated into the PRC Constitution in March 1999.8 An amendment of Article 11 of the Constitution places private businesses on an equal footing with the public sector by changing the original clause “the private economy is a supplement to public ownership” to “the non-public sector, including individual and private businesses, is an important component of 7 Kornai (1998) has emphasized that democracy is not a necessary basis of a market system but a political power that is friendly to private property and the market is. 8 “Top lawmakers yesterday overwhelmingly endorsed China’s [sic] landmark constitutional amendments which enshrine the ‘rule of law’ and bolster the status of private businesses” (China Daily, March 16, 1999). 17 the socialist market economy” (China Daily, March 16, 1999). Immediately after the amendment, local governments started to relax local restrictions on private enterprises. For instance, the Jiangsu provincial government adopted a new policy to give private enterprises equal treatment as state-owned and collective enterprises in the areas of granting business scopes and credit access (People’s Daily, April 9, 1999). Furthermore, Article 5 of the Constitution was amended to include the principle of “governing the country according to law” (China Daily, March 16, 1999). These Constitutional amendments have demonstrated PRC’s commitment to a full market system based on the rule of law. The significance of the strategic move. The failure of Eastern European reform prior to 1990 has made a persuasive argument for the necessity of having democratic reform precede economic transition (Kornai, 1992). The Communist Parties there were unwilling to change their ideology. The collapse of the Communist Parties in Eastern Europe was the logical consequence. PRC provided a case that proved impossible in Eastern Europe and elsewhere: the Communist Party of PRC itself made the strategic shift voluntarily. It appears that PRC is the first and only country under the Communist Party system to embrace private ownership and the rule of law in its Constitution. It is quite remarkable for PRC to have overcome ideological and political opposition to embrace the market system and private ownership without a political revolution. There were both internal and external reasons. The internal reason was that by 1993 reform in PRC had benefitted almost everybody, who envisioned bigger benefits from further reform. Solid political support for further reform came from both the top leaders and the ordinary people, which provided a political basis for ideological change (see more on this in subsection C below). The external reason was that the outside pressure from East Asian countries was enormous; their extraordinary performance pressed PRC to move forward. At the same time, competitive pressure from the Eastern European transition to markets was also significant. The PRC government feared that these transition economies would soon catch up with PRC, which might undermine its legitimacy that was built entirely upon the economic performance of the country. The popular sentiment in PRC for a transition to a conventional market economy can be sensed from the two phrases which have been popular in the 1990s: yu guoji jiegui, which means connect to (or join) the international track (or practice, or standard); and guifan hua, which means standardization. In November 1998, major newspapers in PRC published Joseph Stiglitz’s (1998) article “Second-Generation Strategies for Reform for China,” which contains policy recommendations for PRC for deeper institutional restructuring to complete its transition. This can be interpreted as a strong determination from the top leadership to complete PRC’s move to markets. B. Major Accomplishments in the First Five Years (1994-98) Following the “Decision” of November 1993, a series of radical reforms were launched starting in January 1994. In building market institutions, PRC started a little bit late compared to Eastern Europe or even Russia. Today, it still lags behind the star countries in Eastern Europe such as Poland, Hungary, and the Baltic countries. But this group of countries may be exceptional because of their aspirations to join the European Union. So far, PRC’s progress has been steady, and it has been able to avoid bad mistakes made by some other transition economies. In building a market system, PRC continued its previous practices that were useful, such as government decentralization, financial stability, and compensation for losers in the reform 18 process. It began to address the three problems left from the first stage. First, it corrected some early mistakes, such as monetary decentralization and soft budget constraints on local governments and SOEs. Second, it began delayed reforms, such as privatization of state enterprises and commercialization of state banks. Third, and most important, PRC started to incorporate international best practice market institutions based on uniform rules, but in doing so, it first created new institutions before destroying the old ones. Below, I examine some major accomplishments in those first five years. Many of the reforms will continue into the next decade, but the evidence so far shows that PRC is moving in the right direction and proceeding at a steady pace. Unification of foreign exchange rates and convertibility of the current account. Before 1994, liberalization of foreign exchange markets, like many other markets, followed a dualtrack approach and there existed an official rate and a “swap rate” (i.e., the market rate). Because of the dramatic growth of the market track, by 1993 the share of the plan allocated foreign exchange had fallen to less than 20 percent of the total. On January 1, 1994, plan allocation of foreign exchange was completely abolished, and the two tracks were merged into a single market track. However, for those organizations which were used to receiving cheap foreign exchange, annual lump-sum subsidies in the domestic currency sufficient to enable the purchase of the previous allocation of foreign exchange were offered for a period of three years to compensate for their losses. In December of 1996, PRC went one step further to announce current account convertibility of its currency. However, it did not move to capital account convertibility and yet still maintained capital control. This is one important reason that PRC weathered the Asian financial crisis rather well. Between 1994 and 1998, the exchange rate remained stable and even appreciated slightly from 8.7 yuan per U.S. dollar to 8.3 yuan per U.S. dollar. Both exports and foreign direct investment increased dramatically, and the country’s foreign reserves increased from US$21 billion to US$145 billion. Despite the Asian financial crisis, PRC continued to attract foreign direct investment of about US$45 billion annually in 1997 and 1998. The overhaul of the tax and fiscal systems. Before 1994, the fiscal contracting system had played a positive role of providing badly needed incentives for local governments. But the fiscal contracting was ad hoc and not rule-based. Also, PRC did not have a national tax bureau, and all taxes were collected by local governments, which often reduced or exempted taxes that were supposed to be paid to the central government. On January 1, 1994, PRC introduced major tax and fiscal reforms more aligned with international practices. This reform introduced a clear distinction between national and local taxes and established a national tax bureau and local tax bureaus, each responsible for its own tax collection. This tax reform has made it very difficult for local governments to reduce national taxes as they did in the past (Dong, 1997). Reform also established fixed tax rules between the national and local governments. For example, under the new system, the value added tax (VAT) became the major indirect tax shared by the national and local governments at a fixed ratio of 75:25. But local governments were compensated for their revenue losses for three years. In 1995, the new “Budget Law” took effect. It prohibited the central government from borrowing from the central bank and from deficit financing its current account, but the central government could have deficit financing in its capital account although it had to finance the deficit with government bonds. It also imposed more stringent restrictions on local governments. Local governments at all levels were required to have their budgets balanced (as before), and furthermore, the law strictly controlled their bond issuance and restricted their borrowing in the financial market (a change from the past). To ensure enforcement of the 25 commercial banks, was recently selected by the central bank to experiment with ways of cleaning up its bad debts through a newly-established “financial assets management company” (Singtao Daily, March 6, 1999). The financial reform requires careful research on both the flow and stock problems. To address the flow problem in a fundamental way, PRC needs to introduce a bankruptcy procedure which clearly specifies the rights and obligations of creditors (at present time mainly state banks) in the event of bankruptcy of both liquidation and reorganization types. In particular, banks, as major creditors, should have the rights of receivership and the responsibility for reorganization of the bankrupt firms. Because the current PRC law does not allow banks to hold any equity of firms, research is needed to introduce new regulations which would permit banks to temporarily hold equity during the reorganization period. On the issue of cleaning up the bad debts of state banks, one needs to find a way to ensure that such a clean up will not result in a moral hazard problem from the state banks. To that end, the government must make a credible commitment to no more bailouts in the future. Research is also needed to identify methods to achieve this goal. Another research topic concerns appropriate sequencing of financial liberalization. In the case of Japan, Hoshi and Kashyap (1999) argue that it is not the Japanese main bank system per se but the problematic sequencing of financial deregulation that explains the banking crisis there. Deregulation allowed large corporations to quickly switch to the capital market for direct financing, and at the same time, the banks’ new lending primarily flowed to high risk small businesses and became tied more strongly to the bubble economy. As the bubble burst, a banking crisis emerged. PRC may face similar problems when its state banks become more independent from the government and shift their lending portfolios to smaller firms. To reduce financial risks at the time of financial liberalization, PRC needs to learn the lessons from the recent Asian experiences. B. State-Owned Enterprises and Corporate Governance Reforms of state-owned enterprises have been disappointing. The managerial contract responsibility system promoted in the 1980s had only limited success and SOE performance in the 1990s continued to decline (Wu, 1995). For instance, there were more than one-third of SOEs making losses, and on average, profits and taxes per unit of net capital stock and working capital in state industrial enterprises fell from 24.2 percent in 1978 to 12.4 percent in 1990 and further down to 6.5 percent in 1996 (China Statistical Yearbook, 1997). Even though new private firms are developing and small SOEs are being privatized, this is not a substitute for transforming large SOEs, since they still constitute the backbone of the economy, are the main revenue source and financial burden for the government, and are ultimately responsible for the financial sector problem. Although the excessive “social burdens” of SOEs (i.e., workers’ welfare obligations) are often blamed for their poor performance, the main problems are institutional, concerning finance (the soft budget constraint problem) and personnel appointments (the Party control problem). The soft budget constraint problem has been discussed in Sections 2 and 3, and in recent years the budget constraints of SOEs have been hardening. But Party control over personnel has remained basically unchanged for the past 20 years. The Party has exercised control over the selection and dismissal of SOE managers through its Organization Departments at different levels. For example, the Central Party Organization Department has the authority over appointments of the top managers of very large SOEs (minister or deputy minister level), as does the Provincial (or Municipality) Party Organization Department for 26 most large and medium-sized SOEs (bureau level). This authority applies to joint-stock companies as long as the state has the majority share, even if they are listed on the stock market or are located in the special economic zones. The appointment and dismissal process represents the most important channel of political influence over enterprises by the Party apparatus. Under the Party control personnel system, SOE managers, like mayors, ministers, and Politburo members, are political appointees of the Party. This political process of managerial appointments has several serious problems. First, the appointment process is politicized, secretive, and complicated. When the Party selects both managers and politicians at the same time, it may not choose the right people as managers. Second, the selection and evaluation methods are based on information through bureaucratic rather than market channels (the latter includes the stock market, rating companies, and investment banks). Third, the Party bureaucrats have neither the ability nor the incentives to make the right decisions on managerial selection according to business criteria because they are mainly politically motivated.11 Through “expanding enterprise autonomy” and “increasing enterprise retained profits” (fangquan rangli), the past reforms improved managerial incentives somewhat but the effect was rather limited and short-lived. Why? The main difficulty of reforming SOEs without privatizing them is reflected in the following institutional dilemma (Qian, 1996): On the one hand, delegating more effective control rights to managers provides them with incentives to increase current production but also enables them to plunder state assets, which results in high agency costs. On the other hand, maintaining Party control over the selection and dismissal of managers serves to check managerial asset stripping somewhat but is also the ultimate source of political interference, resulting in high political costs. The SOE problem in PRC is the intertwining problem of both high agency costs and political costs. Before being privatized, large SOEs (including state banks) should aim to reduce both agency and political costs, which can only be achieved by a combination of establishment of corporate governance and depoliticization (Qian, 1996). Corporate governance is a set of institutional arrangements governing the relationships among investors (shareholders and creditors), managers, and workers. The structure of corporate governance concerns (1) how control rights are allocated and exercised; (2) how boards of directors and top managers are selected and monitored; and (3) how incentives are designed and enforced. Corporatization, a process of establishing corporate governance, is a useful step in enterprise reform even without privatization, because it helps hold directors responsible for the assets of the company and prevent further asset theft; provides a mechanism for information exchange; sets the stage for selling shares; and separates the state from enterprise. In Eastern Europe and in other developing countries, corporatization was carried out before privatization and improved enterprise performance. In developed economies, major issues of corporate governance concern legal rules limiting the agency problems, protecting shareholders and creditors, and providing room for managerial initiatives. The same problems arise in PRC, but with a special concern about the role of the state as a large stakeholder. In addition to corporate governance, depoliticization is also necessary, which means that the Party’s direct control over managers should be limited, if not eliminated. Unless the issue of the Party’s role is addressed, the goal of “separation of government and enterprise” cannot be materialized, and unless the state, institutional investors, 11 It is interesting to compare SOEs with TVEs in this regard. Although TVE managers are appointed by township or village governments, they do not go through the higher level Party apparatus and thus they are not subject to the same political process as SOE managers. After all, most TVE managers are not “state cadres.” 27 and individual investors are put on an equal footing, political intervention by the government will continue to plague the performance of these large firms. Corporatization and depoliticization are difficult tasks for PRC because they necessitate some political reform. Future research needs to find a way to limit the Party’s role in the appointment and dismissal process of SOE managers without eliminating its leadership role. There were suggestions about the creation of the State Assets Management Committee to oversee state assets in enterprises. In such a scheme, only the Committee representatives have authority, through the board of directors and depending on the number of shares held by the state, over the appointment and dismissal of top managers (World Bank, 1997). Many questions remain. For example, who will appoint the members of the State Assets Management Committee? The Party, a government agency, the People’s Congress, or others? Will such a person or institution stop interfering in the appointment and dismissal process of the board of directors? More research is needed to make the scheme politically acceptable and economically sensible. C. The Rule of Law The biggest challenge for PRC to complete its market transition is the establishment of the rule of law. The recent Constitutional amendment on the rule of law is a good start. The economic advantages of the rule of law over ad hoc arrangements are transparency, predictability, and uniformity, that reduce idiosyncratic risks, rent-seeking, and corruption, which in turn reduce transaction costs. But the rule of law is more than putting the government’s words into public codes; it fundamentally concerns a relationship between the government and markets that is appropriate for making a credible commitment. There are two economic roles of the rule of law. The first is that the law should be applied to the government — the government needs to be constrained by law vis-a-vis other economic agents in the market. Through the rule of law, the government binds itself and thus makes a credible commitment to the provision of private incentives, which are the ultimate force for economic development. This role of the rule of law provides a foundation for secure private property rights against government intrusion, and it reflects the crucial difference between the “rule of law” and the “rule by law.” One serious problem undermining private incentives in PRC has been insecure private property rights. For example, private enterprises and farmers are frequently forced to pay variety of “unauthorized fees” to local governments, and their businesses are also harassed by local governments. Revenue hiding is a response to government predation, but is costly. Recently, private businessmen and farmers began to use legal means to protect themselves against government’s intrusion. For example, The Wall Street Journal (March 25, 1999) reported a case of Peijiawan village in Shaaxi Province, where 12,000 farmers in 1996 filed a class-action lawsuit against the local government for levying excess fees of $75,000. In the fall of 1998, the local court made an initial ruling in favor of the farmers, the local government appealed, and now the case is before the Shaaxi Provincial Supreme Court. This is an unprecedented event in PRC. The second economic role of the rule of law is that the government needs to protect private property rights and enforce contracts and to create a level field for market competition. This will help achieve credible commitment among economic agents. To achieve this goal, the government needs to become a neutral third party, a regulator rather than a manager. During the recent restructuring of the government bureaucracy, many government agencies were eliminated and the role of the newly established agencies has been reoriented from 28 management to regulation. One example is the Ministry of Information Industry. It used to directly administer China Telecom, the telephone monopoly in PRC. Now, China Telecom is being broken up into three companies, while foreign competition is being introduced, and the Ministry becomes the regulatory agency for the entire telecommunications industry (Singtao Daily, March 6, 1999). To preserve market competition, the national government needs to fight against regional protectionism. In the past, market competition in PRC was largely an accident of regional decentralization under Mao, combined with the more-or-less spontaneous emergence of smallscale industries throughout the country. From time to time, there have been many reports that local governments erected trade barriers to block goods and factor movement in order to protect local interests. PRC needs a free interstate commerce clause as in the U.S. Constitution and the central government should have the responsibility to police the common market against regional market protectionism. Future research is needed to study specific ways of implementing the rule of law. For example, an important topic concerns how to create a substantially independent judiciary system, starting at the grassroots level, and then gradually moving upward. The rule of law requires an independent and uncorrupted judiciary system to function. A completely independent judiciary system seems impossible under a one-Party system, but it may not be necessary for the time being because a substantially independent judiciary system can achieve quite a lot economically for the rule of law to work. The latter can be done because PRC is such a large country and most of the economic decisions are made at the local level. Building a judiciary system that is independent of the local government’s influence is feasible at the present time, and the above example of 12,000 farmers in Peijiawan village suing the local government illustrates this possibility. Two decades ago few economists predicted that PRC would go this far and accomplish so much. PRC has surprised the world. Although past performance is no guarantee of future results, there are good reasons for being optimistic. Today, the ideology against markets and private ownership has subsided, the goals of transition have been set, many market-supporting institutions are being built, and the Chinese people are more willing than ever to integrate PRC’s economy with the global one. For PRC to successfully complete its transition to markets, priority on the research agenda should be given to the three areas outlined above. 5. Reflections on the Economics of Reform and Institutional Change: Lessons from PRC Economists often offer advice to transition economies based on their knowledge about economics. But economics has as much to learn from the experiences of the transition economies as it has to teach them (Walder, 1995). This can be done in two ways: One is by using the data generated from the transition economies to test existing economic theories. Another is through inspiration from the experiences of the transition economies to extend the existing theories or even develop new ones. Studying PRC’s reform is useful for both purposes. Much research has been done using data from PRC to test existing theories. But studying PRC’s experience is even more useful for generating new theories, especially in the area of institutional changes. This is because PRC’s transition path is so unusual that it casts doubt on much of the conventional thinking on fundamental issues concerning system changes and the process of reform (Chow, 1997). 29 A. Reflections on the Principles of System Change PRC differs from Eastern Europe and Russia in many important ways including their initial conditions. PRC had a large agriculture sector which was the springboard for its reform; PRC’s more decentralized planning system made it natural to pursue reform in a more decentralized way based on regional experiments; and the ten-year turmoil of the Cultural Revolution discredited central planning and substantially weakened the government (including the Party) bureaucracy and its vested interests.12 Hence, PRC is unlikely to provide a model for Eastern Europe or Russia to follow. However, because our previous thinking on reform and transition was almost exclusively based on the experiences of Eastern Europe, the conventional wisdom is biased. It is therefore useful now to incorporate PRC — the larger half of all transition economies — into the analysis. It is commonplace to compare the PRC reform experience since 1978 (and often, up to 1994) with the transition experiences of Eastern Europe and Russia after 1990 and to contrast the difference between the two as “gradualism” vs. “big bang.” This is an inappropriate comparison. In Eastern Europe, reforms started as early as 1968 in Hungary, 1980 in Poland, and 1985 in the Soviet Union. PRC, Hungary, Poland, and the Soviet Union all went through a two-stage process: first reforming the planned system and then building the market system. When comparing PRC with Eastern Europe at a comparable stage, I draw three conclusions. The first conclusion, based on PRC’s achievements during the first fifteen years of reform, is that reforming a planned economy, both as a single event and as a step along the longer path, can be successful. The reforms in Eastern Europe prior to 1990 were a failure. Kornai (1992) made a convincing analysis of them and reached the following conclusion: “In spite of generating a whole series of favorable changes, reform is doomed to fail: the socialist system is unable to renew itself internally so as to prove viable in the long run.” In retrospect, the reforms undertaken in PRC between 1978 and 1993 were much more comprehensive and radical than those in Eastern European prior to 1990, the latter having no serious reform of the government, no dynamic development of non-state enterprises, no financial deepening, and no real markets. That is why PRC’s early reform was more successful than those in Eastern Europe. The evidence from PRC is compelling, demonstrating that the Eastern European experience is not universal. The second conclusion, based on the PRC experience of the last five years, is that system change from a planned system to a market system can occur without a political revolution. The Eastern European reform in the 1970s and 1980s led to a dead end because “the system is incapable of stepping away from its own shadow” (Kornai, 1992). It eventually resulted in a political revolution that jump-started the transition in the 1990s. Although it is still too early to predict that PRC can successfully complete its transition to a market system, there is enough evidence to show that the goal is set, the journey is well under way, and the chance for attaining the goal is good. Therefore, the previous conclusion based on the Eastern European experience that planned economies are unable to replace their systems with market systems needs to be reconsidered. If PRC completes its transition, it will be the first country under the Communist Party to do so. The third conclusion, based on PRC’s two decades of reform, is that there are diverse paths for a successful transition. A good path of transition, especially concerning institutional changes, has to consider country-specific conditions. PRC provides a case of a feasible and 12 Due to space limitation, this paper will not discuss how initial conditions affect the transition path. See Qian and Xu (1993), and Sachs and Woo (1994) for discussions. 30 successful alternative path of transition to markets, in which no political revolution predated the change of economic systems as was the case in Eastern Europe. Hence, the assumption that all planned economies were alike and that they should follow the same path of transition needs to be modified. PRC’s case shows that reforming a socialist economy can be successful; the planned system can evolve smoothly to a market system; and there are diverse paths for making a good transition. It may be argued that PRC is special because it was a poor agricultural country. It may also be argued that Hungary and Poland are special because their early reforms were constrained by not being truly independent from the Soviet Union, and their later transitions were facilitated by their aspirations to join the European Union. In any event, the principles of system changes are more complicated than one used to believe. B. Reflections on the Process of Reform After twenty years of experience, PRC’s reform can contribute several lessons about the process of reform in particular and institutional change in general. The main lesson is that considerable growth is possible with sensible but not perfect institutions, and some “transitional institutions” can be more effective than the “best practice institutions” for a period of time because of the second-best principle: i.e. removing one distortion may be counter-productive in the presence of another distortion. In transition economies basic market-supporting institutions (such as the rule of law) are lacking, as well as the people and human capital to operate them (such as law enforcement). Both usually take years to develop, except in the case of East Germany, which was absorbed into West Germany immediately after unification. This often means that the international best practice institutions, even if we know what they are, may not work well for the time being. It also means that some existing institutions can be useful to market-oriented reform even though they may eventually vanish. Fiscal contracting, TVEs, and anonymous banking are all institutional innovations that worked quite well for a certain time period in the PRC environment. All transition economies have great potential for improvement because of enormous allocative distortions and the lack of incentives of the planning system. Therefore, in theory, even if institutions are highly imperfect, impressive results are potentially possible. However, many failures in the early reforms and the recent transition suggest that not all changes can produce good results. What kinds of changes can produce good results? PRC’s experience offers three specific lessons, but they are better viewed as general principles than a formula for transition. First, institutional changes that create incentives, impose hard budget constraints, and introduce competition should not only apply to firms but also to governments. Indeed, reforming government is an important component of economic reform. When the government is provided with positive incentives and is subjected to hard budget constraints and competition (such as the township and village government), the outcome of the reform is productive; if the government is subjected to softer budget constraints (such as higher level local governments were in the 1980s), the outcome will be problematic. Second, successful reform relies on political support, which in turn depends on delivering tangible benefits to a large majority of the population. Economists usually blame “stupid politics” when their beautifully designed reform programs are not implemented. But political scientist Barry Weingast has this to say: “An ironic aspect of the economists’ position is that they want individuals to pursue self-interest in markets but not in politics.” Compensating 31 potential losers in the reform is both a political and economic issue, and a reform that does not create many or big losers can be politically acceptable ex ante and sustainable ex post. The dual-track approach to market liberalization, when appropriately implemented, is one example of good politics and economics. Third, successful institutional change requires appropriate, but not necessarily optimal, sequencing. Unlike macroeconomic stabilization policy, institutional change is an unavoidably long process. Judging from the outcome, the process of PRC’s transition to markets has been fairly fast overall. It took Hungary 30 years and Poland 20 years to achieve their current results and will certainly take Russia even longer. The PRC experience shows that whenever politically feasible, it is better to dismantle the existing institutions after the new ones are put in place, or allow the new ones to emerge from the old, to avoid an institutional vacuum. It also shows that the implementation of reform can be compatible with the institutional capacity of the economy. Examples of appropriate reform sequencing in PRC include: empowering local governments for development of local government enterprises before privatization can be instrumental for growth; pursuing industrial liberalization first while delaying financial liberalization can compensate for fiscal decline, avoid financial crashes, and, at the same time, create better incentives; enforcing a plan track and phasing it out later can minimize the opposition to reform while it improves economic efficiency. On the other hand, the PRC experience shows that one does not need optimal sequencing to achieve an impressive performance, and what is most important is to avoid fatal mistakes rather than to make fine tuning. Indeed, many arguments can be made that PRC’s reform is not optimal. Both in terms of reform sequencing and of any specific reform, arguably, PRC could have done a better job and achieved even greater results if better alternative reforms had been done. The errors made with the “crossing the river by touching the stones” style can be detected. For example, as I have shown above, PRC’s reform fell short in the areas of reforming the financial system and large state-owned enterprise and establishing of the rule of law. However, to this date, these errors have not undermined PRC’s reform in a fatal way. C. Reflections on the Theory and Practice of Transition Transition from a planned to a market economy is one of the most significant economic events of the twentieth century. The core of the transition concerns institutional transformation, which is complicated and difficult. For most transition countries, with the exception of a few, transition will take more time to complete. During the past decade there were two big surprises. One big surprise was the sharp initial decline in output followed by recovery in most countries of Eastern Europe and the former Soviet Union — the phenomenon known as the U-shaped output response (Blanchard, 1997). Another big surprise was PRC’s remarkable success on its different path of transition. The gap between conventional economic thinking and the realities of the transition shows that our knowledge about institutional change in general and transition in particular is quite limited. This limitation has two related components. First, our knowledge about how a capitalist market economy works is still limited. Although neoclassical economics is a powerful tool for explaining how price mechanisms work, it does not provide complete theories about the role of institutions, history, and political economy yet. Ronald Coase (1992), referring to transition economies, says, “without the appropriate institutions no market economy of any significance is possible. If we knew more about our own economy, we would be in a better position to advise them.” Unfortunately, we do not. Douglass North (1997) agreed: “While neoclassical theory is focused on the operation of efficient factor and product markets, few western 32 economists understand the institutional requirements essential to the creation of such markets since they simply take them for granted. A set of political and economic institutions that provides low-cost transacting and credible commitment makes possible the efficient factor and product markets underlying economic growth.” To build a market system from scratch, nothing can be taken for granted. Second, our knowledge about the transition process is even more limited. There is a difference between the final destination and the process of transition, and even if we have perfect knowledge about the destination, how to get there is a separate issue. As Robert Solow 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” (The New York Times, September 29, 1992, p. E1). Richard Freeman (1994) echoed that view, “[E]conomics does not have sufficiently compelling theory or empirical knowledge to answer questions about the institutional design of advanced capitalist economies, much less economies in transition.” Because the transition from plan to market is unprecedented, the practice of transition is original and the theory of transition is in its infancy. Two excellent survey papers on the economics of transition (Dewartripont and Roland, 1996; and McMillan, 1996) recognized the limits of our knowledge on transition. More and more people, both inside and outside the transition economies, have realized this too. Even Anatoly Chubais, one of the leading architects of the Russian reform, acknowledged after the Russian crisis in 1998: “We must recognize that we did not fully understand the scale of the process which we had undertaken. We thought there would be a very difficult three years, five years, eight years. 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