Asia Problem Special Report 2005

NO. 129 JULY 2005

A S I A P R O G R A M S P E C I A L R E P O R T

IntroductionLoren Brandt and Thomas G. Rawski

T hese essays, originally presented at aMarch 2, 2005, symposium at theWoodrow Wilson International

Center for Scholars, represent the initialproduct of a larger project on “China’sEconomic Transition: Origins, Mechanisms,and Consequences.”This project involves aninternational group of 45 researchers, whohave worked for several years to prepare acomprehensive and analytical overview ofChina’s remarkable economic gains duringthe long boom of the past three decades.

Three major themes emerge from thepresent collection of essays: China’s spectac-ular economic gains, China’s potential forcontinuation of rapid economic progress,and formidable obstacles with which Chinamust engage in order to realize its ambitiouseconomic objectives.

CHINA’S ACHIEVEMENTS

China’s long boom is a major episode inglobal economic history.The broad outlinesof China’s protracted growth require nodetailed elaboration.They include enormousexpansion of output, employment, produc-tivity, exports and incomes; unprecedented

progress in poverty alleviation and materialwell-being; and the emergence of China as amajor force in global markets.

These essays highlight specific features ofChina’s economic achievements. LeeBranstetter and Nicholas Lardy emphasizeChina’s aggressive liberalization of trade andinvestment in advance of deadlines built intothe agreements surrounding China’s acces-sion to the World Trade Organization(WTO).From the perspective of earlier Asiangrowth spurts in Japan and Korea, China hasopened its economic doors to imports andoverseas capital to an unprecedented degree,a strategy that seems likely to create futureindustrial structures that differ widely fromwhat we see in Japan and Korea today.

Scott Rozelle and Jikun Huang show thatin addition to overcoming long-standing defi-ciencies in feeding China’s growing popula-tion,China’s farm sector has achieved levels ofmarket integration sometimes approachingU.S. standards, developed a growing array oflabor-intensive export specialties, andachieved major gains in agriculture-relatedresearch, including contributions to cutting-edge innovations in biotechnology.

Our own paper on industry emphasizesthe growth of China’s manufacturing capa-bilities. The growing penetration of China-made goods into global markets reflects the

ASIA PROGRAM

Loren Brandt is professor of economics at the University of Toronto. Thomas G. Rawski isprofessor of economics and history at the University of Pittsburgh. Gang Lin is program associ-ate at the Woodrow Wilson Center’s Asia Program.

China’s Economy: Retrospect and Prospect

EDITED BY LOREN BRANDT, THOMAS G. RAWSKI AND GANG LIN

ABSTRACT: This Special Report highlights China’s remarkable economic achievementsover the past quarter century, including its enormous expansion of output, employment,productivity, exports and incomes; unprecedented progress in poverty alleviation andmaterial well-being; and the emergence of China as a major force in global markets. Italso recognizes, however, China’s domestic problems in governance, banking, finance,law and the creation of institutions. Contributors to this volume do not predict aquick collapse of China’s economic prosperity. Nor do they anticipate that China’s longboom will extend forever, or that China is on a path to overtake the U.S. economy.

INSIDE

China’s Embrace ofGlobalization (page 6)

Rural Development in China(page 13)

Chinese Industry After 25 Years of Reform(page 20)

Institutional Environmentand Private SectorDevelopment in China(page 26)

Will China’s FinancialSystem Stimulate orImpede the Growth of Its Economy?(page 33)

Law, Institutions, andProperty Rights in China(page 42)

Growth and StructuralTransformation in China(page 48)

China’s Growth Prospects(page 55)

China’s Political Systemand China’s Future Growth(page 62)

success of Chinese firms in absorbing and gradual-ly mastering an expanding array of technologiesand manufacturing processes. This developmentnow extends far beyond the labor-intensive sectorsthat dominated export gains early in the reformprocess. While foreign-linked firms play a centralrole in the transmission belts that carry interna-tional manufacturing technologies into Chinesefactories, we expect domestic firms to increasetheir contributions to the process of technicalupgrading, partly because of the knowledge theyhave absorbed from foreign markets and firms, andpartly because of the growing importance ofdomestic research and development spending andthe associated flows of manufacturing innovationin an increasingly competitive domestic economy.

Loren Brandt, Chang-tai Hsieh and XiaodongZhu highlight the important contribution of thelarge-scale transfer of labor out of the agricultur-al sector to China’s economic growth, which aris-es from the significant gap between (higher) out-put per worker outside farming and (lower) laborproductivity in agriculture.They find that the rateof total factor productivity (TFP) growth in thenon-agricultural sector largely drives this struc-tural transformation. Moreover, cross-provincialcomparisons point to the significant drag of thestate sector’s size on the rate of TFP growth, andthus on the rate of labor transfer out of the farmsector. At the provincial level, there is also verystrong negative association between the size of thestate sector at the outset of reform and the rate of

labor productivity growth in both agriculture andnon-agriculture. From this perspective, “growingout of the state sector” should join “growing outof the plan”—the title of Barry Naughton’s influ-ential book—as key metrics for the progress ofChina’s reform.

The roster of achievements extends into areasthat are generally regarded as weak spots inChina’s economy. Donald Clarke, Peter Murrelland Susan Whiting report that China has achievedconsiderable progress in building a system ofcommercial law. Surprisingly, survey studies findthat Chinese businesses make considerable use ofthe court system to resolve commercial disputes.Franklin Allen, Jun Qian and Meijun Qian findsubstantial movement toward modernization ofChina’s financial system. They also highlight theimportant role of China’s “hybrid” financial sec-tor, which draws on informal mechanisms forcontract enforcement discussed by Clarke et al. aswell. And Yasheng Huang writes of belated, butnevertheless substantial gains toward providinginstitutional legitimacy and legal protection forthe assets and rights of private businesses.

CHINA’S PROSPECTS

Following nearly three decades of rapid growth,China’s prospects for continued developmentappear bright. The economy can draw on abun-dant supplies of labor, human capital, entrepre-neurial talent, and savings (including continuedinflows of foreign direct investment). Chinesegovernments at all levels are strongly committedto growth. Thomas Rawski’s essay enumeratesimportant factors underpinning growth inOrganization for Economic Co-operation andDevelopment (OECD) nations and notes China’sfavorable endowment in each category.

Essays on globalization and industry describethe past economic benefits arising from China’sdeepening links to the world economy. Thesegains will expand with China’s growing participa-tion in cross-national manufacturing networks. Inaddition, relaxation of official constraints on over-seas investment by Chinese firms promises to adda new dimension to China’s absorption of usefulknowledge as domestic firms acquire ownershipstakes in overseas producers of natural resources aswell as desktop computers, machine tools, cars,auto parts, and other manufactures.

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ASIA PROGRAM SPECIAL REPORT

THE ASIA PROGRAM

The Wilson Center’s Asia Program is dedicated to the propositionthat only those with a sound scholarly grounding can begin tounderstand contemporary events. One of the Center’s oldestregional programs, the Asia Program seeks to bring historical andcultural sensitivity to the discussion of Asia in the nation’s capital.In seminars, workshops, briefings, and conferences, prominentscholars of Asia interact with one another and with policy practi-tioners to further understanding of the peoples, traditions, andbehaviors of the world’s most populous continent.

Asia Program Staff:Robert M. Hathaway, DirectorGang Lin, Program AssociateAmy McCreedy Thernstrom, Program AssociateMichael Kugelman, Program Assistant

Acceleration of China-based research anddevelopment efforts, reflecting the expansion ofindigenous R&D operations as well as growingactivity by Chinese subsidiaries of multinationalfirms, will contribute to the future expansion ofmanufacturing capabilities, technical sophistica-tion and product quality. Rozelle and Huang’ssummary of Chinese advances in biotechnologyillustrates the growing contribution of domesticscientific efforts in one specific area.

The learning process associated with recentgrowth extends beyond improvements in technol-ogy, production, management, and marketing.Chinese reform experience includes a vast accu-mulation of knowledge about interactionsbetween public administration and economicgrowth.Despite many shortcomings of public pol-icy (discussed below), regional and local govern-ments in China’s coastal region have succeeded increating administrative structures that are suffi-ciently strong to attract and retain large inflows ofoffshore capital, and to encourage domestic invest-ment. Recent infrastructure investments haveupgraded domestic systems of transport and com-munication, effectively reducing the economicdistance between China’s thriving coastal regionsand less ebullient interior districts. If local govern-ments in China’s central and western regions canmaster the art of providing business-friendly regu-lation, both domestic and international firms maybe tempted by the lower labor and land costs avail-able in China’s inland provinces, a prospect thatmay be especially advantageous for producers ofgarments, shoes, toys, and other labor-intensivegoods. Fulfillment of this prospect could equipChina’s economy with two separate drivers ofgrowth and export expansion: clusters of risingmid-level industries like shipbuilding, machinery,and home appliances based along the coast, andnew centers for labor-intensive manufactures inparts of China’s central or western regions.

CHINA’S CHALLENGES

Realization of China’s abundant economicprospects will necessitate further reform across abroad spectrum of institutions. Our authors iden-tify significant weaknesses that span China’s finan-cial, fiscal, investment, legal, and regulatory sys-tems. Despite differences in the details, many sec-tors reflect similar stories. Energetic and imagina-

tive reform efforts have bridged a portion of thelarge gap between institutional arrangementsunder the traditional planned economy and whatis needed to support a smoothly functioning mar-ket system. In each case, our authors find thatstopgap measures and unreformed institutionsnow in place impose large costs that seem likelyto escalate in the absence of substantial newefforts to build suitable institutions.

Take the example of banking and finance.Allen,Qian and Qian trace the genuine, but limitedaccomplishments in broadening the base of China’sbanking system and financial markets. Despitethese efforts,Barry Naughton shows that the dom-inance of China’s state-owned banks has actuallyincreased since the late 1990s, thereby raisingrenewed concern that China’s non-performingloan problem may be worsening. The continuedunwillingness of the big state-owned banks tomake loans to private entrepreneurs limits thegrowth of private business and exacerbates China’salready serious problem of unemployment.

China’s courts and legal system continue to playonly a limited role in enforcing business-relatedlaws, in part because the system lacks clear guide-lines for assigning jurisdiction.These shortcomingsundercut the impact of the growing body of lawsissued by people’s congresses at various levels andobstruct efforts to build a unified legal system.Progress toward badly needed improvements ingovernance structures in support of accountabilityand transparency in China’s large corporations andfinancial institutions seems unlikely without sub-stantial changes in the legal infrastructure.

The fiscal system, although not discussed explic-itly in these essays, fits the same mould.Recentralization has created significant imbalancesin fiscal resources across China, with numerousprovinces, cities and villages lacking financialcapacity to undertake growth-promoting invest-ments in human and physical capital. Recent ini-tiatives aimed at eliminating direct taxes on agri-culture will sharpen the conflict between financialresources and demands on the public purse, partic-ularly for local governments in rural districts.

Although no single institutional weaknessseems likely to halt growth, multiple institutionaldefects could drag China into the kind of eco-nomic lethargy that has afflicted Japan’s formerlydynamic economy for over a decade. A commonthread in discussions of limits to institutional

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CHINA’S ECONOMY: RETROSPECT AND PROSPECT

4


change is the constraint posed by competingobjectives of incumbent power-holders in bothgovernment and Communist Party positions.Leaders often use the power to distribute eco-nomic rents (for example by ordering banks tomake loans to favored clients or by allowing loyalsupporters to extract resources from state enter-prises) to buttress their political control. Market-supporting institutional change, with its emphasison openness, uniform standards, and accountabili-ty, threatens both the scale and the accessibility ofsuch rent-sharing opportunities.The resulting tug-of-war between the demands of growth-orientedreform and regime-building seem particularlyacute in China’s interior regions, where wealth,economic growth, and fiscal resources fall far shortof what is available to richer and therefore moreflexible coastal jurisdictions.

Rising inequality and unfulfilled expectationsmay also pose problems for the regime. DespiteChina’s remarkable achievement in elevating liter-ally hundreds of millions from deep poverty dur-ing the last twenty-five years, the uneven distribu-tion of benefits from rapid growth has producedsignificant increases in income inequality, especial-ly during the last decade.Despite the limitations ofavailable data, China seems to have emerged as aleader among large developing nations in terms ofunequal distribution of income and wealth.

Contrary to popular perceptions, wideninginter-regional or even urban-rural differences arenot the primary source of these recent increases ininequality. Instead, it is widening income gapsamong populations at every level of Chinese soci-ety—within provinces, cities, and villages—thatdominate the recent growth of inequality.Individual characteristics like age, education, andsocial capital strongly influence the capacity ofindividuals and households to take advantage ofnew opportunities. Some of the increase ininequality is a natural product of market liberal-ization, but policy also plays a role. For example,education policies may favor particular socialgroups and raise tuition and fees to prohibitivelevels for others. Widespread corruption, nowoften linked to transactions involving land, furthertilts market outcomes toward select groups with-in China’s populace.

Economists increasingly agree that risinginequality can be detrimental for economicgrowth, a conclusion that probably fits China’s

present circumstances. Inequality brings risingpressures for redistribution, which in the Chinesecontext is likely to encourage increased alloca-tion of resources through the highly inefficientstate sector. China’s current “Develop the West”campaign illustrates how measures aimed ataccelerating development in poor regions canactually act as a drag on growth. In addition, lim-ited income growth among large cohorts oftoday’s population can restrict current investmentin physical capital and also obstruct investmentsin education and health for young people whosecapabilities will influence future growthprospects. Finally, rising inequality surely increas-es the possibility of social and political unrest.

CONCLUSION

China’s prospects for continued rapid growthappear excellent. China’s remarkable economicachievements create momentum and inspire con-fidence. China’s capacity to absorb overseasresources and to contribute to cross-nationalmanufacturing networks enhances its economicpotential. A further advantage arises from theintense focus on economic growth visible at everylevel of Chinese public administration.

These advantages cannot guarantee thatChina’s long boom of the past quarter centurywill extend into the future. China’s large andgrowing dependence on global markets meansthat external events could damage China’s econ-omy by disrupting resource flows, obstructingmarket access, or slowing the growth of globaldemand for Chinese products. International con-flict within East Asia (over Taiwan, North Korea,or offshore oil deposits) or elsewhere (particular-ly in the Middle East) could undercut China’seconomic prospects.

While globalization subjects all participatingnations to the risk of destabilizing change, ourauthors highlight domestic obstacles to China’scontinued high-speed growth.Their central pointis that China’s reform progress, while broad andoften deep, remains highly uneven.Vital institu-tions affecting important clusters of activity inbanking, legislation, land allocation, dispute reso-lution, business regulation, exchange of property,corporate governance, capital markets, privatebusiness, public finance, investment decisions, andthe administrative structures surrounding these

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and many other segments of China’s economyhave experienced only limited reform. In someinstances, we see little change from pre-reformpatterns, the seasonality of investment spendingbeing a case in point. Elsewhere, for instance, inmacroeconomic regulation, ad hoc procedurespartially bridge gaps arising from the slowadvance of institution building.

Chinese economists and policy-makers arekeenly aware of these difficulties. Newspapers,journals and web sites pulse with critiques,analyses of reform progress, and proposals forpolicy initiatives.We see dynamic administratorspushing reform efforts with fierce determina-tion—for example eliminating nearly 90,000state-owned enterprises between December1998 and August 2004.

Economic history, including Chinese experi-ence over the past three decades, is replete withinstances in which growth advances despite insti-tutional weaknesses (think of “wildcat banking” innineteenth century American history). A mix of

thoroughgoing and partial reform along withpatchwork improvisation often opens the door tocontinued expansion. But the same historicrecord provides instances in which long-neglect-ed institutional deficiencies constrict seeminglypromising growth prospects. We conclude that,while appreciating China’s glittering array of eco-nomic opportunities, sober onlookers shouldrecall that Japan’s painful slowdown of the past 15years arises from a litany of institutional rigiditiesand shortcomings that makes familiar reading toChina specialists.

Our thanks to the Woodrow Wilson Center,and to Dr. Gang Lin of the Center’s Asia Program,for hosting the symposium last March that gavesome of the scholars associated with our China’sEconomic Transition project an opportunity toshare their findings with a Washington audience.We are equally pleased to have worked with theCenter’s Asia Program in preparing this report toreach a broader audience.

THE MOVE TO FREER TRADE PRIOR TO

WTO ACCESSION

The Pre-Reform Trade RegimeUp through the 1970s, Chinese trade took placewithin the context of a planned economy.The StatePlanning Commission’s import plan covered morethan 90 percent of all imports. Its export plan wassimilarly comprehensive, specifying physical quanti-ties of more than 3,000 individual commodities.Prior to 1978, a handful of foreign trade corpora-tions owned and controlled by the Ministry ofForeign Trade were responsible for carrying out theimport and export plans. In this context, neitherexports nor imports were sensitive to exchange ratesor relative prices.1 Furthermore, the composition ofChinese trade appears to have diverged fromChinese comparative advantage, with capital-inten-sive goods, including refined petroleum products,playing a large role in Chinese exports into the early1980s. As a consequence, the volume of Chinesetrade, relative to world trade, declined sharply from1.5 percent in 1953 to 0.6 percent in 1977.

Import tariffs on a number of commodities actu-ally went up in the early years of the reform period.By 1982, the average statutory tariff rate was a rela-tively high 56 percent.This was reduced to 43 percentin 1985,but that level was maintained throughout thenext seven years. Beginning in 1992, however, tarifflevels fell in a series of adjustments that brought theaverage tariff level down by two-thirds, to roughly 15percent on the eve of World Trade Organization(WTO) accession. In addition to tariffs, the Chinesegovernment increasingly restricted trade by imposingimport quotas and import license requirements. Bythe end of the 1980s China restricted nearly half ofall imports through the use of licenses or quotas.However, these restrictions also were dramatically cutin the 1990s. Import commodities subject to quotasor licenses fell to 18 percent of total imports by 1992and to 8 percent by 2001.

In addition to reducing tariff and non-tariff bar-riers, the Chinese government liberalized the rightto engage in foreign trade.This was reflected in the

rapid and substantial expansion in the number ofdomestic firms granted trading rights, as shown inTable 1. The initial 12 firms directly controlled bythe Ministry of Foreign Trade expanded to about800 firms by 1985. A decade later, the number oftrading firms stood at 12,000. By 2001 the govern-ment had granted trading rights to 35,000 firms,including a large number of private firms.With sucha large number of potential suppliers of trading serv-ices, it is likely that the market for such services hadbecome reasonably competitive by the mid 1990s.

China’s openness to imports expanded evenfaster than the decline in formal barriers might sug-gest. A major reason was the special privileges thegovernment extended to firms involved in exportprocessing. Initially, this legal framework provided

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China’s Embrace of GlobalizationLEE BRANSTETTER AND NICHOLAS LARDY

Lee Branstetter is the Daniel W. Stanton Associate Professor of Business at Columbia Business School. NicholasLardy is Senior Fellow at the Institute for International Economics.

Table 1. Growth in Companies Authorized to Conduct Foreign Trade

1978198519861988199619971998199920002001

12800

12005000

120001500023000292583100035000

Year Number of Companies

Sources: Nicholas R. Lardy, Foreign Trade and Economic Reform inChina, 1978–1990 (Cambridge University Press, 1992), 39: ZhangYan,“Access to Trade Rights Expands,” China Daily, February 23,2000, 5; Editorial Board of the Almanac of China’s ForeignRelations and Trade, Almanac of China’s Foreign Economic Relationsand Trade 1987 (Hong Kong: China Resources Advertising Co.,Ltd., 1987), 48; Almanac of China’s Foreign Economic Relations andTrade (various issues); Ministry of Foreign Trade and EconomicCooperation, Zhongguo duiwai jingji maoyi baipishu 1999 (China’sWhite Paper on Foreign Trade and Economic Cooperation 1999),192; Chen Yao,“Trade with Northeast Asia Countries BouncesBack,” China Daily, June 8, 2001, 4; and World Trade Organization,Draft Report of the Working Party on the Acession of China tothe WTO, rev. 7 (Geneva, July 10, 2001), 21 (www.insidetrade.com[July 16, 2001]).

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various incentives for the processing of raw materi-als for export and the assembly of imported goodsto produce finished goods for export. In 1987, thegovernment expanded these incentives to providefor duty-free import of all raw materials, parts, andcomponents used in the production of goods forexport.This represented an extension of the right ofjoint ventures and wholly-owned foreign companiesto import capital goods duty-free, which was estab-lished early in the reform period.As an increasinglyopen FDI regime brought in more foreign invest-ment, this allowed a larger and larger fraction ofChina’s imports to escape the formal trade barriers.Finally, in the late 1990s, the Chinese governmentbegan to exempt certain categories of domesticfirms and other organizations from import duties.

By the first half of 2000, less than 40 percent ofimports were subject to any tariff.Thus, actual tariffrevenues have been far lower than the average statu-tory rates would suggest.As shown in Figure 1, tariffrevenues as a fraction of the value of imports peakedin the mid 1980s at 17 percent and fell steadily there-after, reaching a low of less than three percent by1994.Tariff revenues relative to the value of importsdid tick upward briefly starting in 1999, apparently asa result of a crackdown on widespread smuggling.But by 2004 tariff revenues were only slightly morethan two percent of the value of imports. Thisdecline to such an extraordinarily low level reflectsthe combined effect of expanding foreign directinvestment, the increasing importance of export pro-

cessing, and the exemption of selected industries andorganizations from import tariffs altogether.

Foreign Exchange PolicyThe expansion of foreign trade was also abetted bychanges in foreign exchange and tax policy. Prior toreform, the regime maintained an overvaluedexchange rate in order to subsidize the import ofcapital goods that could not be produced domesti-cally. Overvaluation led to excess demand for for-eign exchange, necessitating an extensive system ofrigid controls. Key elements of this control systemincluded a 100 percent foreign exchange surrenderrequirement for exporters, tight limitations on therights of individuals to hold foreign currency, andstrict controls on the outflow of foreign capital.

Over the course of the reform period, all ofthese restrictions were relaxed. The officialexchange rate was devalued in stages, from an offi-cial exchange rate of RMB 1.5 to the dollar in1981 to 8.7 in 1994. Following a modest apprecia-tion, the exchange rate was effectively fixed atRMB 8.3 to the dollar in 1995. The InternationalMonetary Fund (IMF) estimates that the Chinesecurrency lost about 70 percent of its value againstthe dollar in real terms over this period, substantial-ly enhancing the international competitiveness ofChina-based export operations. In addition to sub-stantial real devaluation, Chinese exporters wereallowed to retain part of their foreign exchangeearnings, individuals have been allowed to hold for-

Figure 1. Tariff Revenues as a Fraction of Import Value, 1978–2004

Source: Lardy, Integrating China in the Global Economy (Brookings Institution Press, 2002).Tariff Revenue (As a Percentage of Imports)

20%

18%

16%

14%

12%

10%

8%

6%

4%

2%

0%

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

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eign exchange, and controls on capital outflowshave been slightly relaxed.

THE OPENING TO FDI PRIOR

TO WTO ACCESSION

Liberalization of Foreign Direct InvestmentChina’s policies with respect to foreign direct invest-ment were dramatically changed in 1979. In thatyear a new Law on Joint Ventures was passed, pro-viding a basic framework under which foreign firmswere allowed to operate. In the same year, four “spe-cial economic zones” were established in which for-eign firms were offered preferential tax and admin-istrative treatment and given an unusually free handin their operations.2

These “experiments” in attracting foreign directinvestment were quite successful. In 1984, 14 addi-tional government units, mostly municipalities onChina’s Pacific coast, were granted similar exemp-tions from taxes and administrative procedures in abid to attract foreign direct investment (FDI).Known variously as “Open Cities” or “Export andTechnology Development Zones,” these new specialzones were granted authority to approve investmentprojects at the local level for FDI projects under $30million (a threshold later raised to $50 million).Thenext major regulatory change in FDI came in 1986,with the implementation of the so-called “22Regulations.” These changes represented a majorliberalization which applied throughout China.“Foreign invested enterprises” were made eligiblefor reduced business income tax rates regardless oflocation, and were given increased managerialautonomy.Tight controls on the remittance of prof-it in foreign currencies were lifted. Finally, and mostimportantly, the 22 Regulations designated two cat-egories of foreign investments as being eligible foradditional special benefits—“export oriented” proj-ects (defined as projects exporting 50 percent ormore of their production value) and “technological-ly advanced” projects (defined as projects whichupgrade domestic production capacity through theuse of ‘advanced’ technology).

The Rise, Fall, and Rise of FDI since 1989The next major shift in FDI in China marked not somuch a regulatory shift as a change in the composi-tion of foreign investors. FDI in China slowedbriefly after the Tiananmen Incident, but the inflows

resumed and quickly grew in the 1990s. WhereasFDI in China in the 1980s had been overwhelm-ingly dominated by Hong Kong and Taiwan-basedinvestors seeking to exploit relatively low cost laborin the Special Economic Zones (SEZs) for exportprocessing, in-flows diversified in the 1990s. HongKing and Taiwan-based investors continued to playa very important role, but Japanese, American, andEuropean firms also increased their FDI into China,much of it focused on the domestic market. Figure2 illustrates the growth over time in contracted FDIand actual foreign investment. Figure 3 shows vari-ation over time in the number of FDI contractsapproved and in the nature of the entity created. Ofparticular interest is the growth in wholly-ownedforeign enterprises relative to equity joint ventures.Figure 4 breaks down growth in actual investmentflows by the nationality of the investing country.3

As Figure 2 shows, contracted FDI peaked in theearly 1990s and declined sharply for the rest of thedecade. Since these contracts contained multi-yearbusiness plans, there is a lag between the approval ofa contract and the actual investment associated withit. However, the sharp divergence in these two timeseries is greater than that which would be impliedby a simple lag between approval and investment. Inour view, the divergence hints at some problems thatforeign investors in this period, particularly Westernfirms with little previous experience in China,encountered as they rushed to enter the market.Webelieve many projects approved during the FDIsurge of the early 1990s were either abandoned orradically scaled down in subsequent years.

The FDI boom began when China was in themidst of an unsustainable expansion, brought on inpart by rapid credit creation. Demand growth wasrapidly outstripping supply, leading to a surge in infla-tion that peaked in 1994, when consumer prices shotup by one-fourth. Zhu Rongji, then serving as vicepremier and governor of the central bank, initiatedcontractionary monetary and fiscal policies thatreduced aggregate demand and moderated priceinflation. By 1996, growth and inflation were downto more sustainable levels. Then the Asian crisis hit,leading to yet slower growth in domestic demand, adramatic slowdown in export growth, and domesticprice deflation.The scale and number of FDI projectsapproved in the early 1990s appear to have beenmotivated in part by an extrapolation of the (unsus-tainable) expansion of domestic demand observed in

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Figure 2. Foreign Direct Investment in China

140000

120000

100000

80000

60000

40000

20000

0

1996

1998

2000

2002

2004

Contracted Amounts

Actual Investment

U.S

. $ m

illio

ns

Figure 4. Inward FDI in China by Source Country

60000

50000

40000

30000

20000

10000

0

1986

1988

1990

1992

1994

1996

1998

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2002

U.S

. $ m

illio

ns

Figure 3. Counts of FDI contracts by Contractual Form

90000

80000

70000

60000

50000

40000

30000

20000

10000

0

1990

1991

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1993

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1995

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Wholly Owned Foreign Enterprise

Contractual JV

Equity JV

Hong Kong

TaiwanJapan

USA

Europe Other

1988

1990

1992

1994

1984

1986

those years. Firms also appear to have been unpre-pared for the barriers they encountered in attemptingto distribute their goods within China.

In the context of the domestic demand retrench-ment that followed, it is unsurprising that manyventures proved to be spectacularly unprofitable.Most foreign firms targeting the domestic marketwere required to form a joint venture with a localChinese firm, usually an SOE.The supply of well-run, effectively managed SOEs was also quite limit-ed. In their eagerness to set up operations, manyfirms forged alliances with enterprises that turnedout to be far less efficient, amenable to Westerndirection, or politically connected than theythought. The survey and interview evidence pre-sented by Daniel Rosen suggests that many Westerninvestors were unprepared for the cultural clashes,administrative difficulties, and operational ineffi-ciencies created by their “forced marriages” toChinese SOEs.4 Figure 3 illustrates a sharp down-turn in the number of contracts signed and a strik-ing shift toward wholly owned foreign enterprises,as this option became feasible in an expanding num-ber of industries and situations.

Even as actual FDI levels had begun to fall,reformers in the Chinese government were negoti-ating terms for WTO accession that dramaticallyexpanded the freedom with which foreign firmscould operate in China. Prior to the signing of theagreement, more categories of foreign investedenterprises (FIEs) were allowed to sidestep jointventures entirely and set up wholly owned foreign

enterprises. Interference in supply chain manage-ment, product development, and operations wasscaled back. The final bilateral agreement with theU.S., signed in November 1999, signaled a dramaticchange in the Chinese operating environment.Contracted FDI increased almost immediately, andlevels of actual utilization began to follow suit, as canbe seen in Figure 2.

A pickup in demand growth also spurred FDI.Chinese export growth rapidly expanded as theregional economy recovered from the effects of theEast Asian crisis. While the veracity of the officialgross domestic product (GDP) growth rates in theimmediate aftermath of the East Asian crisis havebeen called into question, even the most pessimisticviews suggest that Chinese GDP growth was moreresilient than that of other large economies in theregion, possibly inducing firms that might haveinvested elsewhere to focus on China.5 The govern-ment reversed the austerity regime it had put inplace in the mid 1990s after the Asia crisis, the cen-tral bank cut interest rates several times, state banksexpanded their lending, and the government used asizable fiscal stimulus to boost domestic demand.Export growth slowed sharply again in 2001, withthe worldwide slowdown generated by theSeptember 11 attacks, but rapidly rebounded in2002.While difficult to measure with precision, esti-mates of the profits of foreign enterprises providedin Figure 5 appear to be consistent with this patternas they declined steadily through 1998, andrebounded sharply thereafter.

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Figure 5. Foreign-Invested Enterprise Profitability, 1994–2003

ROA (Pre-Tax)

ROA (Pre-Tax, Including Patent and Licensing Revenue)

16%

14%

12%

10%

8%

6%

4%

2%

0%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Domestic demand was rapidly expanding again bythe end of 2002 as investment spending surged tohigh levels.The impact of more expansionary mone-tary and fiscal policy on the Chinese economy hadbeen partially offset from 1998 through mid-2001 bya substantial restructuring of state-owned enterprisesin the manufacturing sector. 36 million state workers,one-third of the total, lost their jobs, and hundreds ofstate factories were shut down. Once this period ofretrenchment ended, however, the economy begangrowing at a pace increasingly reminiscent of theboom of the early 1990s. Even the uncertainty creat-ed by the outbreak of severe acute respiratory syn-drome (SARS), a previously unknown and fatal res-piratory ailment that rapidly spread throughout EastAsia, failed to slow growth in 2003. By late 2003,however, the Chinese government was once againtaking steps to try to limit overinvestment and exces-sive growth, primarily through direct administrativemeasures rather than higher interest rates or a reval-ued exchange rate.While these measures appeared tohave had some success as of late 2004, the scale ofexpansion in lending and investment suggested thatsome of the progress made in scaling back non-per-forming loans in the late 1990s and early 2000s waslikely undone in the boom of 2002–2004.6

CHINA’S WTO ACCESSION AGREEMENT

AND ITS IMPLEMENTATION: A WATERSHED,NOT A SEA CHANGE

While negotiations over China’s WTO entry wereongoing in the late 1990s, a number of studies wereconducted estimating the impact of WTO accessionon Chinese trade, employment, and growth. Some

predicted that China would incur significant restruc-turing costs in meeting its WTO commitments.7

Other studies forecast fairly dramatic increases inimports as import tariffs were reduced.There was atendency for these studies to overestimate the impactof WTO, because many were based on conditionsthat existed in the mid 1990s, and did not take intoaccount the dramatic acceleration of reform in theyears immediately preceding WTO entry.

As we have already stressed, China cut tariffs,broadened trading rights, and liberalized its FDIregime even prior to formal WTO accession. TheChinese government also launched a major effort torestructure state-owned manufacturing industries,engineering a dramatic decline in SOE manufactur-ing employment and an improvement in profitabil-ity. Steps were also taken to eliminate or reduceimport price differentials prior to WTO accession.The government substantially cut the prices forwheat and corn in 1999, two years before WTOaccession, driving prices toward international levels,and starting the process of moving farmers out ofgrain and into less land intensive crops. Steps werealso taken to hasten the convergence of prices toworld levels for petroleum products, transportationservices, wholesale electricity, and water and naturalgas. Because the structural change and price conver-gence the WTO-mandated liberalizations wouldgenerate were already underway prior to formalaccession, the impact of WTO per se, has arguablybeen smaller than some might have predicted.

That being said, the combination of pre-WTOand post-WTO reforms is making China arguablyone of the most open large developing economies.This view is supported by several metrics. First,

11


Figure 6. Chinese Imports as a Percentage of GDP, 1990–2004

40%

35%

30%

25%

20%

15%

10%

5%

0%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

China’s import tariffs provide only a modest degreeof protection for domestically produced goods.China’s average bound tariff rate across all goods is10 percent. For Argentina, Brazil, India, andIndonesia, the figures are 31.9, 31.4, 49.8 and 37.1percent, respectively. Second, China’s ratio ofimports to gross domestic product, shown in Figure6, has increased significantly over the past decade orso and stood at about one-third in 2004. By com-parison, the comparable ratio for Japan is 9 percent.Third, China’s FDI regime is one of the most openand welcoming of any country in the world, asreflected in China’s status as the world’s largestrecipient of inward foreign direct investment in2003. Not only are there few restrictions on inwardinvestment in the manufacturing sector, China hasmade liberalization commitments in all of the serv-ice industries covered by the WTO GeneralAgreement on Trade in Services. Only a handful ofmembers come close to meeting this standard.Former U.S. Trade Representative CharleneBarshefsky described China’s commitment to liber-alize its distribution system as “broader actually thanany World Trade Organization member has made.”8

China’s commitments to liberalize financial andtelecommunications services are particularly strong.

ENDNOTES

1. For more comprehensive examinations of the pre-reformtrade regime and early trade and FDI reform, see NicholasLardy, Foreign Trade and Economic Reform in China, 1978-1990 (Cambridge: Cambridge University Press, 1992);Nicholas Lardy, China in the World Economy (Washington:Institute for International Economics, 1994).

2.These SEZs included Shenzhen (across the border fromHong Kong), Zhuhai (across the border from Macau),Shantou (on the Guangdong coast facing Taiwan), andXiamen (directly across the Taiwan Straits from Taiwan).

3. Because of official restrictions on direct Taiwanese invest-ment in the mainland, some Taiwanese FDI gets routedthrough Hong Kong or through “tax haven” nations suchas the Cayman Islands. Such “tax haven” jurisdictions are aprominent component of the “other nations” categoryshown in Figure 4.

4. Some of the operational inefficiencies were related to the“performance requirements” then in place in FIE con-tracts. Firms were often asked to meet targets for export offinal output or localization of parts procurement than rancounter to what profit maximization would dictate. SeeDaniel Rosen, Behind the Open Door: Foreign Enterprises inthe Chinese Marketplace (Washington, DC: Institute forInternational Economics, 1999); and Joe Studwell, TheChina Dream:The Quest for the Last Great Untapped Marketon Earth (New York:Atlantic Monthly Press, 2002).

5.Thomas Rawski suggests that growth in 1998 might havebeen less than one-half of the officially recorded level. SeeTomas Rawski, “What’s Happening to Chinese GDPStatistics?” China Economic Review,Vol. 12, No. 4 (2001),347–354.

6. Similarly pronounced cycles of rapid growth followed bysubstantial slowdown can be seen in the trade statistics andin measures of domestic investment. For one theory-basedanalysis of the macroeconomic instability of the reformperiod, see Loren Brandt and Xiaodong Zhu,“Redistribution in a Decentralized Economy: Growth andInflation in China under Reform,” Journal of PoliticalEconomy,Vol. 108, No. 2 (2000), 422–439.

7. One study predicted that the opening in agriculture alonewould eliminate employment for 8 million wheat farmers,30 percent of the number engaged in wheat production.Substantial reductions in employment and output werealso forecast for natural rubber, plastics, and rolled steel. SeeYansheng Zhang, Zhongxin Wan and Shuguang Zhang,Measuring the Cost of Protection in China (Washington, D.C.:Institute for International Economics, 1998).

8. Charlene Barshefsky, “U.S. Trade Policy in China,”Hearings before the Senate Finance Committee on theStatus of China’s Application to Join the World TradeOrganization,April 13, 1999, www.fnsg.com.

12


13


China’s future rural development faces twofundamental and inter-dependent tasks.First, rural development requires changes in

governance. Rural China needs a new frameworkfor managing fiscal and other governmental mattersto suit the modernizing and increasingly market-oriented economy. Leaders must instill a new ethicinto local government; officials must become facili-tators of economic growth and equity rather thandirect actors. Reformers also need to encouragenew partnerships with rural citizen organizationssuch as Farmer Professional Associations that cancontribute to the development process and assistvulnerable groups. Second, a concentrated effort isstill needed to improve the resource base of the ruraleconomy. Despite the great progress of the past 50years, many parts of the agricultural sector remainunderdeveloped.There are 50 million more farmersin China than at the beginning of reform. Farms arefragmented, small and getting smaller. Otherresources—water and forests—are just as scarce.Farm prices, at least for certain commodities, willalmost certainly fall as the nation implements itsWorld Trade Organization (WTO) commitments.In such an environment the state and its partnershave much to do to help farmers increase theirresource base. China’s most abundant resource, itsrural population, lacks adequate human capital.Land, water and forests also require large invest-ments and new institutional arrangements toincrease productivity and raise household incomes.Millions of people remain at or under the povertyline; most are poor farmers in remote, mountainousareas of China’s western provinces.

RURAL DEVELOPMENT PRIORITIES

While rural development has many components, werestrict our attention to three broad issues: (a) thenature of China’s new economic landscape and meas-

ures to enhance it, (b) reforms that are needed toimprove rural government and its partnerships withthe rural population, and (c) investments that canimprove China’s resources, including labor, land, cap-ital, water, forests and the environment of the poor.

Enhancing China’s New LandscapeChina’s rural economy stands on the brink of a newera. Reform has engineered a broad transition fromplan to market, with most inputs in China’s ruraleconomy now under the control of farm house-holds. The government can contribute to furtherdevelopment by redefining key food policy priori-ties, fostering markets, completing grain marketingreforms, and continuing to integrate China intointernational markets.

Changing Priorities on Food Security. With such alarge population and limited resources, China’s lead-ers have always placed a high priority on food secu-rity. Since 1983 China has been a net food exporter.Even if the nation completely liberalized all trade(which is beyond its current trade commitments), by2020 rice and wheat will still be almost fully pro-duced in China. Although the nation will be a netimporter of maize and soybeans, by 2020 the exportof vegetables, fruits and livestock and aquatic prod-ucts will grow faster. Given this strength, future pol-icy should focus on raising rural incomes rather thanmaintaining grain self sufficiency. The recent poli-cies to promote crop diversification are appropri-ate—as long as the planting decisions are made bythe households themselves. Artificial restrictions ongrain imports are no longer needed. Protectionistmeasures not only create international tensions, butalso cause inefficiencies and stifle structural change.Self sufficiency policies also slow down exports oflabor-intensive, higher-valued products and reducerural incomes. Policy attention by China’s leaders tokeep its border open to imports, however, also needto be matched by efforts to keep the markets of

Rural Development in China:New Challenges in a New Landscape

SCOTT ROZELLE AND JIKUN HUANG

Scott Rozelle is professor at the Department of Agricultural and Resource Economics, and Chancellor’s Fellow atthe University of California, Davis. Jikun Huang is professor and director of the Center for Chinese AgriculturalPolicy, Institute for Geographical Sciences and Natural Resource Research, Chinese Academy of Sciences.

14


other nations open to China’s agricultural exports.China also could redirect attention from nation-

al food security toward measures that promotehousehold food security among China’s poor. In fact, itis arguable that China’s main food problem is thatthe poor are not always able to provide their familymembers with enough nutrition, health and educa-tion. Since the problems are essentially those target-ed by China’s poverty alleviation program, the cur-rent investment policies in poor areas that increasethe productivity of the resource base and encouragesdiversification also will have the secondary effect ofimproving household food security.

Fostering Domestic Food Markets. Liberalization ofdomestic markets over the past 20 years has deliv-ered remarkable benefits.The cost of shipping goodsacross China has fallen dramatically. The cost ofshipping maize, rice and soybeans across the north-eastern region or down the Yangtze River is aboutequal to the cost of shipping grain down theMississippi River in the United States. Markets alsohave integrated rapidly.Table 1 shows that by 2002,prices between almost all pairs of markets acrossChina–even those as distant from one another asXian and Guangzhou or Heilongjiang andShanghai–move consistently together for all majorcrops. Part of the improvement in domestic marketintegration is due to the construction of roads andimproved communications. The improvements inChina’s market also are from rising competition;since the mid 1990s, thousands of private tradershave entered the commodity markets and arbitrage

away price differences between regions.Against this background of well-functioning

domestic output markets, experimentation with newgrain policies is vital. Such reforms should observeprinciples derived from international experience.While limited payments to farmers may make senseto facilitate structural adjustment, farmers quicklycome to view such payments as entitlements thatthen become difficult to eliminate. It is therefore

preferable to channel newly available resources intopublic goods, especially because China’s agriculturalpolicies are among the least distorted in the world.This absence of distortions represents a valuable assetthat deserves careful preservation.

Any direct payments to farmers should haveclearly specified time limits; payments should be de-linked from production decisions, with targetingbased on easily observable indicators (e.g., county-level cropping patterns and yields). The entireprocess should be highly publicized, simple and useeasy-to-observe criteria to ensure that funds actual-ly reach their intended recipients.

Deepening Integration Across the Border. Despite con-cerns about the impact of an increasingly open econ-omy on China’s farmers, implementing China’sWTO agreement have created many benefits withonly minimal negative impact.1 Workers gain accessto employment. Consumers benefit from lowerprices. All producers benefit from lower fertilizerprices. Producers of rice, most vegetables and fruits,many livestock and aquatic products and other high-er-valued, labor-intensive goods also benefit as WTOentry leads to higher exports.While producers of bar-ley, soybean and other edible oils were hurt by liber-alization during the 1990s, most of the fall in theprices of these commodities had already taken placeprior to the WTO agreement, so the agreement itselfhad little impact. Only maize, cotton and wheatfarmers are adversely affected.However, because mostfarmers are highly diversified and are able to changeproducts if prices fall, the overall cost is small. Theonly groups that need support are poor maize, cottonand wheat producers in the central and western partsof the nation. According to Chinese estimates, how-ever, the annual loss due to WTO to these most vul-nerable households only averages about RMB50 perhousehold. A policy that compensates such house-holds by RMB50 per year for the first several yearsafter WTO (through direct payments or reducedtuition and school fees) have offset the negative con-sequences of WTO accession without introducingcostly economic distortions.

Taking full advantage of opportunities linked toWTO accession requires complementary policyefforts.Chief among these is to allow farmers to haveaccess to the lowest priced and most productiveinputs and technologies from inside or outsideChina. The WTO agreement challenges China’sfarmers with competition in output markets from

Table 1. Integration in China’s Markets(percent of market pairs that have integrated prices series)

46

56

93

95

100

98

1991–92

Corn

Soybean

1997–00 2001–2003

15


producers in the rest of the world.To compete, farm-ers need to have access to the same low-cost inputsand same high-quality technologies.There are manyrestrictions keeping seeds and other inputs frommoving around the country. There also are barriersagainst the importation of inputs and technologies orinvestment by foreign technology firms. Theseshould be sharply reduced and eventually eliminatedin order to improve the income of farm households.According to international experience the entry offoreign seed and technology firms into the countrycould lead to both more competition and bettertransfer of technology.

Restructuring Rural Government and PartnershipsReform of public administration can contribute torural development. While there are many measuresthat are needed, in this brief we limit our commentsto discussions on rural fiscal reforms and policiesthat will promote the expansion of China’s emerg-ing farmer association movement.

Rural Fiscal Policy.The conduct of public financeis arguably one of China’s biggest problems. Thepresent fiscal system rests on a design that does notfit today’s circumstances. The system also generatesinadequate revenues and their poor redistribution,and fails to provide enough public goods.There areproblems with expenditure and revenue mandates atthe sub-national level and with the implementationof government transfers. Insufficient provision ofpublic goods and services for the rural economyreflects the larger problems afflicting inter-govern-ment finance in China, a subject that lies outside thescope of this brief overview.

Role of the State and Rural Partnerships. Reform hasshifted government activity in China’s rural econo-my toward indirect rather than direct participation.Further progress in this direction seems likely toinclude a comprehensive rethinking of govern-ment’s role at each level of administration as well asspecific measures to improve the provision of publicgoods, to overcome market failure, and to provideuseful services that the private sector is unlikely tofind profitable.

Recent issues surrounding anti-poverty initia-tives illustrate government’s new role in creating,implementing and coordinating policies that involveconflicting goals. Efforts to encourage poor house-holds to raise goats and sheep in ecologically unsuit-able areas resulted in serious environmental damage.

Some sub-national governments have taken drasticbut effective measures to manage natural resourceswhile still helping the poor, but others need betterguidance.

In a modern society in which markets dominatethe flow of commodities and private individuals orenterprises control most assets and information, effec-tive development requires close partnership betweenstate agencies and non-government organizations.International experience underlines the potentialbenefits of developing truly independent FarmerProfessional Associations (FPA) as well as other infor-mation networks, business support groups, marketingsystems and credit cooperatives. Today such institu-tions are still weak in China. While there are morethan 60,000 farmer associations, their membershipaccounts for only about 2–3 percent of all farmers;the structure of these associations remains ill-defined.

Although the impetus to meet and act as a groupmust come from the farmers themselves, the govern-ment can contribute by creating a supportive envi-ronment. The expansion of farm-related organiza-tions and agencies can benefit from laws and regula-tions that support the creation of FPAs. Above allmeasures are needed to clarify the legal status ofthese groups and allow FPAs to enter into contracts.International experience shows that even with afavorable legal and regulatory framework, an inde-pendent catalyst is often needed to get FPA started,to spark FPA expansion and to improve perform-ance. China needs rural non-government catalyststhat respond first and foremost to the needs of farm-ers and farmer groups.

INVESTING IN RURAL CHINA’S RESOURCES

Improving the productivity of resources can directlyimprove the welfare of rural residents by raising theirincomes and making them less vulnerable to risk.Having a better resource base also will provide farm-ers with the means for making major decisions tomove off the farm, migrate to the city or to makeproductive investments.

Raising Productivity on the Farm. China’s researchsystem has increased productivity for major staplecrops at more than two percent annually during thereform era,with more than 60 percent of this increasecoming from new technology. These R&D effortshave already delivered substantial results: productivityin cotton-growing, for example, has risen by nearly

16


25 percent along with reduced use of pesticides,which has simultaneously improved farmers’ health.

Despite these and other successes, China’s sys-tem of agricultural research faces great challenges.Research work, almost totally publicly funded, hasalways focused primarily on the major staple graincrops, which receive over 80 percent of agricultur-al research funds. Growing fiscal pressures havemade sub-national governments (the chief spon-sors of agricultural research—a feature that isunique to China) increasingly reluctant to invest inresearch and extension work.As a result, China stillinvests less than 0.5 percent of agricultural grossdomestic product (GDP) in R&D, a level far belowother countries.

Given the small size of China’s farms and inten-sity of post-WTO competition, China needs tostay at the forefront of technological developmentin order to raise farmer incomes. This means asharp increase in spending on agricultural technol-ogy to at least one percent of agricultural GDP(note that the United States, Canada and Australia,each devotes two to four percent of agriculturalportion of GDP to farm-related research). Whilereserving funds for research designed to benefitfarmers in poor areas, to transfer some researchtasks to the private sector (a common internation-al practice) can improve results by taking advantageof the ideas, capital and entrepreneurship of indi-viduals and businesses. Such transfers, for example,in developing hybrid maize and horticulturalcrops, can help to support the emergence of pri-vate research and seed firms.

China ranks among the global leaders in agricul-tural biotechnology. In the late 1990s China invest-ed more in agricultural biotechnology research thanall other developing countries combined. Its publicspending on agricultural biotechnology was secondonly to the United States. Figure 1 summarizesChina’s steeply rising R&D outlays on plantbiotechnology. The outlay for 2003 (not shown)topped US$ 300 million.

While such investments have created a great dealof potential, the gains need to be realized.Allowingscientists to commercialize the results of theirresearch, for instance the recently-developed vari-eties of indica rice and wheat, can deliver largeincreases in both productivity and farmers’ health.

Recent research shows that Chinese consumerswelcome new technologies; their opinions moreclosely resemble those of U.S. consumers, who read-ily accept scientifically-modified food items, thanthose of (more critical) European consumers. Thepromotion of new bio-technologies, however, deliv-ers highest returns when products are channeledthrough an effective bio-safety system that allowscommercialization only when they are safe, and keepsunapproved products off the markets. As in the caseof cotton, China has benefited greatly from the par-ticipation of foreign firms, and farmers have gainedhigh returns from using imported technology.

Preparing Labor for Migration Out of Rural Areas.Development involves more than making the farm-ing sector more productive. Access to off-farm jobsis the conduit through which population shifts fromrural to urban occupations and from agriculture to

Figure 1. China Plant Biotech Research Expenditure (million yuan in 1999 prices, 22 institutes)

100

90

80

70

60

50

40

30

20

10

0

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

17


industry and services.Although China has been latein starting this demographic transition, recent yearshave witnessed a rapid acceleration of labor flows.The erosion of barriers to labor mobility in bothrural and urban areas beginning in the mid 1990sstarted an unprecedented, and perhaps irreversible,flow of labor to the cities. Despite the macroeco-nomic conditions of the late 1990s, the surge in off-farm employment accelerated after 1995. By now,almost 80 percent of rural households have at leastone member in the off-farm sector.

Table 2 shows how current labor flows differ fromthose in the past. For the first time rural workersshow signs of specialization. Young workers—bothmen and women—are much less likely to work onthe farm than older workers. In 2000, more than 75percent of men and women between 16 and 25worked in the off-farm sector, almost double the ratein 1990. Almost all of them live away from home.Unlike their counterparts a decade ago that mostlylived at home while working in local enterprises,most young workers are moving increasingly farfrom home. Perhaps most important, many of theyoung people that work in off-farm jobs have neverfarmed. Firms with migrant workers have muchhigher efficiency and exporting firms employ ahigher proportion of such workers than firms pro-ducing for the domestic market. Employment off thefarm is the main way that rural residents increasetheir incomes and that attenuate inequality among

regions and sectors. It is one of the most importantdeterminants of poverty alleviation.

Despite these rapid changes, the exodus of work-ers from farming has just begun and many barriersremain. Because the ability to find a job off the farmis inextricably tied up with human capital, invest-ment in education and health can facilitate off-farm

employment. The beneficiaries of human capitalinvestments are those outside the immediate ruralcommunity (i.e., the factory owners in industry andconsumers of services in urban areas). Internationalexperience shows that the central government musttake responsibility for investment in rural educationand health. In recent decades, however, rural educa-tion and health in China have been left mostly onthe shoulders of local governments and the poorhouseholds. Complementary policies in both therural and urban sectors can encourage the rise of off-farm employment and contribute to the increase inproductivity that occurs when rural residents moveto urban areas. Examples include investment in ruralhealth, policies that encourage the expansion of ruralindustries, the relaxation of employment regulationsin urban industries, and easier access to urban hous-ing, education and social services.

Encouraging Land Rental Markets. Secure propertyrights and well functioning land markets are impor-tant catalysts for growth because they make invest-ment worthwhile and facilitate transfers of land tothe most efficient users. Government actions overthe past decade and the new Rural LandContracting Law have improved the security of landtenure to the point that poor tenure security nowhas only minor effects on agricultural investment orproduction efficiency. Despite the progress, imple-mentation and enforcement in some regions stillremain problematic. A large part of the problemexists due to insufficient dissemination of informa-tion about salient clauses that affect farmer rights.

The rights environment, however, has improvedenough in recent years to positively affect the rentalmarket for cultivated land. Figure 2 illustrates theconsiderable expansion of rental markets for farm-land at the national level. Zhejiang is a leader in thisfield, with nearly 30 percent of farmland nowtransacted in rental markets. Such an expansion isimportant as it allows those families that have notbegun to focus their livelihood strategies on citiesto increase access to land resources and improvetheir income. The payoff for effective measures toimplement the new Rural Land Contracting Lawand to improve existing mechanisms for land regis-tration will be very large, because progress in theseareas will allow migrant households to rent theirland out, and enable those who remain in the vil-lages to gain access to additional land in order toraise their incomes from farming. International

Table 2. Percent of Rural Work Force OffFarm by Age Range, 1990 and 2000

16–20

21–25

26–30

31–35

36–40

41–50

23.7

33.6

28.8

26.9

20.5

20.8

75.8

67.2

52.5

47.6

43.3

37.6

Age Range 1990 2000

18


experience shows that land registration can stimu-late rental market activity and also encourage banksto accept land as collateral for loans. Land registra-tion protects farmers by improving transparency inland transactions. Uniform certification across largeregions can broaden the market and raise the ben-efits of land registration.

Experimenting with Rural Finance. The develop-ment of rural finance from the currently low levelsrepresents another pressing issue. The effectiveimplementation of many other policies (e.g., to pro-mote migration) and investments (e.g., to encouragethe dissemination of new technologies) rely on aneffective rural financial system.

Water, Forest and Grasslands Management: Watershortages pose a serious barrier to growth, limitefforts to alleviate poverty, and create a major envi-ronmental problem. Past efforts have not resolvedwater shortages because, for the most part, they arenot capable of increasing future supplies and havenot lowered water consumption. Even with “southto north transfer projects,” there will still not beenough water to support continued consumption atcurrent levels.

These circumstances call for new and moreambitious water policies that can reduce water con-sumption. First, water savings in irrigated agricultureneed to focus on reducing the water consumed perunit of crop production. This requires the integra-tion of improvements in irrigation technology, agro-nomic practices, and farm water management.Second, water management agencies need moreauthority to make and enforce difficult choices.

Third, a system that endows local residents withrights for both surface and ground water can con-tribute to outcomes that achieve true water savingswhile avoiding inequitable outcomes. Fourth, estab-lishing a system of water rights will facilitate effortsto begin the investments and management shifts thatwill allow for volumetric pricing and regulation ofwater. Finally, with the institutions and facilities inplace to implement a system of water rights andcharge for water volumetrically, the nation canbegin to raise water prices, promote genuine watersaving technologies such as reduced-irrigation cul-tivation practices for wheat, and reform manage-ment institutions in order to achieve more appro-priate cropping patterns and sustainable levels ofcropping intensity as well as municipal and industri-al consumption of water.

China has implemented two programs to improvethe environment in the middle and upper reaches ofChina’s main river basins. The National ForestProtection Plan (NFPP) banned logging in manyareas.The Slope Land Conversion Program (SLCP)pays farmers in cash and grain for converting mil-lions of hectares of fragile and erosion-prone culti-vated land into forests and grassland.These programsare very generous,with average payments per hectare(in purchasing power parity or PPP terms) morethan 10 times the amount paid to farmers in the U.S.Conservation Land Retirement Program. Currentpolicies appear effective, but only as long as farmerscontinue to receive compensation that offsets theirlost earnings at least. If payments cease, rural house-holds seem likely to resume cultivation of the slopelands. Along with continuation of initiatives to pro-tect fragile forests and hillsides and to provide farm-ers with suitable technologies, environmental agen-cies should work to formulate a comprehensive strat-egy for developing China’s pastoral areas.

POLICY PRIORITIES FOR RURAL

DEVELOPMENT

This review has focused on illustrating the greatprogress that China’s rural economy has made inrecent years. Despite the progress, however, largechallenges remain.The government needs to play akey role in several policy areas that will influence thefuture path of China’s rural economy. Strong andinnovative policy efforts in these arenas can enhancerural development, help restructure government and

Figure 2. Land Rented-In

12

10

8

6

4

2

0

1988

1995

2000

2001

2003

Per

cen

t

19


create new partners to share the responsibilities fordevelopment, and improve the productivity of ruralChina’s resource base. We see the following as keypolicy issues that deserve top priority for the effortsof policy-makers to guide China’s rural economyand for researchers seeking to evaluate the outcomeof such efforts: getting the fiscal and financial systemsright; continuing market liberalization; opening upChina’s markets to private-sector investments in seedand agricultural technology; encouraging truly inde-pendent Farmer Professional Associations; raisingallocations for R&D to at least one percent of agri-cultural gross domestic product; and promoting edu-

cation and labor movement to encourage off farmemployment.

ENDNOTE

1. China has promoted international trade, reducing averagetariff rates, removing licensing requirements for manycommodities, reducing the role of state trading and allow-ing thousands of enterprises to engage in the import andexport of most goods. For example, average tariffs fell frommore than 50 percent in 1991 to around 20 percent by theend of the 1990s. During this time, the total value ofChina’s agricultural trade expanded by about six percentannually with agricultural exports outgrowing imports.

20


Beginning with the start of reform in the late1970s, China’s industry has recordedimpressive growth of output, labor produc-

tivity, and exports as well as dramatic upgrading ofthe quality and variety of output.These gains haveoccurred in spite of difficulties arising from lethar-gic state enterprises, weak corporate governance,excessive official intervention, corruption, and weakfinancial institutions.

We see globalization and intensified domesticcompetition as the driving forces behind this steadyaccumulation of manufacturing capabilities. Theimpact of China’s growing interaction with globalmarkets is widely understood. China has graduallyopened its economy to trade and investment. UnlikeJapan and Korea during their rapid growth phases,few sectors of Chinese industry escape the directimpact of international market pressures.

Exports provide the clearest evidence of progress.At the start of reform, most Chinese manufacturescould not fulfill customer requirements in middle-or high-income nations. Today, the competitivestrength of Chinese manufactures is a topic ofworldwide discussion.While foreign investment hascontributed to the growing quality and range ofChina’s manufactures, recent industrial development

reflects a broad and deep expansion of Chinese pro-duction and management capabilities.

Domestic competition is more controversial.Information from provincial input-output tablesand other sources leads some authors to describeChina’s economy as deeply segmented, with localprotectionism imposing stringent limits on domes-tic trade.1 However, recent surveys show trade bar-riers in decline.2 Along with official policy efforts,national advertising and massive improvements intransport and communication have underminedbarriers to commerce.

The consequences of increasing market liberal-ization and competition from both domestic rivalsand imports act through multiple channels.3 Theseforces typically result in falling prices and increasingconcentration as weak firms exit and strongerenterprises expand their market share. Where thereturns to investment in product quality and pro-ductivity are high, and “economies of scope” per-mit capable firms to capture market share, weexpect higher R&D spending to add to the upwardmomentum of market concentration. As competi-tion intensifies, market turbulence is likely to pro-duce considerable turnover in industry leadershipand in the ranking of firms.

Chinese Industry After 25 Years of ReformLOREN BRANDT AND THOMAS G. RAWSKI

Table 1.The Scale of Beer Producers in China (1994–2000)1994

655

21.63

5.4

2119.9

3616.6

59558.1

Number of Firms

Average Size (1000 tons)

Above 200,000 tons

100,000 –200,000 tons

50,000 –100,000 tons

Below50,000 tons

NumberShare (%)

NumberShare (%)

NumberShare (%)

NumberShare (%)

1995

656

25.17

12.1

2318.6

4419.1

55250.2

1996

589

30.68

14.5

2821.8

4718.2

20645.5

1997

550

34.313

21.4

2820.9

5720.1

45237.6

1998

495

40.218

31.3

2617.1

6021.2

39130.4

1999

474

44.319

35.2

2517.1

6221.1

36826.6

2000

495

45.120

41.8

2616.7

6018.9

38922.6

Loren Brandt is professor of economics at the University of Toronto.Thomas G. Rawski is professor of economicsand history at the University of Pittsburgh.

Source: Zhongguo qinggongye nianjian [China Light Industry Yearbook], 1995–2001.

21


These elements figure prominently in the evolu-tion of individual Chinese industries during the lasttwenty-five years. In old industries like beer, forexample, local breweries have crumbled before theonslaught of large firms (see Table 1), while in newindustries like television, there has been a combina-tion of increasing concentration and massive leader-ship shifts during the past decade, as newly domi-nant firms eclipsed first Nanjing Panda and nowSichuan’s Changhong.

Television manufacture also illustrates howChinese experience replicates classic market-econ-omy development patterns for new industries.4 Aninitial rush to enter this new sector—by 1990 therewere over 100 TV manufacturers in China—led toa painful interlude of high costs, excess capacity, andfinancial distress. Figure 1 shows that 1990 outputof color TV sets lagged far behind the capacity of

production lines installed during 1978–1985 inevery province.

During the ensuing decade, we observe consider-able shakeout. The number of manufacturersdeclines considerably, while several of the sicklystart-ups portrayed in Figure 1 metamorphose intoglobal export leaders amidst sweeping industry-wide consolidation. This is evident in Figure 2,which shows output of color TVs in 2000 inprovinces with the leading firms in industry, i.e.,Guangdong (TCL and Konka) and Sichuan(Changhong), well in excess of earlier capacity.

Figure 3 shows a classic “product cycle” pattern—initial imports followed by a steep rise in exportsthat rocketed Chinese producers into a prominentposition among global exporters of televisions.Theequally abrupt decline in the ratio of importedcomponents to export sales reflects new domestic

Source:Authors’ file Tvbyprov.042605.

Figure 1. China: Investment and Production of Color Televisions By Province (1), 1978–1990

300

250

200

150

100

50

0

-50

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Guangdong

Fujian

SichuanTianjin

LianoningBeijingZhejiang

Shanghai

45˚ Line Y = Xy = 0.1116x - 11.553R2 = 0.7573

An

nu

al O

utp

ut

in 1

990

(100

0 se

ts)

Capacity of Production Lines Imported in 1978–1985 (1000 sets)

Figure 2. China: Investment and Production of Color Televisions By Province (2), 1978–2000Omitting Guangdong

6000

5000

4000

3000

2000

1000

0

0

200

400

600

800

1000

1200

1400

Sichuan

Liaoning y = 2.4292x - 16.23R2 = 0.3662Shanghai

JiangsuShandong

ShanghaiShaanxi

Zhejiang Beijing

Fujian

Tianjin

45˚ Line Y=X

GuangdongOutput 14,714Import Cap. 1,860

Co

lor

TV

Ou

tpu

t in

200

0 (1

000s

)

Annual Capacity of Production Lines Imported 1978–1985 (1000s)

y = 2.4062xR2 = 0.3661

22


capacity to manufacture key components formerlyprocured from abroad.

Top firms in some leading sectors alreadyapproach world-class performance, while others lagfar behind. Auto parts illustrate both outcomes.When the new wave of international carmakersestablished factories in China during the 1990s, offi-cial regulations required local sourcing of 70 percentof all components. With international suppliers tothe global auto majors following their big clientsinto the People’s Republic, the top tier of compo-nent suppliers quickly evolved into a mix of inter-national and domestic firms. The combination ofextensive foreign penetration and explicit, widelypublicized standards led to a steep rise in productquality and productivity among first-tier supplierswho sell directly to First Auto Works, Shanghai-GMand other leading auto assemblers. In 2004, localsourcing exceeds 90 percent.

Field research carried out in 2003/2004 docu-ments some of the improvement in product qualityand productivity. Domestic firms already matchglobal norms for labor productivity in the assemblyof auto seats. In the case of exhaust systems, a con-siderable gap in labor productivity remains.However, the productivity gap is substantially small-er than the wage differential between China andhigh-income countries.

Figures 4 and 5 show both the achievements andthe shortcomings of quality control in China’s autoparts sector. Figure 4, which tabulates defect rates for100 first-tier component suppliers to a major car-maker’s Chinese operations, shows that over half ofthese component makers had achieved defect ratesbelow 100 parts per million (ppm), the internationalbest practice standard for the global auto industry.This impressive outcome, however, pertains only tothe top-tier of suppliers. Moving one rung down theladder of component makers, Figure 5 shows veryhigh defect rates for components delivered to a typ-ical first tier supplier: here the defect rate is measuredas a percentage, rather than ‘parts per million’. Firsttier suppliers, typically mid-size firms, are reluctantto invest in training their own suppliers. They aremore willing than the carmakers to tolerate a higherlevel of product defects in return for a lower pricefrom their own (‘second tier’) suppliers.The result isa much slower rate of capability building—a patternseen also in the United States, Japan and Europe,though in the Chinese case the gap between first andsecond tier suppliers is particularly wide.

Generalized expertise in supply chain manage-ment is a key determinant of performance across thegeneral run of manufacturing industries.The devel-opment of tightly organized and well-managed sup-ply chains in some segments of the automotive

Figure 3. China’s Trade in TVs and Components 1992–2003 (US$ million, left scale) and percent

Total Exports (US$mn)

Net Exports (US$mn)

Imported parts as % of TV exports

5000

4000

3000

2000

1000

0

-1000

180

160

140

120

100

80

60

40

20

0

Mill

ion

s $U

S

Year

Source: UNCOM Trade Data

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

23


industry stands in stark contrast with the extremevertical integration observed under China’s pre-reform plan system and with continuing weak sup-ply chain management in many domestic industries.

Reform has raised both capabilities and wages.Interconnected upward shifts in capabilities andwages generate a continuing transformation ofChina’s export mix from “unskilled labor-intensive”to “skilled labor-intensive” and capital- and technol-ogy-intensive sectors. It is easy to exaggerate thecontribution of low-cost labor to Chinese growth.To be sure, the initial wave of incoming foreigninvestment, much of it from Hong Kong, and to alesser extent, Taiwan, reflected foreign producers’efforts to replicate low-wage environments previ-ously available in Taiwan and Hong Kong. Whilemakers of garments, toys and many other productscontinue to employ millions of migrant workers inplants built around labor-intensive processes, foreigninvestment is now well into a second stage, in whichit is no longer low wages alone, but rather China’sunique combination of rising capabilities and mod-erate labor costs that motivates FDI decisions.

In Figure 6, we use information on the R&Dcontent of U.S. manufacturing industries from aunique 1977 survey to calculate the annual “R&Dintensity” of China’s manufactured exports duringthe period 1987–2003. The procedure is far fromperfect. Some exports fall outside the available R&D

categories. Imported components often enhance thetechnology component of Chinese exports, asChinese workers install hard disks from Singaporeand microchips from Taiwan or Korea in electronicgoods destined for overseas markets. Nonetheless,both the summary figures compiled in Figure 6 andmore detailed breakdowns (not shown) reveal a dis-tinct shift toward export sectors with increasingdegrees of capital- and knowledge intensity as wellas a gradual erosion of the large but declining exportshare of labor-intensive products.

The extreme diversity among China’s disparateregions adds a geographic dimension to the process ofcapability building. Foreign investment, industrialexports, and expansion of manufacturing capability allcluster in China’s dynamic coastal areas. As theseregions expand their manufacturing capabilities, ris-ing wages and land costs compel earlier cohorts oflabor-intensive manufacturers to depart from theseleading areas,5 as occurred previously in Taiwan andHong Kong. If China’s interior provinces can providea hospitable investment climate to complement mas-sive new investments in airports, roads and telecom-munications, firms and industries forced to departfrom coastal locations may find new homes in centraland western China rather than moving overseas.

Foreign technology, imported capital goods, andcooperation with multinational enterprises occupyprominent roles in the product innovation and capa-

Figure 4. Defect Rate for 100 Component Suppliers to a Multi-national Car Maker

60

50

40

30

20

10

0

<100

pp

m

100–

300

300–

700

700–

1500

1500

–300

0

3000

–700

0

Nu

mb

er o

f C

om

po

nen

t M

aker

s

Defect Rate: parts per million

Source: John sutton, The Auto-component Supply Chain in China and India - A Benchmark Study (London: STICERD, 2004),Table 2.1.

Figure 5. Defect Rate for 101 Component Suppliers to a Chinese Maker of Steering Gear

70

60

50

40

30

20

10

0

< 1%

1–10

%

10–2

0%

20–4

0%

Nu

mb

er o

f fi

rms

Defect Rate (percent)

Source: John sutton, The Auto-component Supply Chain in China and India - A Benchmark Study (London: STICERD, 2004),Table 2.6.

Figure 6. R&D Intensity of China’s Exports, 1987–2003

bility expansion described in this essay. But Chinahas rich entrepreneurial resources. Tim Wright’scharacterization of pre-World War II China as hav-ing “an abundance of small-time entrepreneurs”remains valid today,6 when we also observe an amplesupply of big-time entrepreneurs, many withadvanced overseas training and international experi-ence.This talent pool will enable domestic firms toseize opportunities to combine new capabilities,including skills initially monopolized by foreignfirms, to achieve economic gain. Recent develop-ments in telecommunications, semiconductors,biotechnology and many other industries underlinethe implausibility of claims that Chinese firms willnot challenge “the continued industrial and techno-logical preeminence of the United States and otheradvanced industrial democracies.”7

Looking forward, we anticipate continuedexpansion and deepening of manufacturing capabil-ities in the coastal regions that have dominatedChina’s initial achievements, now joined by newstreams of upgrading and innovation, already visiblein sectors like silk and steel manufacture, arisingfrom the spread of capabilities across sectors andregions, and by fresh impetus originating in domes-tic R&D operations.8 Signs of domestic innovativepotential include qualification of nearly 100,000Chinese firms for ISO 9001 certification by the endof 2003 and advances in biotechnology, shipbuilding

and other sectors with limited foreign participation.Mutual interaction among these streams of innova-tion, reinforced by continuing official efforts to pro-mote institutional reform, points to continued rapiddevelopment of Chinese manufacturing capabilities,with market-induced upgrading and enlarged inter-national competitiveness spreading to a growingarray of industries and geographic regions.

China’s manufacturing achieved remarkablegains during the first quarter century of reform.These advances, although costly, uneven, and oftenforeign-led, are noteworthy both for their largescale and for the strong momentum that over-whelmed seemingly powerful obstacles, includingintrusive and capricious regulation, extensive cor-ruption, and weak systems of law, management,finance, and corporate governance.

Our expectation of continuing advance forChinese manufacturing does not rule out cyclicalfluctuations, including substantial and painful down-drafts. However, we see the emergence of the com-petitive mechanisms driving recent advances inmanufacturing capabilities as a permanent structur-al change that will survive any cyclical fluctuations.

ACKNOWLEDGEMENT

This paper draws on joint work with John Sutton.We acknowledge valuable assistance from Peng Liuand Xiaoming Shang of the China Enterprise

24


1.8

1.6

1.4

1.2

1

0.8

0.6

0.4

0.2

0

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Source:Authors’ file Table_6_data.TR mod.042605 based on “Annual Line of Business Report 1977” [Baker Library call number 9163120] andUNCOM Trade Data.

Confederation and from Xi Chen and Yifan Zhangas well as financial support from the SmithRichardson Foundation, the National ScienceFoundation, the William Davidson Institute, theUniversity of Pittsburgh and the Institute forInternational Business at the University of Toronto.

ENDNOTES

1. For example, see Genevieve Boyreau-Debray and Shang-jin Wei, “Can China Grow Faster? Diagnosis on theFragmentation of the Domestic Capital Market” (MS,2003); Sandra Poncet, “Measuring Chinese Domestic andInternational Integration,” China Economic Review,Vol. 14,No.1 (2003), 1–21; Alwyn Young, “The Razor’s Edge:Distortions and Incremental Reform in the People’sRepublic of China,” Quarterly Journal of Economics,Vol. 115,No. 4 (November 2000), 1091–1136.

2. Li Shantong et al., “Survey and Analysis of ChineseDomestic Regional Protection Problem,” Jingji yanjiu[Economic research], No. 11 (2004), 78–84, 95. See alsoChong-En Bai et al., “Local Protectionism and RegionalSpecialization: Evidence from China’s Industries,” Journal ofInternational Economics,Vol. 63, No.2 (2004), 397–417.

3.These issues are spelled out more fully in John Sutton, RichTrades, Scarce Capabilities: Industrial Development Revisited

(Keynes Lecture, British Academy; London, 2000) and inLoren Brandt, Thomas G. Rawski and John Sutton,“Industrial Organization” (MS, 2004).

4. Steven Klepper and Elizabeth Graddy, “The Evolution ofNew Industries and the Determinants of MarketStructure,” RAND Journal of Economics, Vol. 21, No.1(1990), 27–44.

5.Widely reported “labor shortages” in Guangdong factoriesmay reflect this phenomenon. If market pressures preventold-line industries from raising wages, workers may departin search of better opportunities, leaving their formeremployers with the choice of relocating or closing theirbusinesses.

6.Tim Wright, “Growth of the Modern Chinese CoalIndustry: An Analysis of Supply and Demand,” ModernChina,Vol. 7, No.3 (1981), 325.

7. George J. Gilboy, “The Myth Behind China’s Miracle,”Foreign Affairs,Vol. 83, No. 4 (July/August 2004).

8. See Albert Hu and Gary Jefferson,“Science and Technologyin China (MS, 2004); Emily Hannum, Jere Behrman andMeiyan Wang,“Human Capital in China” (MS, 2004); andJiang Xiaojuan,“China’s Economic Development Enters aNew Stage: Challenges and Strategy,” Jingji yanjiu[Economic research], No. 10 (2004), 4–13.

25


Private sector development is an under-researched topic in the economic and othersocial science literature on China. Much of

the microeconomic work has focused on thereforms of the state-owned enterprises (SOEs), therise—and now the fall—of non-traditional firms,such as township and village enterprises (TVEs), andthe operations of foreign-invested enterprises (FIEs,in which foreign firms have a substantial equityinterest). Purely private—and domestic—firms havenot received the same level of attention.

By 2005, it is increasingly difficult to ignore therole of private firms in Chinese economy. By variousmeasures, purely private firms account for between 20to 30 percent of non-agricultural GDP. Private entre-preneurs and investors are now able to invest in arange of sectors and operate on a scale unprecedentedin the history of reforms. They are also increasinglytaking over the loss-making and defunct SOEs, inject-ing profit incentives and managerial dynamism intothe sector in a way that twenty-five years of SOEreforms have failed to accomplish. There is also agrudging recognition from the top policy makers thatprivate firms are unquestionably more efficient thanSOEs or TVEs. In the past three years, the Chinesepolicy makers have moved to improve the businessand institutional environment for private firms at aspeed comparable to the initial liberalization of theprivate sector in the early 1980s.

This essay presents simple, descriptive findingsfrom a larger book-length project on China’s privatesector development—tentatively entitled, Survivingthrough the C-rack: Private Firms in China during theReform Era. This research is based on both statisti-cal/documentary evidence and detailed case studiesof firms.While it is still ongoing, my research raisesquestions about the gradualist perspective onChina’s economic reforms, which sees economicliberalization as a gradual process in China, begin-ning with baby steps and, in response to the dynam-ics on the ground, moving toward deeper and sys-temic reforms over time.

While this logic serves well to explain foreigndirect investment (FDI) liberalization and SOEreforms, the evidence is mixed at best that this viewaccurately describes the private sector policies—espe-cially financial policies. My own emerging view leanstoward the following portrayal of the private sectorreforms: Much of the private sector liberalization infact took place in the early 1980s.This early liberal-ization of private sector was a byproduct of agricul-tural reforms, which were not gradual at all.Agricultural reforms in essence were the Chinese ver-sion of the “big bang” reforms. Important policyexperiments supportive of private business accompa-nied the agricultural reforms, some as early as 1981.These initiatives involved increasing loans to privatefirms, interest rate liberalization, permitting privateownership of rural financial institutions, setting upregional stock exchanges to cater to private firms, etc.

During the 1990s, the ideological environmentfacing private firms improved. For example, small-scale SOEs and many TVEs were privatized.Licensing restrictions were eased for private firmsover time. Amidst this improvement, the generalfinancing treatment did not improve substantially forprivate firms.While there is a widespread impressionthat the TVE/SOE privatization in the 1990s impliesa liberal environment for private firms, the fact is thatin the late 1990s the share of fixed asset investmentby the explicitly private sector businesses was small-er than their share during much of the 1980s. Incontrast, the investment share by the collective sectorwas much larger throughout the 1990s than it was inthe early 1980s.1

This is still being investigated but there are twopossible and tentative explanations for this lag in thefinancial treatment in the 1990s. One is that the lead-ership in the 1990s implemented policies that had asubstantial urban bias. Private sector activity, much ofwhich was located in the rural areas, was starved offinancing because the state mobilized resources toinvest heavily in the cities—airports, skyscrapers andhighways connecting cities. (This hypothesis is com-

26


Institutional Environment and PrivateSector Development in China

YASHENG HUANG

Yasheng Huang is associate professor of international management at the Massachusetts Institute of TechnologySloan School of Management.

patible with the fact that private real estate firms in theurban areas prospered.) The other hypothesis is thatthe leadership in the 1990s pursued an industrial pol-icy agenda that privileged established, bigger firms,which tended to be SOEs and/or foreign joint ven-tures allied with the state (such as automotive firms).Private firms, which populated labor-intensive indus-tries, remained credit constrained.

To be sure, private entrepreneurs adopted a rangeof ad hoc coping mechanisms to overcome theirfinancing constraints, some quite successfully. Onereason is the substantial heterogeneity in the financialpolicies. Some regions, for whatever reasons, contin-ued the financial liberalization policies from the1980s; others did not (or they never liberalized in thefirst place).The second coping mechanism, well doc-umented by Kellee Tsai, is resorting to informalfinance.3 The third mechanism, as I have document-ed elsewhere, is FDI, especially labor-intensive FDI,which brought equipment financing to credit-con-strained private entrepreneurs in the labor-intensiveindustries.4

My research on private sector development buildson and extends these previous lines of inquiry. I dowant to emphasize two points. One is that thoseregions where one observes financial innovations wereselected in the 1980s by the pro-reform leaders as sitesof experimentation (Wenzhou being an example).Thus, a portion of the regional heterogeneity weobserve in the 1990s in fact originated from the delib-erate policy choices in the 1980s (and some as early as

in 1981). Second, while informal finance and labor-intensive FDI made up for some of the shortcomingsof a generally inefficient financial system, these substi-tute mechanisms are not “functionally equivalent” toan efficient financial system.Their geographic cover-age is narrow; FDI only reached certain areas of thecountry, but not other regions where indigenousentrepreneurship is most needed. Informal financemight be sufficient to finance entry of businesses orsmall-scale,mom-and-pop operations,but it is not suf-ficient to finance large-scale, technologically sophisti-cated, modern operations. This brief paper summa-rizes my ongoing research on these issues.

THE LAGGING FINANCING ENVIRONMENT

FOR PRIVATE FIRMS

There is a wealth of data illustrating the extremefinancial constraints facing the domestic private firms.A number of international surveys show that, althoughChina has one of the biggest banking systems in theworld, its private firms are more financially con-strained than private firms in other countries.

Let me just cite one study. Geeta Batra, DanielKaufmann, et al. show that, based on survey evi-dence over 10,000 firms in 81 countries around2000, China’s financing constraints—as measured bythe subjective perception by the entrepreneurs—arequite similar to those prevailing in transitionaleconomies such as Croatia, Czech Republic,Romania, and Slovak Republic or in poor countries

27


Chart 1. Bank Financing of Private Firms in Their Startup Years, 1980–2001

60

50

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0

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–198

8

1989

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1991

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1993

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1996

1997

1998

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2001

% of firms in rural areasreceiving bank loans instartup year

% of all firms receiving bankloans in startup year

% of all firms in urban areasreceiving bank loans in start-up year

Per

cen

t

such as Ghana and Ethiopia. Indian entrepreneursfared far better in this study than their Chinesecounterparts. The same study also shows thatChinese firms relied more substantially on retainedearnings and informal finance than firms in India.

The surveys organized by the Chinese govern-ment itself point to exactly the same problem. Letme cite one large-scale survey conducted in 2002 bythe All-China Federation of Industry andCommerce, which covered 3258 private firms in allprovinces in China. All of the surveyed firms wereselected from the registration lists maintained by thelocal bureaus of industry and commerce.Thus, thesefirms were explicitly registered as private firms atthe time of the survey, which included some enter-prises converted from SOEs or collective firms.

The main questions of the survey cover (1) firmsize, status of development, organization, and opera-tion; (2) management system and decision-makingstyle; (3) socialeconomic background of enterpriseowners; (4) social mobility and network of owners; (5)source and composition of employees and employee-employer relations; (6) self-assessment by entrepre-neurs on a range of issues related to government-busi-ness relations, business environment, financing, and (7)income, expenditures and assets of entrepreneurs.

Prior to the 2002 survey, four other nationwideprivate sector surveys showed that private entrepre-neurs consistently ranked financing as their top con-straint. Each of these surveys shows that financialliberalization in the 1990s was tentative at best; eachreflects the presence of policy reversals. Charts 1 and

2 present trends showing the financial treatment ofprivate firms in the 1990s relative to the averagefinancial treatment of private firms in the 1980s.

Both charts show no substantial increase duringthe 1990s in the percentage of private firms receiv-ing bank loans in their initial year of operation.Chart 1 shows that the percentage of private firmsreceiving a bank loan during their startup year waspersistently lower in the 1990s (except for 1997–99,after which this ratio declined again) than in the1980s. Chart 2 shows that at the end of the 1980sinformal and formal financing already played similarroles, as measured by the percentage of private firmsreceiving loans from formal and informal channels.During the course of the 1990s, informal financingsubstantially overtook the formal financing. Unlessone assumes, unrealistically, that there is a naturalpreference for informal over formal financing, thisdevelopment suggests that private entrepreneursturned to informal financing because they could notget formal financing.

These data are entirely consistent with the data onthe lending side. As a share of total lending, in fact,private sector lending in the 1990s was smaller thanin the 1980s. This is in large part because of thecrowding-out effect of TVEs. In the mid-1980s,TVEsand private firms received about the same shares ofbank lending. (Bank documents in the 1980s repeat-edly called for equal treatment of TVEs and privatefirms.) Beginning in the early 1990s,TVEs, while farless efficient, substantially overtook private firms inbank lending, only to fail on a massive scale toward

28


Chart 2. Formal and Informal Financing in the Startup Capital, 1980–2001

60

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–198

8

1989

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1993

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% of firms that hadinformal credit in startup capital

% of firms that had bankloans in startup capital

Per

cen

t

the end of 1990s and to accumulate huge non-per-forming loans on their books in the process.

THE EFFECT OF FINANCIAL DISCRIMINATION

The rapid growth of what is loosely referred to as the“non-state” sector of the Chinese economy in the1980s and 1990s has led many to argue that a goodinstitutional environment is neither necessary norsufficient for private sector development. I disagreewith both the blanket characterization of the institu-tional environments in the 1980s and 1990s as well aswith the normative implications of this statement.

For one thing, China’s institutional environmentpertaining to private firms in the 1980s represents aquantum improvement over what was prevailing inthe 1970s. Relative to the size and scale of privatefirms, this improvement was sufficient to inducemassive entry of private businesses. Although notideal, the level of security was good enough tomotivate many private entrepreneurs to ramp upscale quickly. In the 1990s, at least in the financialarea, the quality of institutional environment did notnoticeably improve until very late in the decade.One can even argue that there were policy reversals,whose effect was cushioned partially by the copingmechanisms described above.

The constraining effect of a poor institutionalenvironment shows up in the size of private firms,not necessarily in the size of private sector as awhole. The reason is simple and intuitive. A poor

institutional environment is defined as one that pro-tects property rights poorly and one that financiallydiscriminates against efficient but politically weakfirms (such as private firms in China in the 1980sand 1990s). Under such an environment, entry canbe still massive. It is difficult for predatory govern-ments to squeeze small and numerous firms that canrely on inheritance, savings, and informal finance toenter into small-scale businesses.The total size of theprivate sector can grow as long as the entry of smallfirms is relatively unimpeded. Under these circum-stances, the combination of dynamism among smallprivate firms and the poor efficiency of SOEs canlead to a quick rise of the private/state sector ratio.

The rise of this ratio is used by many to illustratethe improvement of the institutional environmentfor private firms but it is important to keep in mindthat this ratio can rise without any institutionalimprovement as long as the entry of small firmscontinues (and as long as SOEs, which appear in thedenominator, continue to be inefficient). A far bet-ter indicator of the changes in institutional environ-ment is the size of individual firms, not the size ofthe entire private sector.

Here the evidence is sobering. Based on detailedofficial private sector nationwide surveys conductedin 1991,1993,1995,1997, and 2002 with sample sizesranging from 1,400 to 14,000 firms, I have found evi-dence that the individual size of private firms at thetime of registration remained fairly flat during muchof the 1990s and that the average size of private firms

29


Chart 3. Employment Size of Private Firms in Their Initial Year of Operation, 1980–2001

140

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60

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0

1980

–198

8

1989

1990

1991

1992

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1996

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1998

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2001

Number of workers atthe median startup firm

Average number ofworkers per firm

Per

son

s

in the 1980s was surprisingly large.This is especiallytrue using the most common measure of firm size inthe economic literature—employment per firm.

Chart 3 is based on the private sector survey con-ducted in 2002. There is a question in the surveyabout how many employees were hired in the firstyear of the business.We use this question to show theevolution of firm size over time. A tentative readingof Chart 3 is that the firm size changed over time ina highly uneven fashion. Of those firms polled in2002, the average number of employees during theinitial year of operation for firms established duringthe period 1980–1988 already reached 72.5 persons.From that level, the size of start-up firms declined,although not linearly, until 1998, when the averageemployment for new firms was 92 persons. Thusbetween 1988 and 1998, the average size of newlyestablished private firms was actually smaller thanwhat was prevailing earlier in the 1980s.

More tellingly, the median size of new private firmsdid not change at all. It was 30 during the 1980–1988period, declined during the 1990s, and only recoveredto 30 in 1997. The size of newly established privatefirms has become considerably larger since 1998, inpart because of privatization. Since 1998, some of thesmall and medium SOEs were privatized.These SOEs,although small by the SOE standard, are still quitelarge by the standard of private firms.The 2002 surveyshows that privatized firms are much larger than pri-vately-founded firms. One major improvement in the1990s over the 1980s is the privatization policy but itshould be pointed out that this policy was adoptedvery late in the decade and that there were in factsome privatization activities in the 1980s as indicatedby the 2002 survey.6

There are complications with this interpretation.One is the survival bias, i.e., the firms that startedout quite large in the 1980s had a better chance tosurvive and therefore to appear in the 2002 survey.This is a serious sample bias that needs to be tackledmore rigorously but it is not the only reason for thisresult. One indicator is that those firms that startedout in the distant past (i.e., before 1985) in fact hadfewer employees than those firms that started out inthe mid to the late 1980s.

The other objection has to do with the con-founding influences of privatization.The idea here isthat the data may pick up the effect of those firmsoriginally registered as “red-hat” firms in the 1980s.Another objection is that the graph may pick up

some industry effect: if industry composition dif-fered between the 1980s and 1990s, then this differ-ence could have affected employment size.

These two objections are not borne out by thedata. Here I use data for private manufacturing firmsthat were explicitly registered as private firms at thetime of start-up. The average employment was 41persons for those firms registered before 1985, 71 forthose registered between 1985 and 1989, 59 for thoseregistered between 1990 and 1995, and 74 for thoseregistered during 1996–2001. It was only in the late1990s that the average size of start-up firms surpassedthe levels attained during the mid to late 1980s.

PARTIAL AND IMPERFECT

SUBSTITUTE MECHANISMS

Given the lags in the financial treatment of the pri-vate firms in the 1990s, many private entrepreneurswere unable to alleviate their financing constraintsand the individual size of private firms remainedconstant.The failure to ramp up scale during a peri-od of rapid economic growth ought to be extreme-ly puzzling.

However, some private firms were able to over-come their financing constraints, not just by resort-ing to expensive informal financing channels. Hereforeign direct investment played a critical role.Much of the FDI originating from Hong Kong,Taiwan and Macao essentially was equivalent toventure capital in that it funded operations run bycredit-constrained entrepreneurs. This is a topic Idealt with in great detail in Selling China.

Most China scholars view Hong Kong as a sourceof capital and a window onto the world market forChina. In fact, the most important function of HongKong is that it is a substitute mechanism for China’spoorly functioning financial system. Consider thecase of Lenovo. Many Western analysts herald itsacquisition of IBM’s PC business as a harbinger of therising world-class domestic Chinese companies.Using the success of firms like Lenovo as evidence, aMcKinsey Quarterly article has gone so far as to claimthat China has the “best of all possible models.”

These business analysts are unusually perceptiveexcept in one detail: Lenovo is a foreign company.All of the manufacturing, service and R&D opera-tions of Lenovo in China are legally organized assubsidiaries of its Hong Kong firm and as such theyare subject to laws and regulations pertaining to

30


FDI, rather than those far more restrictive laws per-taining to domestic private businesses. (UnderChinese law, as in Britain before 1997, investmentsfrom Hong Kong are treated as FDI.) In 2003, sevenof Lenovo’s Hong Kong subsidiaries were amongChina’s 500 largest foreign operations.

There is a good reason for this arrangement. As Ishowed in my book, Selling China, one of the sub-stantial distortions in China is that laws and regula-tions have treated foreign firms better than domesticprivate firms (although worse than inefficient statefirms). This has several effects, one of which is thatChinese entrepreneurs are motivated to set upbranches in Hong Kong and use them to makeinvestments in China.This is one of the few ways forthem to ease the massive regulatory restrictions ontheir activities.

At the time of its founding, Lenovo was denied alicense in PC manufacturing because it was not a tra-ditional state firm. It ventured into PC manufactur-ing only under the legal cover of a Hong Kong firm,QDI, which Lenovo acquired. While many heraldLenovo as a rag-to-rich story, with a start-up capitalof only $24,000, the reality is more complicated. Itssubsequent rounds of financing, including an IPO inHong Kong, were all quite substantial and they allcame from Hong Kong. (Hong Kong’s IPO raisedabout US$10 million.) China’s massive financial sys-tem had little to do with Lenovo’s success.

Almost all other dynamic entrepreneurial firms inChina have benefited from connections to HongKong.TCL, Galanz, and Kelon, the three most suc-cessful home appliance firms in China, all have sub-stantial legal and financial ties to Hong Kong. In2002,Forbes compiled a list of the most dynamic smallfirms in the world. There were thirteen from Indiabut only four from China and each of these fourfirms, although run by Chinese entrepreneurs andderiving all of their revenues in China, is actuallyheadquartered in Hong Kong.

The example of Kelon shows the importance offormal finance. Kelon, one of China’s top refrigeratormakers, went IPO in Hong Kong in 1996 and thenin 1997 issued additional shares, which raised aboutUS$90 million. Its Hong Kong affiliate also borrowed$70 million from Bank of America in 1997. Thesefinancing schemes were critical to Kelon as the firminvested heavily in distribution networks and acquisi-tion of compressor facilities.7 No informal financingscheme could have raised this kind of capital.

But doesn’t the success of Lenovo and othersprove that entrepreneurial firms can thrive withoutan efficient market-based legal and financial environ-ment? Not at all.Yes, China lacks good institutions,but it has access to good institutions in Hong Kong.Good institutions are vital for economic growtheverywhere in the world and nothing from China’sexperience suggests otherwise.

In this connection, it is important to recognizehow special China is: China has Hong Kong butmany other poor countries do not. McKinsey’s rec-ommendation of China as “the best of all possiblemodels” is equivalent to urging other countries tohave their own Hong Kong.This advice is extremelylimited in its utility.

There is another policy implication. Amidst mas-sive institutional inefficiencies, Chinese policymakershave done two things vitally right and important.One is that they have allowed FDI to come in; theother, which is under-appreciated, is that they haveallowed Chinese citizens to travel abroad since theearly 1980s.This mobility of people is probably thesingle most important reason that some of the entre-preneurs could at least escape from the clutches of avery bad system.Thus, China’s success has less to dowith creating efficient institutions but with allowingan escape valve from inefficient institutions.

But this escape valve is not sufficient.What aboutwould-be entrepreneurs located in China’s vast ruraland interior regions that are distant from Hong Kongboth geographically and culturally? Because they can-not access Hong Kong’s efficient capital and institu-tions, FDI can never be a full substitute for good legaland financial institutions. One can even go further:China’s need for successful entrepreneurs is evengreater in the interior regions than in the coastalprovinces because the interior is so short of otherconditions for growth.

The concentration of FDI in urban areas demon-strates a further cost of restricting the potential ofindigenous entrepreneurs. Many of the mostdynamic, risk-taking and talented entrepreneurs inChina reside in the countryside.These rural entre-preneurs created China’s true miracle growth in the1980s, first by dramatically improving the agricul-tural yield and then by starting many small-scalebusinesses in food processing and constructionmaterials. In fact, my research shows that many ofthe biggest private firms in the 1980s were locatedin the interior regions but that these firms atrophied

31


in the 1990s due to the failure of China’s financialinstitutions to support them. FDI and Hong Kongcan do very little—and they did very little—to helpentrepreneurs in those regions.

CONCLUSION

China’s poor institutional environment has not hurtChina’s growth to the extent it could have onlybecause of a set of unique factors, such as the role ofHong Kong in providing finance to China’s aspiringentrepreneurs. Institutions matter tremendously.Thegood news is that in the last two years, Chinese lead-ers have begun to address the country’s institutionalgaps, including a Constitutional amendment in 2004that strengthened private property rights protection.But they could do far more, including immediatelygranting peasants ownership of the land they till, re-privatizing what were substantially private financialinstitutions in the 1980s—rural credit coopera-tives—and opening China’s financial sector to entryby both domestic and foreign private institutions.

ENDNOTES

1.As with all statements based on the Chinese data, there arecomplications. If one assigns the investments by all the list-

ed firms to the private sector, then the private share wouldbe larger (although only by 5.6 percent or so in 1998).Such attribution would be extremely questionable on sub-stantive grounds. The vast majority of the investmentactivities under “Other” category—in addition to SOEs,collective firms, and individual businesses in the Chinesestatistical reporting—took place in the foreign sector.

2. Loren Brandt and Hongbin Li show that the banking poli-cies are closely correlated with a set of attributes of bankmanagers and that banking policies differed among bankbranches depending on these attributes. See Loren Brandtand Hongbin Li, Bank discrimination in transition economies:Ideology, information or incentives? (MS, Department ofEconomics, University of Toronto,Toronto, 2002).

3. Kellee S. Tsai, Back Alley Banking: Private entrepreneurs inChina (Ithaca: Cornell University Press, 2002).

4.Yasheng Huang, Selling China: Foreign Direct InvestmentDuring the Reform Era (New York: Cambridge UniversityPress, 2003).

5. Geeta Batra and Daniel Kaufmann, et. al., Investment climatearound the world: Voices of firms from the World BusinessEnvironment Survey (Washington, DC:World Bank, 2003).

6. If nothing else, in this research project I hope to gain adeeper understanding of the 1980s rather than simplyassuming that the business environment improved linearlyand across-the-board in the 1990s.

7. For more details, see Yasheng Huang and David Lane,Kelon: China’s Corporate Dragon (Boston: Harvard BusinessSchool, 2002).

32


What is the role of China’s financial systemin supporting the growth of its economy,and how will it develop in the future?

Almost every functioning financial system includesfinancial markets and intermediaries (e.g., a bankingsector), but how these two sectors contribute to theentire financial system and economy differs signifi-cantly across countries.Although there is no consen-sus regarding the prospects of China’s future econom-ic growth, a prevailing view on China’s financial sys-tem speculates that it is one of the weak links in theeconomy,and it will hamper future economic growth.

Based on our analysis, including the comparisonbetween China’s financial system and that of othercountries, we draw three main conclusions aboutChina’s financial system and its future development.First, the continuing effort of reforming the bankingsystem, in particular, reducing the amount of non-performing loans (NPLs) of the major banks to nor-mal levels, is probably the most important task forChina’s financial system in the near future. Second,financial market development needs to be promoted.Regulation should be improved, domestic financialintermediaries that act as institutional investorsshould be encouraged, new products and servicesshould be developed, and more financial profession-als such as accountants and lawyers should betrained.The large holdings of shares held by variousgovernment entities in listed companies should bereduced by announcing and carrying out a plan tosell them off slowly over time.

Third, in a companion paper, we find that themost successful part of the financial system, in termsof supporting the growth of the overall economy, isnot the banking sector or stock markets, but ratherother mechanisms including internal finance, non-bank financial intermediaries and coalitions of vari-ous forms among firms, investors, and local govern-ments.1 Many of these channels rely on alternativegovernance mechanisms, such as trust, reputationand relationships and on competition.These meth-

ods of financing have supported the growth of a“Hybrid Sector” of firms with various types ofownership structures.2 The growth of the HybridSector has been much higher than that of the StateSector (state-owned firms including all firms wherethe government has ultimate control) and the ListedSector” (publicly listed and traded firms), and con-tributes most of the growth of the economy. Goingforward, we believe these alternative channels andmechanisms should be encouraged. They can co-exist with the banks and markets and can continueto fuel the growth of the Hybrid Sector.The rest ofthe article expands on these themes.

HISTORY AND CURRENT STATUS OF

CHINA’S FINANCIAL SYSTEM

Prior to 1978, China’s financial system consisted of asingle bank — the government owned and controlledPeople’s Bank of China (PBOC), which served asboth the central bank and a commercial bank, con-trolling about 93 percent of the total financial assetsof the country and handling almost all financial trans-actions.The first main structural change occurred in1978, when the single bank was split into four state-owned banks: the PBOC was formerly established asChina’s central bank, the Bank of China (BOC) wasgiven the mandate to specialize in transactions relat-ed to foreign trade and investment, the People’sConstruction Bank of China (PCBC) was set up tohandle transactions related to fixed investment (inmanufacturing), and the Agriculture Bank of China(ABC) was set up to deal with all banking business inrural areas.The financial sector was further diversifiedin 1984. The fourth state-owned commercial bank,the Industrial and Commercial Bank of China(ICBC) was formed to take over all commercialtransactions of the PBOC.This period also witnessedthe entry of non-state owned banks, including for-eign financial institutions (branches and offices), intothe financial system.

33


Will China’s Financial System Stimulate orImpede the Growth of Its Economy?

FRANKLIN ALLEN, JUN QIAN, AND MEIJUN QIAN

Franklin Allen is the Nippon Life Professor of Finance and Economics of the Finance Department, University ofPennsylvania. Jun Qian is an assistant professor, and Meijun Qian is a Ph.D. candidate, both at the FinanceDepartment of Boston College.

China’s domestic stock exchanges, the ShanghaiStock Exchange (SHSE) and the Shenzhen StockExchange (SZSE), were established in 1990. Thesehave been growing very fast since then. However,the corporate bond market is virtually non-existent.

Financial sector reform has focused on state-owned banks since 1997, especially the problem ofNPLs. Finally, China’s entry into the World TradeOrganization (WTO) in 2001 marked the begin-ning of a new era, in which increasing foreign com-petition and the continuing growth of the non-statefinancial institutions are the defining characteristics.

In Table 1 we compare China’s financial system tothose in other countries using the standard classifica-tion system introduced to the law and finance litera-ture by Rafael La Porta, Florencio Lopez-de-Silanes,Andrei Shleifer and Robert Vishny (hereafter LLSV,1997, 1998), with some measures taken from AsliDemirgüç-Kunt and Ross Levine.3 The LLSV (1997,1998) sample includes 49 developed and developingcountries with four legal origins, but excludes China.It can be seen that China’s banking system is impor-tant in terms of size, with its ratio of total bank cred-it to gross domestic product or GDP (1.11) higherthan even the German-origin countries (with aweighted average of 0.99). However, when we con-sider bank credit issued (or loans made) to theHybrid Sector only, China’s ratio dropped sharply to0.24, suggesting that most of the bank credit is issuedto companies in the State and Listed Sectors.Moreover, China’s banking system is not efficient: Itsoverhead cost to total assets (0.12) is much higher

than the average of French-origin countries (0.05),the next highest group of countries.

In contrast to the banking sector, China’s stockmarkets are smaller than most of the other coun-tries, both in terms of market capitalization and thetotal value traded as a fraction of GDP. Notice that“total value traded” is a better measure than “mar-ket capitalization” to measure the actual size of themarket, because the latter includes non-tradableshares, while the former measures the fraction oftotal market capitalization traded in the markets, orthe “floating supply” of shares in the markets.

In summary, China’s financial system primarilyconsists of a large but inefficient banking sector whilestock markets are still quite small relative to GDP.

BANKING SYSTEM:THE PROBLEM

OF NPLS AND REFORMS

China’s banking sector is dominated by four largeand inefficient state-owned banks.The most glaringproblem for China’s banking sector is the amountof NPLs within the four largest state-owned banks.A large fraction of these bad loans resulted frompoor lending decisions made for state-ownedenterprises (SOEs), many of which were due topolitical or other non-economic reasons, and theseloans accumulated over the years without everbeing resolved.The additional problem is that dataavailability on NPLs is limited.This lack of disclo-sure of NPLs fuels speculation that the problemmust be severe. Many commentators believe that

34


Table 1. A Comparison of Financial Systems: Bank-based vs. Market-based Measures (Value-weighted approach)

English Origin*

0.62

0.04

0.31

0.58

French Origin*

0.55

0.05

0.07

0.18

German Origin*

0.99

0.02

0.37

0.55

Scandinavian Origin*

0.49

0.03

0.08

0.25

Sampleaverage

0.73

0.03

0.27

0.47

China

1.11

(0.24)a

0.12

0.11

0.32

Measures

Bank credit/GDP

Overhead Cost/Bank Total Assets

Total value traded/GDP

Market Cap/GDP

Notes:All the measures for countries other than China are from Asli Demirgüç-Kunt and Ross Levine, Financial Structure and EconomicGrowth: Cross-Country Comparisons of Banks, Markets, and Development (Cambridge, Massachusetts: MIT Press, 2002). Measures on China areauthors’ own calculations using definitions from the same book.*:The numerical results for countries of each legal origin group are calculated based on a value (GDP of each country)-weighted approach.a: Numbers in bracket indicate bank credit issued to only the Hybrid Sector (instead of total bank credit).Source: Almanac of China’s Finance and Banking (Editorial Bureau of Almanac of China’s Finance and Banking, 2000); China Statistical Yearbook(China Statistics Press, 2000).

the true amount of NPLs is much higher than theofficially announced figures suggest.

Table 2, based on the Asian Banker database onbanks, compares the announced NPLs and prof-itability of the entire banking system (not just state-owned banks) in China and other major Asianeconomies. NPLs, either as a fraction of total newloans made by all banks or as a fraction of GDP in agiven year, are the highest in China from 2000–2002(Panel A).The comparison includes the period dur-ing which Asian countries recovered from the 1997financial crisis, and the period during which theJapanese banking system was disturbed by a pro-longed bad loan problem. In addition, the profitabil-ity of China’s banking system, measured by thereturn to equity or assets, is also among the lowestin the same group of countries (Panel B).

In recent years, the Chinese government hastaken active measures to solve this problem. First,four state-owned asset management companies wereformed with the goal of assuming these NPLs andliquidating them. Second, state-owned banks have

improved their loan structure by increasing loansmade to individual lenders while being more activein risk management and monitoring of loans madeto SOEs.Third, there has been a boom in the entryand growth of non-state financial intermediarieswithin the banking system, and this trend is expect-ed to continue with more foreign banks enteringthe domestic credit markets in the near future as aresult of China’s entrance into the WTO. All theabove facts taken together can explain why NPLshave been falling during the period of 2000–2002(Panel A of Table 2). However, due to the lack oftransparency on the disclosure of bank statements,the improvement shown here could be significantlyoverstated, and thus should be viewed cautiously.

As stated above, we believe that the continuingeffort of reforming and improving the banking sys-tem is one of the most important tasks for China inthe near future. In fact, China’s central bank hasinjected foreign currency reserves into 2 of the big4 state-owned banks to improve their balancesheets, so that these banks can go public. Given that

35


Table 2. A Comparison of Non-performing Loans and Profitability of Banking Systems

1997

n/a

1.3

n/a

0.3

2.7

2.9

2.4

6.6

18.7

17.0

-3.8

-18.6

-12.5

11.2

(3)

(0.2)

(5.4)

(5.1)

(3.2)

(0.21)

(1.8)

(0.9)

(-0.3)

(-0.6)

(-0.6)

(0.9)

1998

2.0

4.3

7.8

11.8

5.1

4.8

3.0

4.0

11.0

9.7

n/a

-19.2

-80.4

9.5

(2.2)

(10.2)

(1.6)

(4.6)

(10.8)

(6.3)

(3.9)

(0.2)

(1.0)

(0.5)

(-0.7)

(-3.0)

(0.8)

1999

9.5

6.3

7.0

8.1

5.3

12.9

4.0

3.2

18.2

14.2

n/a

2.7

-34.0

6.9

(10.6)

(13.9)

(1.6)

(2.0)

(10.9)

(12.9)

(5.7)

(0.18)

(1.6)

(0.7)

(0.1)

(-1.5)

(0.6)

2000

18.9

5.2

6.6

13.6

5.8

8.0

5.2

3.9

18.8

10.9

15.9

-0.7

-7.0

5.1

(24.9)

(12.6)

(1.6)

(3.2)

(11.5)

(8.6)

(7.6)

(0.21)

(1.6)

(0.5)

(0.3)

(0)

(-0.3)

(0.4)

2001

16.9

4.9

4.6

9.9

9.2

3.4

6.2

3.5

15.7

19.2

9.7

-10.4

15.8

4.0

(22.7)

(12.9)

(1.7)

(2.2)

(15.3)

(3.4)

(9.4)

(0.21)

(1.4)

(0.9)

(0.6)

(-0.5)

(0.7)

(0.3)

2002

12.6

3.7

2.2

4.5

7.4

2.5

4.1

4.16

15.6

19.6

21.1

-14.5

13.1

-5.2

(15.2)

(9.6)

(0.8)

(0.9)

(12.8)

(2.6)

(5.2)

(0.21)

(1.4)

(1)

(1.4)

(-0.6)

(0.6)

(-0.4)

China

Hong Kong

India

Indonesia

Japan

South Korea

Taiwan

China

Hong Kong

India

Indonesia

Japan

South Korea

Taiwan

Notes: NPL is measured as % of total loans made, and as % of GDP (numbers in brackets). Both the loan and NPL are the aggregate of allbanks in a country.The profitability is measure as the return on average Equity (ROAE), and the return on average Assets (ROAA).The latteris presented in the brackets.Source:The Asian Banker data center 2003, http://www.theasianbanker.com.

Panel A Non-performing Loans (% of total loans made and % of GDP)

Panel B Banking System Profitability (% return on equity and % return on assets)

China’s total foreign exchange reserve at the end of2004 was US$610 billion while the total amount ofNPLs as of the end of 2002 was 15 percent of GDP(Panel A of Table 2), or US$188 billion (using theUS$1 = 8.28 RMB exchange rate), the foreignreserve itself should be more than enough to removethe NPLs off the books of all the banks in China.

Whether the government will do exactly thisremains to be seen, but it is clear that the ultimatesource of solving the problems of NPLs lies in over-all economic growth.As long as the economy main-tains its strong growth momentum so that the gov-ernment’s potential for raising taxes also increases,the government can always assume the remainder ofthe NPLs without significantly affecting the econo-my. This is the positive perspective. The negativeperspective is that NPLs may be much bigger thanthe official statistics suggest. If the growth of theeconomy significantly slows down in the nearfuture, while the accumulation of NPLs continues,the banking sector problems could lead to a finan-cial crisis.This could spill over into other sectors ofthe economy and cause a slowdown in growth or a

recession. In this view the NPL problem poses aserious problem to China’s continued prosperity.

FINANCIAL MARKETS AND LISTED FIRMS:GROWTH AND IRREGULARITIES

China’s domestic stock exchanges, the SHSE andSZSE, have been growing very fast since their estab-lishment in 1990.At the end of 2002, the combinedtotal market capitalization, including non-tradableshares, of these two exchanges ranked 11th amongthe largest stock exchanges in the world (Table 3).The Hong Kong Stock Exchange (HKSE hereafter)ranked 10th. If we rank the combined size of allstock exchanges in a country, China would rankfifth, behind only the United States, Japan, theUnited Kingdom, and France.

As fast as the growth of China’s stock markets hasbeen, they are not efficient in that prices, andinvestors’ behavior do not reflect fundamental valuesof listed firms. In Table 3, “Concentration” measuresthe fraction of total market capitalization of anexchange that is coming from the combined capital-

36


Table 3. A Comparison of the Largest Stock Markets in the World (2002)

Stock Market

NYSE

Tokyo

Nasdaq

London

Euronext

Deutsche Börse

Toronto

Swiss

Italian

China (Hong Kong)

China (Domestic)

Total Market Cap (US$ billion)

9,015

2,095

1,994

1,800

1,538

686

570

547

477

463

463

Concentration (%)

61.3

60.6

63.1

84.5

72.3

72.0

67.8

81.2

66.1

83.0

29.4

Turnover Velocity (%)

294.8

267.9

159.8*

297.3

153.6

125.1

267.9

138.6

120.7

239.7

224.2

Rank

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

Notes:1.All figures (except those relating to China's domestic exchanges) are from http//:www.fibv.com, the web site of the international organizationof stock exchanges.The Chinese data is from http://www.csrc.gov.cn, the web site for the China Security Regulation Committee (CSRC).2.All figures relate to the period of 01/01/2002 to 12/31/2002.3. Concentration measures the fraction of total market capitalization of an exchange that is coming from the combined capitalization of thelargest firms ranked in the top 5 percent (by capitalization).4. Turnover velocity is the total turnover for the year expressed as a percentage of the total market capitalization.5. (*) The published number for Nasdaq includes double counting.The number shown is half the published number to make it comparable tothe figures for the other exchanges.

ization of the largest firms ranked in the top 5 percent(by capitalization).The dominance of large-cap stocksin China is the lowest among major stock exchangesin the world, with its concentration ratio of 29.4 per-cent less than half of that of Tokyo, which has the sec-ond-lowest concentration. Stocks are traded extreme-ly frequently in China, as shown by the highest“Turnover Velocity,” defined as the total turnover forthe year expressed as a percentage of total market cap-italization, among the largest exchanges.

The inefficiencies in the Chinese stock marketscan be partly attributed to poor and ineffective reg-ulation. The current process of listing companiesfosters both a problem of adverse selection amongfirms seeking an initial public offering (IPO), and amoral hazard problem among listed firms. First, thegoing public process, including obtaining listingquota/permission and disclosing information, isinefficient due to bureaucracy, fraudulent disclosure,and lack of independent auditing.As a result, certainnon-state-owned firms from the Hybrid Sectorwith solid growth potential find it costly to gainaccess to the stock market, while the same process ofgoing public is relatively easier for some large andinefficient companies from the State Sector.4

Second, once listed, managers in firms with severeagency problems do not have an incentive to man-age assets to grow, but rather to rely on the externalcapital market to raise funds (mainly through merg-ers and acquisitions, and seasoned offerings of secu-rities) to pursue private benefits. If China is todevelop a vibrant high-tech sector with fast growingcompanies, it would be helpful if such firms couldhave easy access to the public markets.

Another way to improve the efficiency of China’sstock markets is to encourage the further develop-ment of domestic financial intermediaries that canact as institutional investors. Insurance companies,pension funds, mutual funds, and hedge funds,which are currently relatively small compared tothose in Europe, Japan, and the U.S., can provide alevel of stability and professionalism that is lacking inChina’s markets.

In terms of the role of financial markets in helpingfirms raise funds, both the scale and relative impor-tance (compared with other channels of financing) ofChina’s external markets are not significant. Forexample, for the ratio of External Capital (i.e., fund-ing external to the firm) and gross national product(GNP), the LLSV (1997) sample average is 40 per-

cent, compared to China’s 16 percent (using only thefloating supply or value traded part of the stock mar-ket, rather than the total market capitalization); for theratio of total debt (including bank loans and bonds)over GNP, the LLSV sample average is 59 percent,compared to China’s 35 percent.When we relate andcompare the aggregate financing channels with thegrowth of the economy during different growth peri-ods, we find that the development of China’s marketsas sources of funding external to the firm relative toits overall economic growth is not dramatically dif-ferent from other emerging countries. One of thecommon patterns emerging from these comparisonsis that the development of external markets trails thatof the growth of the overall economy.This is not sur-prising given that the development of these marketsrequires a minimum efficiency for a country’s institu-tions including the legal system, accounting standards,and the development of associated professionals. Bycontrast, during the early stages of economic growth,alternative institutions and mechanisms alone cansupport the growth of firms and the overall economy,as is the case for China based on our evidence.

Firms in the Listed Sector in China issue bothtradable and nontradable shares. The nontradableshares are either held by the state/government or byother legal entities, (i.e., other listed or non-listedfirms or organizations), and constitute a majority ofall shares.The standard corporate governance mech-anisms are limited and weak in the Listed Sector.Listed firms have a two-tier board structure: theBoard of Directors and the Board of Supervisors.Rather than being elected by shareholders, a signif-icant fraction of both boards are officials chosenfrom government branches, or executives from theparent companies, and the nomination process isusually kept secret.The external governance mech-anisms are also weak. First, the existing ownershipstructure, characterized by the large amount of non-tradable shares including cross-holdings of sharesamong listed companies and institutions, makes itdifficult to carry out value-increasing mergers andacquisitions (M&As).5 Second, institutional investorsdo not have a strong influence on management oron the stock market, as they are a very recent addi-tion to the set of financial institutions in China.Third, ineffective bankruptcy implementationmakes the threat and penalty for bad firm perform-ance non-credible. Fourth, the government plays thedual roles of regulator and blockholder for many

37


listed firms, including banks and financial servicescompanies, which can lead to conflicting goals indealing with listed firms and weakens the effective-ness of both of its roles. Finally, based on a large sam-ple of listed firms, we find that on average Chinesefirms have concentrated ownership (among the stateand founder’s families), tend to under-pay dividendsto their shareholders, and have lower Tobin’s Q,compared to firms in countries studied by LLSV.

One of the major problems Chinese stock mar-kets face is caused by the large amount of shares inlisted companies owned by the government andgovernment entities. This overhang creates greatuncertainty about the quantity of shares that will betradable going forward. Investors fear that if pricesgo up then the government will sell their holdingsand this will prevent further price rises or evendepress them. This uncertainty has caused shareprices to stagnate despite the very high levels ofgrowth in the economy. In order to remove thisuncertainty the government should announce a planfor selling these shares slowly over time. Each year asmall amount would be sold so that the market

could easily absorb the shares. Such a plan mighttake several decades to complete. Once announcedthe plan should be carried out without any devia-tion irrespective of the prevailing circumstances.

In summary, the overall evidence on the compar-ison of China and other countries’ external marketsis consistent with LLSV (1997, 1998) predictions:With an underdeveloped legal system and weakinvestor (both shareholder and creditor) protection,the fact that China has small external markets comesas no surprise. Figure 1 compares China’s legal sys-tem and external financial markets to those of LLSVcountries. The horizontal axis measures overallinvestor protection in each country, while the verti-cal axis measures the (relative) size and efficiency ofthat country’s markets for funds external to the firm.Countries with English common-law systems(French civil-law systems) lie in the top-right region(bottom-left region) of the graph, while China isplaced close to the bottom-left corner of the graph.

Finally, going forward, in addition to improvingthe regulatory environment surrounding listed firmsand the stock market, China should develop finan-

38


Figure 1 compares China’s legal system and external financial markets (i.e., those for raising funds from outside the firm) to those of LLSV countries(LLSV, 1997, 1998). Following LLSV (1997, 1998), the score on the horizontal axis measures overall investor protection in a country. It is the sum of(overall) creditor rights, shareholder rights, rule of law, and government corruption.The vertical axis measures the (relative) size and efficiency of thatcountry’s external markets.The score of a country measures the distance of the country’s overall external markets score (external cap/GNP, domesticfirms/Pop, IPOs/Pop, Debt/GNP, and Log GNP) to the mean of all countries, with a positive (negative) figure indicating that this country’s overallscore is higher (lower) than the mean.

Figure 1. Comparison of Legal and Financial Systems

8

6

4

2

0

-2

-4

10 12 14 16 18 20 22 24 26

HK (E) Singapore (E)

Malaysia (E) UK (E)

US (E)

South Africa (E)Japan (G)

Taiwan (G)Thailand (E)France (F) German (G)South Korea (G)

Pakistan (E)

India (E)

Brazil (F)Argentina (F)

Indonesia (F)Mexico (F)China

Ext

ern

al M

arke

t

Investor Protection

cial markets that are diversified and more balanced.This includes the further development of the bondmarket (including both government and corporatebond markets), the venture capital market so as tosupport the growth of high tech firms, and the realestate market. Moreover, more financial productssuch as derivative securities should be introduced tothe market so that investors can form more balancedportfolios in addition to stocks.

ALTERNATIVE FORMS OF FINANCING

The weaknesses of the banking sector and limitedsize of the stock markets raise the question of howChina’s phenomenal growth over the last twodecades has been financed. Our view is that alterna-tive channels of finance allow firms in the HybridSector to raise funds and to grow from start-ups tosuccessful industry leaders. We also examine thealternative governance mechanisms employed byinvestors and firms that can substitute for China’sweak formal corporate governance mechanisms.

A Comparison of the Hybrid Sector vs.the State and Listed Sectors In terms of the growth of industrial output producedin the three sectors from 1996 to 2002, the HybridSector grew at an annual rate of 14.3 percent, whilethe State and Listed Sectors combined grew at only5.4 percent annually during the same period. Inaddition, the growth rate for investment in fixedassets of the Hybrid Sector is comparable to that ofState and Listed Sectors combined, which impliesthat the Hybrid Sector is actually more productivethan the State and Listed Sectors. Finally, there hasbeen a fundamental change among the State, Listed,and Hybrid Sectors in terms of their contribution tothe entire economy: the State Sector contributed 76percent of China’s total industrial output in 1980,but in 1996 it only contributed 28.5 percent; in 1980individually/privately owned firms, a type of HybridSector firms, were negligible, but in 1996 they con-tributed 15.5 percent of total industrial output.

The Hybrid Sector is a much more importantsource for employment opportunities than the othertwo sectors. Over the period from 1995 to 2002, theHybrid Sector employed an average of over 70 per-cent of all non-agricultural workers, while theTownship Village Enterprises (TVEs, a type of HybridSector firm) are by far the most important employer

for workers from the rural areas. Moreover, the num-ber of employees working in the Hybrid Sector hasbeen growing at 1.5 percent over this seven-yearperiod, while the labor force in the State and ListedSectors has been shrinking.These patterns are partic-ularly important for China, given its vast populationand potential problem of unemployment.

Discussion on How Alternative Financing Channels WorkThere are two important aspects to alternativefinancing channels in the Hybrid Sector.The first isthe way in which investment is financed.The secondis corporate governance.We consider each in turn.

Once a firm is established and doing well, inter-nal finance can provide the funds necessary forgrowth. We found earlier that about 60 percent ofthe funds raised by the Hybrid Sector are generatedinternally. Of course, internal finance is fine once afirm is established but this raises the issue of howfirms in the Hybrid Sector acquire their “seed” cap-ital, perhaps the most crucial financing during afirm’s life cycle.We have presented evidence on theimportance of alternative and informal channels,including funds from family and friends.There is alsoevidence that financing through illegal channels,such as smuggling, bribery, and other undergroundor unofficial businesses also play an important role inthe accumulation of seed capital.Though a contro-versial issue for the government, our view, based onsimilar episodes in the history of other developingcountries, is that as long as the purpose of moneymaking is to invest in a legitimate company, it maybe more productive for the government to provideincentives for investment rather than to expend costsdiscovering and punishing these activities.

Perhaps the most important mechanism for cor-porate governance within the non-standard financialsector that supports the growth of the Hybrid Sectoris trust, reputation and relationships.6 According tothe World Values Survey conducted in the early1990s, China has one of the highest levels of socialtrust among a group of 40 developed and developingcountries. Without a dominant religion, one canargue that an important force in shaping China’ssocial values and institutions is the set of beliefs firstdeveloped and formalized by Kong Zi (Confucius).This set of beliefs clearly defines family and socialorders, which are very different from the westernbeliefs on how legal codes should be formulated.

39


The second important mechanism is competitionin product and input markets, which has workedwell in both developed and developing countries.7

What we see from the success and life cycles ofhybrid sector firms, such as those in Wenzhou ofZhejiang province, is only those firms that have thestrongest comparative advantage in an industry (ofthe area) that survived and thrived. Based on surveyevidence, we also find that entrepreneurs utilize var-ious methods to remove entry barriers during theirstartup period, which, in turn, leads to more com-petition in the industries.

SUMMARY AND CONCLUDING REMARKS

We began this article by asking whether China’sfinancial system will stimulate or hamper its eco-nomic growth. Our answer to this question, basedon examining the history and current status of thefinancial system and comparing them to those ofother countries, is in three parts. First, the large butinefficient banking sector has been the dominantforce in the financial system, and has played a cen-tral role in funding the growth of all types of firms.However, it is currently plagued by the problem ofNPLs, which, if not corrected properly, may causemajor economic difficulties. Second, the stock mar-ket has been growing very fast since 1990, but hasplayed a limited role in supporting the growth of theeconomy. However, the role of the financial marketsis likely to change in the near future and they willplay an increasingly important role in the economy.Third, while the banking sector and financial mar-kets have done enough not to slow down the growthof the economy, the alternative financing channelshave had great success in supporting the growth ofthe Hybrid Sector, which contributes most of theeconomic growth as compared to the State andListed Sectors. The non-standard financial sectorrelies on alternative financing channels includinginternal finance, and on alternative governancemechanisms, such as those based on trust, reputationand relationships, and competition to support thegrowth of the Hybrid Sector. Going forward, webelieve that these alternative financing channels andgovernance mechanisms should be encouragedrather than replaced.They should be allowed to co-exist with the banks and markets and continue tofuel the growth of the Hybrid Sector.

We conclude by pointing out the most significantchallenge for improving China’s financial system:Economic stability is crucial for the continuingdevelopment of the Chinese economy, and the sta-bility of the financial system relates to economic sta-bility in three dimensions.The continuing effort toreduce and eventually bring down NPLs to normallevels is important in avoiding a banking crisis, whilethe effort to improve the regulatory environmentsurrounding the financial markets (including gover-nance and accounting standards) can certainly helpprevent a stock market crash/crisis.The entrance ofChina to the WTO introduces cheap foreign capitaland technology, but free capital inflow and foreigncompetition and speculation also bring the risk of atwin crisis (foreign exchange and banking/stockmarket crisis), which severely damaged emergingeconomies in Asia in 1997. In order to prevent sucha crisis, policies toward improving the financial sys-tem must be made along with supportive fiscal andtrade policies.

ACKNOWLEDGEMENT

We appreciate comments from Loren Brandt, NickLardy, Tom Rawski, and participants of “China’sEconomic Transition: Origins, Mechanism, andConsequences” project.The authors are responsiblefor all remaining errors. Financial support fromBoston College, the Smith Richardson Foundation,and Wharton Financial Institutions Center is grate-fully acknowledged.

ENDNOTES

1. Franklin Allen, Jun Qian and Meijun Qian,“Law, finance,and economic growth in China,” Journal of FinancialEconomics 77 (2005), 57–116.

2.The Hybrid Sector includes 1) privately owned companies(but not publicly listed and traded) where controlling own-ers can be Chinese citizens, investors (or companies) fromTaiwan or Hong Kong, or foreign investors or companies;and 2) collectively—and jointly—owned companies,where joint ownership among local government, commu-nities, and institutions is forged.

3. See Rafael La Porta, Florencio Lopez-de-Silanes, AndreiShleifer and Robert Vishny,“Legal determinants of exter-nal finance,” Journal of Finance 52 (1997), 1131–1150; and“Law and finance,” Journal of Political Economy 106 (1998),1113–55. See also Asli Demirgüç-Kunt and Ross Levine,Financial Structure and Economic Growth: Cross-CountryComparisons of Banks, Markets, and Development(Cambridge, Massachusetts: MIT Press, 2002).

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4.While few privately owned firms from the Hybrid Sectordo become listed and publicly traded, we find that morethan 80 percent of listed companies from their sample(more than 1,100 companies) are converted from SOEs.See Franklin Allen, Jun Qian and Meijun Qian, “Law,finance, and economic growth in China,” Journal ofFinancial Economics 77 (2005), 57–116.

5.According to the China Mergers and Acquisitions Yearbook(Posts & Telecom Press, Beijing, China, 2004), there were925 M&A’s involving listed firms in 2003 totalingUS$9.35 billion, which is about 1.8 percent of the totalmarket capitalization. In many deals, a Hybrid Sector firm(non-listed) acquires a listed firm that is converted from anSOE, but the large amount of non-tradable shares held bythe state remain intact after the transaction.

6. See Avner Greif, “Reputation and Coalitions in MedievalTrade: Evidence on the Maghribi Traders,” Journal of

Economic History 49 (1989), 857–882; and “ContractEnforceability and Economic Institutions in Early Trade:The Maghribi Traders’ Coalition,” American EconomicReview 83 (1993), 525–548.

7. For example, see John McMillan,“China’s NonconformistReform,” Economic Transition in Eastern Europe and Russia:Realities of Reform, ed. Edward Lazear (Stanford: HooverInstitution Press, 1995), 419–433; John McMillan,“Markets in Transition,” in Advances in Economics andEconometrics Vol. 2, ed. David Kreps and Kenneth Wallis(Cambridge: Cambridge University Press, 1997), 210–239;Franklin Allen and Douglas Gale, Comparing FinancialSystems (Cambridge: MIT Press, 2000), and “Corporategovernance and competition,” in Corporate Governance:Theoretical and Empirical Perspectives, eds., Xavier Vives(London: Cambridge University Press, 2000), 23–94. 41


The most outstanding feature of post-MaoChina is unquestionably its economicgrowth. This growth poses a challenge for

any theory that posits a formal legal system guaran-teeing secure rights of property and contract as a pre-condition for significant growth, because at least onthe surface China does not appear to have such a legalsystem. However, the Chinese experience may showsupport for a theory that development induces law.

This essay examines the relationship between law,institutions, and property rights in China. It showson the one hand that Chinese legal institutions areunquestionably weak, such that it is hard to imaginethem playing a major role in inducing economicgrowth.At the same time, however, it finds that eco-nomic actors use legal institutions such as courts toa perhaps surprising degree. It also finds that legalinstitutions, while generally weak, are stronger thanthey were in pre-reform China.

It concludes that while the Chinese experiencecasts considerable doubt on the thesis that a formallegal system guaranteeing rights of property andcontract is necessary for substantial growth, theChinese legal system does appear to have some roleto play in the country’s economic life and is notsimply ignored by economic actors.

THE RIGHTS HYPOTHESIS

Economic growth requires that economic agentsbelieve that the politico-socio-economic equilibriumis such that they can expect a reasonable return fromtheir investments in property and that they can rea-sonably expect that agreements made with other eco-nomic agents will be fulfilled. Therefore, in under-standing the determinants of a country’s growth per-formance, a central question is which mechanisms fos-tered the appropriate expectations among propertyowners and those making agreements.

The emphasis in the recent economics literature,echoed in the pronouncements of the World Bank

and similar organizations, is on formal institutions orthe rule of law as crucial in fostering the appropri-ate expectations among property owners and amongthose undertaking transactions.1

The emphasis on the rule of law follows animportant school of thought in institutional eco-nomics dating back to Max Weber (which we shallhere call the Rights Hypothesis). This holds thateconomic growth requires a legal order offering sta-ble and predictable rights of property and contract.A typical formulation can be found in the work ofDouglass C. North, who asserts that “impersonalexchange with third-party enforcement . . . [via aneffective judicial system] has been the crucial under-pinning of successful modern economies involved inthe complex contracting necessary for modern eco-nomic growth”2 and that “the inability of societiesto develop effective, lowcost enforcement of con-tracts is the most important source of both histori-cal stagnation and contemporary underdevelopmentin the Third World.”3

THE CHINESE LEGAL SYSTEM

Economic reform in China was marked from thebeginning by a recognition that law had a new andimportant role to play.4 Yet this role was not at firstthe role contemplated by those who would stress theimportance of formal institutions in the process ofeconomic development, which is essentially a claimabout how healthy private economic activity is fos-tered. Early Chinese reform policy did not contem-plate a major role for the private sector in econom-ic life—it was essentially about running the statesector better—and therefore was not concernedwith what might encourage entrepreneurship. Therole for the legal system in the early reform era wasone of bringing order and stability to political andsocial life after the chaos of the Cultural Revolution.In particular, a key ambition of those promoting legalreform was to bring regularity to operations of gov-

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Law, Institutions, and Property Rights in China

DONALD CLARKE, PETER MURRELL, AND SUSAN WHITING

Donald Clarke is a professor at the George Washington University Law School. Peter Murrell is a professor in theDepartment of Economics, University of Maryland. Susan Whiting is an associate professor in the Department ofPolitical Science, University of Washington.

ernment and the policy-making process as a cure forexcessive devolution of power from the center andthe resultant policy inconsistencies and outright con-tradictions.5 While predictability was praised as avirtue in law, such discourse was largely confined tothe realm of substantive criminal law and not linkedto economic growth.

In the economic realm, law was intended to be amechanism for regulating the operation of state-owned enterprises that would replace the particularis-tic bargaining regime of the past—a regime associat-ed with soft budget constraints and wastefulness—with a regime of strict, impersonal, and universalisticrules that would impose discipline on enterprise man-agers and force them to operate more efficiently. Aprime example of this type of mechanism is theBankruptcy Law, passed in 1986. According to con-temporary commentary, “the threat of bankruptcyurges all enterprises and people on and will turn mud-dleheaded people into shrewd ones and lazy peopleinto diligent ones.”6 The important point to note isthat prior to the Bankruptcy Law, the state already hadthe power to close down loss-making enterprises inthe same way that General Motors has the power toshut down an inefficient factory.Thus, the BankruptcyLaw and other similar enactments were as muchefforts by the state to effect policy in a new way asthey were new policies in and of themselves.

Only more recently have policymakers begun tothink about the legal system as a guarantor of expec-tations of non-governmental actors, and thus as apromoter of entrepreneurship and investment. YetChina’s current system has a number of problemsthat make the achievement of this goal difficult.Prominent among these is the bewildering array ofbodies that have the right or the practical power tomake rules of varying degrees of binding effect, cou-pled with the absence of an effective system forresolving conflicts.

The Constitution and relevant statutes assign statuslevels to different types of rules, and make clear thatrules of lower status must yield before rules of higherstatus.The problem is that there is no effective systemeither for enforcing jurisdictional and subject-matterlimitations on any particular body’s lawmaking poweror for resolving the conflicts that must invariably arise.Various bodies such as the National People’s Congress(NPC), its Standing Committee, and the StateCouncil may review and invalidate legislation passedby lower-level bodies. To date, however, the NPC

Standing Committee is not known to have over-turned a single administrative or local regulation.7

To be sure, conflicting rules and over-ambitiousclaims of jurisdiction do not come self-labeled andunambiguous, and it is difficult to expect any institu-tion to find such problems in the abstract. Yet theinstitution that would appear ideally suited to look atsuch claims in concrete situations, the court system, isequally unsuited for the task. Although higher-levelrules are in theory superior to conflicting lower-levelones, courts are prohibited from invalidating legisla-tion. This prohibition, operating together with theprinciple of local control over court personnel andfinances, means that in practice courts must generallyuphold the conflicting lower-level rule, at least whenit issues from the level of government that controlsthe court in question. This principle works againstunity within the legal system.

Moreover, despite the stunning increase in thesheer volume of legislation, much less has changed inthe institutional structure for implementing NPC leg-islation.This is not to say that such legislation cannotbe implemented (although that is sometimes true); itis to say that the legal system as a mechanism forimplementing legislation has changed relatively little.

Courts, for example, are recognizably the sameinstitution they were at the outset of reform. Both atthe outset of the reform era and now, court personnelare appointed locally, such appointments being as apractical matter within the jurisdiction of the localParty organization department.Then as now they aresubject to local financial control.The general level oflegal training of judges remains low, although it is sig-nificantly higher than before in large cities.

Courts remain not a source of overarching author-ity, but simply one bureaucracy among many.Whenthe Supreme People’s Court issues an instruction tolower courts on matters such as enforcement of judg-ments where the cooperation of banks is needed, theinstruction must be co-signed by the People’s Bank ofChina in its capacity as regulator of the banking sys-tem if it is to have any hope of being effective.Courtshave their own particular sphere of competence andjurisdiction, but it cannot be assumed that any partic-ular law contemplates court involvement in case ofviolation, or that court involvement would be effec-tive even if contemplated.

Indeed, Chinese legislation is often remarkable forits lack of institutional anchoring. Like the policydocuments it has come largely to replace, it is often

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evidently intended more for edification than for liti-gation, and continues, a quarter of a century into thereform era, to contain broad statements of policy andlegally unenforceable norms.The July, 2004 draft ofthe revised Company Law, for example, providesmore duties for directors and officers than the currentCompany Law, enacted more than a decade earlier,but little more by way of remedies for shareholdersand others injured by a breach of those duties. So lit-tle consideration is given to institutional context thatthe entire section on fines and other state-imposedsanctions on companies for breaches of the law neg-lects (in both the original version and the draftrevised version) to specify which state organ has theauthority to impose such sanctions.

In short, reform-era China has seen a great manypolicy initiatives that are clearly different in contentfrom the pre-reform era, and many of those policyinitiatives have been embodied in legislation.Moreover, it seems clear that many of those policyinitiatives, from decontrol of pricing in large sectorsof the economy to the lowering of barriers to mar-ket entry, have contributed mightily to economicgrowth. But this is not the same thing as saying thatthe legal system as such has promoted this growth.That claim must be supported by an analysis of theinstitutions of the legal system, and more particular-ly by a showing that the policy changes expressed inlegislation were made meaningful through institu-tions that did not exist (at least in any importantway) before the reform era.

MAKING SENSE OF THE CONUNDRUM

The experience of China clearly poses a challengefor the Rights Hypothesis, with its emphasis on theimportance of a well-functioning legal system.There are, however, several possible solutions to theconundrum.

One is the unfalsifiable proposition that Chinawould have grown even faster with secure propertyrights. However interesting this conjecture, notmuch more can be said about it.

There are, however, other more tractablehypotheses. First, it could be that although courtsand other formal legal institutions do not effective-ly enforce rights, rights are enforced somewhere elsein the system through some other mechanism.Thereare many mechanisms for the vindication of claimsarising out of contractual relationships that do not

involve the court system—for example, social orbusiness networks. It is also possible that while cer-tain types of rights are not well protected, othertypes of rights are, and it is the latter that are impor-tant for economic growth.8

Consistent with this view is one line of reasoningthat has been particularly influential in economics:China’s reform has been characterized by a series ofarrangements that have been second-best substitutesfor the more formal institutions envisaged by theRights Hypothesis.9 Thus the dual-track pricing sys-tem meant that administrative methods of contactenforcement would be effective for a while in largespheres of the economy, giving enterprises andentrepreneurs time to develop newer methods ofcontract-enforcement that were consistent withmarket-based exchange. Stronger managerial incen-tives in state-owned enterprises can also be inter-preted as an institutional substitute, providing animpetus toward greater efficiency at a time whenprivate ownership with effective corporate gover-nance was not politically palatable. Similarly, effec-tively decentralizing property-rights to local gov-ernments and allowing anonymous bank accountscan be viewed as mechanisms for an overly power-ful central government to bind itself, when formallegal institutions cannot possibly play that role.

Second, it could be that the Rights Hypothesis issimply wrong: the system does not provide rightsbut significant growth occurs, and therefore there isnot an important connection between the two.BothChina and the Soviet Union managed considerablegrowth through planning.10 McMillan and Woodruffdocument a thriving private sector in Vietnam,although virtually none of the enterprise managersthey interviewed believed that courts were of anyvalue in dispute resolution.11

It could also be that growth does not strictlyspeaking require that the legal system provideenforceable rights that is, the actual ability, in certainspecial circumstances, to choose to invoke the coer-cive power of the state in support of one’s personalinterests. All that is needed is that the system oper-ate in a predictable manner. Therefore, the RightsHypothesis could be wrong in focusing so stronglyon the particular institution of rights provided bythe formal legal system.

Another approach to understanding the relation-ship between China’s data on growth and the RightsHypothesis is to disaggregate the general notion of

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“rights” into property rights and contract rights, andto hypothesize that the institutions that matter arenot so much those that enable private contractingbetween citizens as those that protect investorsagainst unpredictable or excessive expropriation bygovernment.We could call the former “contractinginstitutions” and the latter “property rights institu-tions” as a convenient shorthand. The key is thatthere is a difference between institutions that protectexpectations vis-à-vis private parties and those thatprotect expectations vis-à-vis government.

The basis for distinguishing these institutions is thefact that they differ in the availability of substitutesand in the amount of economic activity that dependson institutions for which there is no good substitute.There are many substitutes for formal legal institu-tions in the realm of contract: informal and socialsanctions, trusted middlemen, networks such asguilds, reputation (in a repeated-game context), andself-enforcement mechanisms such as hostage-taking.These mechanisms can all, it would seem, go far.

Effective property rights institutions as definedhere, however, have few if any substitutes. How canone protect one’s self informally from governmentseizures? Moreover, the absence of effective proper-ty rights institutions (whether formal or informalsubstitutes) makes difficult or impossible a muchlarger class of activity than the absence of effectiveformal contract institutions: any economicallyrational investment whose payoff is significantlydeferred into the future.

This intuition finds empirical support in a recentpaper by Acemoglu and Johnson, who unbundle“institutions” into institutions that support contractrights and institutions that support property rights, andfind proxies for each.12 Their ultimate finding is thatwhile contracting institutions do affect some thingssuch as the form of financial intermediation (debtcontracts, because easier to enforce, are used moreoften that equity contracts where contracting institu-tions are poor), it is property rights institutions thatmatter for investment and long-run economic growth.

The relevance of this work for the RightsHypothesis as applied to China is that it suggeststhat the various shortcomings of China’s legal insti-tutions insofar as they protect contract rights maynot matter very much, provided that the politicalstructure in a sufficient number of places provides areasonable degree of certainty to investors, bothpublic and private.

This kind of predictability does indeed appear toexist, at least in some places. Public investors includevarious departments of the central government aswell as local government. Such investors do notgenerally fear expropriation. First, local govern-ments in practice have fairly robust rights to theirassets against the central government.Although suchrights have no basis in China’s legal and constitu-tional system—China is unitary state, and local gov-ernments could no more maintain ownershipagainst the central state than the Chevrolet divisioncould maintain ownership against General Motors—they are generally respected in practice. Second,the individual officials who make investment deci-sions on behalf of state agencies are not in generalpersonally harmed by a decision of a superioragency to appropriate the benefits of the invest-ment. Consequently, even if they expect somedegree of appropriation, they still have an incentiveto make the investment if its success would result inpersonal benefits (for example, promotion).Third, asWhiting has shown, local governments can and doencourage or discourage growth through the pres-ence or absence of investment-protective policies.13

THE ROLE OF LEGAL INSTITUTIONS:DISPUTE RESOLUTION AMONG

BUSINESS FIRMS

A case study may demonstrate the complexity of thehistory of legal institutions in post-Mao China. It isnot a simple story of one-directional development,but neither is it one of stagnation. Contract law andcourt enforcement have been of significance amongbusinesses. This is surprising given the customarynotion of law as unimportant in this realm, whetherin traditional or modern China, and whether in theMao era or the post-Mao era.

Data drawn from a World Bank survey of 1500Chinese firms show that in the year 2000, 31.1 per-cent of firms had at least one “major dispute” withclients, while 21.9 percent of firms had at least onemajor dispute with suppliers.14 Once enterprisesencounter disputes, what mechanisms do they relyupon to resolve these disputes? This section exam-ines the dispute resolution mechanisms employedby Chinese firms and finds that the courts play amoderately important role in the strategies firmsemploy.The importance of the courts likely reflectsa number of factors, including the relative absence

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of alternative mechanisms. The following para-graphs address mediation, arbitration, litigation, andthe ability of to enforce judgments.

Negotiation and mediationNegotiation directly between the contracting par-ties is the norm for resolving contract disputes inChina. In a study of firms in Shanghai and Nanjingconducted by Whiting, 92.8 percent of firms typi-cally relied on direct negotiation to resolve dis-putes. In the World Bank survey, 87.1 percent offirms used negotiation in the final resolution of dis-putes with at least one client, while 93.2 percentused negotiation in the final resolution of disputeswith at least one supplier. The Shanghai andNanjing study differentiates direct negotiation andnegotiation employing a third party. In the lattercase, only 11.8 percent of firms typically turned toa third party.

Self-enforcement, in which two parties bargainto attain a long-term cooperative solution based onthe anticipated value of future contracts, is animportant mechanism in contractual relations withChinese firms. In the study of businesses inShanghai and Nanjing, 90.6 percent of firmsreported that in the event of a serious dispute, theirguanxi (here, the long-term reciprocal relationsgrounded in social ties) with a supplier or contrac-tor would be broken.

Furthermore, reputation also functions withinbusiness circles to help police contractual relations.In Shanghai and Nanjing, 74.2 percent of firms saidthat other businesses would know about it if a dis-pute arose between the firm and one of its suppli-ers. Economic (as opposed to strictly social) networks are important sources of information forboth the search for contractual partners and infor-mation on their business practices. This is particu-larly true in the absence of institutions such as cred-it evaluation services.

Arbitration The Arbitration Law went into effect only in 1995(before that year, similar functions were handled bythe Industrial and Commercial Bureau).The arbitra-tion commission in Nanjing, the capital of one ofthe wealthiest coastal provinces, was not even estab-lished until 1998. In the first five years followingpassage of the law, all domestic arbitration commis-sions accepted only 17,000 cases, involving RMB

25.7 billion.15 This compares with 1,329,020 strictlyeconomic contract disputes involving RMB 413billion handled by courts in 1998 alone.

In Whiting’s Nanjing/Shanghai survey, somerespondents had arbitration clauses in their con-tracts, but many fewer used them. These clausesapparently still allowed parties to choose to seekrelief in court. In the Shanghai part of the sample,most respondents (domestic firms) had little aware-ness or understanding of the potential role for arbi-tration and perceived it as less authoritative than thecourts despite the fact that they could apply forenforcement of arbitral decisions by the courts inthe same way that they could for court decisions.Comments such as “where is there an arbitrationcommission” were common.

LitigationBetween 1983 and 2001, economic disputes, broad-ly defined, accepted by courts of first instance (asopposed to courts hearing appeals) increased at anaverage annual rate of 18.8 percent, peaking in1999.16 Put in wider domestic context, civil disputesincreased at less than half that rate on average—8.3percent per year—while criminal cases grew at only4.7 percent per year over the same period.While itis difficult to specify a meaningful metric for evalu-ating the pace of growth, the courts appear to play asignificant role during the reform period.

Contract dispute litigation in particular, whichaccounts for the lion’s share (more than 90 percent)of all economic dispute cases accepted by the courts,increased at an average annual rate of 20.1 percentbetween 1983 and 2001. Data on the average valueof disputes is available only through 1998. From1983 to 1998, the total value of disputes grew 40.9percent per year on average, while the average valueof disputes grew at 11.9 percent per year on average.In 1998, the average value of a contract disputeheard in the courts nationwide was 310,167 RMB.The average value of arbitrated cases was much larg-er, but the number of disputes heard by arbitrationcommissions was minuscule in comparison.17 InChina, as elsewhere, litigation of contract disputes israrely the first resort.18 Nevertheless, in a WorldBank survey of 1500 firms in the year 2000, 38.8percent of firms used litigation in the final resolu-tion of disputes with at least one client, while 29.8percent used litigation in the final resolution of dis-putes with at least one supplier.

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CONCLUSION

Courts play an interesting role in the Chinese polit-ical economy in transition; they are seen as authori-tative (despite problems with enforcement) but notnecessarily fair. According to one private businessowner interviewed in Nanjing, “Going to court isnot because it’s fair but rather because it’s authorita-tive.” Strikingly, an intermediate court judge echoedthis sentiment:“You need an authoritative person tohandle [the dispute], and the resolution of the mostauthoritative person is the easiest to accept. It’s notnecessarily the fairest solution, but fairness isn’t thestandard.The key is whether it solves the problem.”Somewhat surprisingly, the rating by business peo-ple of the legal system as a whole is solidly average:56.3 percent of respondents in Shanghai andNanjing rated the legal system as average, while 25.3percent found it to be low or very low, and 18.3percent found it to be high or very high.The con-trast with their assessment of trustworthiness in con-tracting is noteworthy, since it is more negative—42.9 percent of respondents found it to be average,while 53 percent found it to be low or very low, andonly 4.1 percent found it to be high or very high.Thus, there does appear to be a need for a neutral,third-party arbiter, yet such services appear to beundersupplied by informal and formal non-stateinstitutions.The formal legal system clearly plays animportant role, albeit an imperfect one.

ENDNOTES

1. Robert Hall and Charles Jones,“Why Do Some CountriesProduce So Much More Output Per Worker Than Others?”The Quarterly Journal of Economics, Vol. 114, No. 1 (1999),83–116; Daron Acemoglu, Simon Johnson, and JamesRobinson, “The Colonial Origins of ComparativeDevelopment: An Empirical Investigation,” AmericanEconomic Review, Vol. 91 (December, 2001), 1369–1401;Dani Rodrik, Arvind Subramanian, and Francesco Trebbi,“Institutions Rule: The Primacy of Institutions overGeography and Integration In Economic Development,”NBER Working Paper No. 9305 (October 2002), availableat http://www.cid.harvard.edu/cidwp/097.htm andhttp://www.nber.org/papers/w9305.

2. Douglass C. North, Institutions, Institutional Change andEconomic Performance (Cambridge: Cambridge UniversityPress, 1990), 35.

3. Ibid., 54.4.This view is encapsulated in the popular formula (tifa),

“The state regulates the market, and the market guides theenterprises.”

5. Donald C. Clarke, “Regulation and Its Discontents:Understanding Economic Law in China,” Stanford Journal ofInternational Law,Vol. 28, No. 2 (Spring 1992), 283–322.

6. Hu Ge, “The Implications of Enforcing the BankruptcySystem,” Guangming Ribao [Enlightenment Daily], July 26,1986, 3; in Foreign Broadcast Information Service, DailyReport: China, FBIS-CHI-86-152,August 7, 1986, K17.

7.Albert Chen, An Introduction to the Legal System of thePeople’s Republic of China (3rd ed.) (Hong Kong:Butterworths, 2004), 114.

8. Donald Clarke, “Economic Development and the RightsHypothesis: The China Problem,” American Journal ofComparative Law,Vol. 51 (2003), 89–111; Daron Acemogluand Simon Johnson, Unbundling Institutions, MITDepartment of Economics Working Paper No. 03-29(August 2003), available at http://ssrn.com/abstract=442900.

9. See particularly Yingyi Qian “How Reform Worked inChina,” in Dani Rodrik, ed., In Search of Prosperity:AnalyticNarratives on Economic Growth (Princeton: PrincetonUniversity Press, 2003), 297–333.

10. See, e.g., Barry Naughton, Growing Out of the Plan (NewYork: Cambridge University Press, 1996), 53.

11. John McMillan and Christopher Woodruff, “DisputePrevention Without Courts in Vietnam,” Journal of Law,Economics and Organization,Vol. 15, No. 3 (1999), 637–658.

12.Acemoglu and Johnson, op. cit.13. Susan Whiting, Power and Wealth in Rural China:

The Political Economy of Institutional Change (Cambridge:Cambridge University Press, 2001).

14.World Bank, “Competitiveness, Technology and FirmLinkages in Manufacturing Sector, 1998–2000 (WDI ID0359).The dataset is created from a firm-level survey con-ducted by the World Bank in 2001.The survey covers1,500 Chinese firms, which are evenly distributed acrossfive big cities: Beijing, Chengdu, Guangzhou,Shanghai,and Tianjin.The sample firms are drawn from tensectors: five in manufacturing and five in services.

15. He Bing, “Jiufen jiejue jizhi zhi chonggou”[Reconstructing the Mechanism of Dispute Resolution],Zhong-Wai Faxue [Chinese and Foreign Legal Studies(Peking University Law Journal)],Vol. 14, No. 1 (2002), 28.

16. Quanguo Renmin Fayuan Sifa Tongji Lishi Ziliao Huibian1949–1998 (Minshi Bufen) [Collected Historical JudicialStatistics from the People’s Courts of the Whole Country,1949–1998 (Civil Part)] (Beijing: Renmin FayuanChubanshe, 2000); Zhongguo Falü Nianjian [China LawYearbook], (Beijing: Zhongguo Falü Nianjian Chubanshe,various years).

17. He Bing, op. cit.18. Litigation of contract disputes in the U.S. commonly

involves failed businesses, abandoned product lines, veryhigh stakes, or extreme miscalculations. Daniel Keating,“Measuring Sales Law Against Sales Practice: A RealityCheck,” The Journal of Law and Commerce, Vol. 17, Fall1997, 99.

47


A PUZZLE

Between 1978–2000, China experienced a real rateof growth in gross national product (GNP) of 7.1%per capita. On a per worker basis, GNP increased at aslightly lower real rate of 5.1%.1 This puts China’sexperience more or less on par with that for SouthKorea and Taiwan at a similar stage in their econom-ic development. Most analyses of the Chinese econ-omy since reform have focused on the role of thenon-agricultural sector (mainly manufacturing andservices) in explaining this growth.2 However, GNPper worker in the non-agricultural sector has grownat an annual rate that is actually significantly less thanthat in the aggregate, 3.3% versus 5.1%.This observa-tion prompted Alwyn Young to comment: “To thedegree that the reforms have improved efficiency,these gains may principally lie in agriculture.”3

GNP per worker in the primary sector (largelyagriculture) has increased more rapidly than that inthe non-agricultural (4.5 versus 3.3 percent), but thegrowth is still less than that observed overall in theeconomy (5.1 percent).This suggests an alternativesource of growth in the Chinese economy over thisperiod: the reallocation of labor from agriculture tothe non-agricultural sector, or the process of struc-tural transformation.

Growth from this source arises because labor pro-ductivity is much lower in the agricultural sector thanit is in the non-agricultural sector. In the late 1970sand early 1980s, for example, the difference in aver-age labor productivity may have been on the order of4:1–5:1.Thus, the reallocation of labor from the lowproductive to the high productive sector contributesto an increase in output per worker in the aggregate.Since the late 1970s, the percentage of the labor forcewith their major source of employment in the pri-mary sector has fallen from over seventy percent towell less than fifty percent, while the number of indi-viduals working in the non-primary sector has near-ly tripled from 120 million to almost 360 million.

THE ROLE OF STRUCTURAL

TRANSFORMATION

The contribution of each of these three sources tothe growth in GNP per worker in the economy canbe quantified through a simple accounting decom-position. In this accounting, the contributions of theprimary and non-primary sector are measured by thegrowth of labor productivity in each sector, weight-ed by their respective shares of GNP.The contribu-tion of the reallocation of labor, or structural trans-formation, is equal to the growth in non-agricul-

48


Growth and Structural Transformation in China

LOREN BRANDT, CHANGTAI HSIEH, AND XIAODONG ZHU

Table 1. Simple Growth Accounting

GrowthGNP per worker

5.1

6.2

4.2

5.6

Agriculture

1.3

1.4

0.5

1.4

Non-agriculture

2.4

3.7

2.0

2.2

Reallocation

1.4

1.1

1.6

2.0

PERIOD

1978–2000

1994–2000

1984–1994

1978–1984

Source:These estimates are based on nominal GNP and employment data reported by China’s National Bureau of Statistics (Chinese StatisticalYearbook, various years).We convert these data to real terms using an alternative set of deflators also used by Alwyn Young in “Gold into Base Metal:Productivity Growth in the People’s Republic of China during Reform,” Journal of Political Economy,Vol. 111, No. 6 (December 2003), 1220–1261.

GROWTH CONTRIBUTIONS

Loren Brandt is professor of economics at the University of Toronto. Changtai Hsieh is associate professor of econom-ics at the University of California, Berkeley. Xiaodong Zhu is professor of economics at the University of Toronto.

ture’s share of total employment weighted by the gapin labor productivity between the two sectors meas-ured as a percentage of aggregate labor productivity.For example, if the gap in productivity is equal to200 percent, an increase in the share of employmentin non-agriculture by 10 percent implies an increasein output per worker of 20 percent.

In Table 1, we report the results of these calcula-tions for the period between 1978–2000, and sever-al sub-periods. What do we learn? Over the entireperiod, growth in labor productivity in the non-agricultural sector was the source of slightly morethan 45 percent of the overall growth (2.4/5.1) weobserve in output per worker. Labor productivitygrowth in agriculture accounted for a quarter of thegrowth, while the reallocation of labor from the lessproductive agricultural sector to the more produc-tive non-agricultural sector contributed thirty per-cent. Performing the same decomposition over sev-eral sub-periods, we learn that the role of the real-location was larger the first 15 years of reform thanthe last 10 years (40 percent versus 25 percent).

The important quantitative role of structural trans-formation raises a question fundamental to any inter-pretation of the growth process in China duringreform: what determines the pace of structural trans-formation, and the rate at which labor leaves the farmto work in the non-agricultural sector? With slightlyless than half of the labor force still primarily work-ing in the agricultural sector, this also has obviousimplications for China’s future growth dynamics.

From a theoretical perspective, three separate fac-tors could explain how rapidly labor leaves agricul-ture for non-farm employment. In the traditionalstructural transformation story, low productivity inagriculture and high farm prices inhibit growth inthe non-agricultural sector.Thus, a fall in the price ofagricultural goods relative to non-agricultural goodsarising from more rapid total factor productivity(TFP) growth in agriculture relative to non-agricul-ture could encourage out-migration from the vil-lages. Second, an increase in the rate of total factorproductivity growth in manufacturing and servicesrelative to agriculture with no offsetting effects onrelative prices, i.e., the price of agricultural goods rel-ative to non-agricultural goods, which increases thedemand for labor in the non-agricultural sector.Finally, a decline in barriers or market distortions thatreduce the productivity gap between the two sectorswill hasten the rate of structural transformation.These

barriers can arise from such factors as restrictions onmigration from the countryside to the cities;4 the lim-ited capacity of villagers to obtain the human capitalrequired to work in the non-agricultural sector; orthe local red tape and capital market imperfectionsthat restrict the ability of rural households to start andexpand their own businesses.

How can we determine which of these three wereimportant in China? There are two things we know.First, over the last 25 years, the price of manufacturedgoods relative to agricultural goods has been relative-ly constant. Second, the ratio of average labor pro-ductivity in non-agriculture relative to agriculturehas also been relatively constant. In a fuller version ofthis analysis, we show that long-term stability in theratios of non-farm to farm product prices and outputper worker enables us to pinpoint changes in the ratioof non-farm to farm TFP as a key determinant of therate of China’s structural transformation.5 In otherwords, the driving force behind the reallocation oflabor from agriculture to non-agriculture has beenthe more rapid growth of total factor productivity,which measures output per combined unit of allinputs (including not just labor, but also land, capital,energy and materials) in China’s non-farm sector.6

This also suggests that TFP growth in non-agri-culture has both a direct and an indirect effect ongrowth in China, and thus, a larger overall role inChina’s development process.The direct effect comesin the form of an increase in output per worker in thenon-agriculture sector; the indirect effect occursthrough the effect of more rapid growth in total fac-tor productivity in the non-agricultural sector onlabor absorption from the agricultural sector, or therate of structural transformation in the economy.

CHINA’S OTHER TRANSFORMATION

Any analysis of productivity growth in China’s non-agricultural sector must factor in China’s other impor-tant transformation, namely, that involving the statesector. At the outset of reform, the non-agriculturalsector, especially in the cities,was predominantly state-owned. For example, in 1978, 80 percent of totalurban employment was in the state sector. In industry,76 percent of the gross value of industrial output(GVIO) was produced by state-owned enterprises.7 Itis generally acknowledged that over much of thereform period, total factor productivity growth in thestate-sector lagged considerably that in the non-state

49


sector, perhaps by as much as a 2:1 ratio.8 Moreover,despite market liberalizing reforms that allowed entryof new firms into most sectors and freed up inputmarkets through the dual-track system, the state sectorcontinued to absorb enormous amounts of resources.9

Overall, for example, the state sector was the benefici-ary of nearly two-thirds of fixed investment in theeconomy up through the early-to-mid 1990s, muchof which was financed through the banking system,which continues to direct its lending primarily towardstate-sector clients. Even as late as 2003, half of fixedinvestment was in the state sector.

Until the massive layoffs beginning in the last halfof the 1990s, this investment helped to supportemployment growth and a wage premium in the statesector in spite of the sector’s lower TFP growth anddeclining share of both output and value-added inthe economy.We observe the drag of the state sectorin the growth process in the highly cyclical behaviorof the economy up through mid 1990s. Periods ofhigher growth are associated with more rapid growthin output and employment in the non-agricultural,non-state sector.10 Central to this expansion is the“leakage” of credit from the state financial system tothe non-state sector. Periods of declining growthrates, on the other hand, are associated with financialrepression, and tight administrative control over theflow of financial resources to the non-state sector.

The state sector’s important role and its long-last-ing negative influence on total factor productivitygrowth in non-agriculture and on the process ofstructural transformation are also visible in the size-able differences we observe in growth rates acrossChina’s provinces. On average, GNP per worker innon-agriculture increased 3.3 percent in real termsper annum, but this conceals enormous heterogene-ity. In Guangdong, Fujian, Zhejiang, and Jiangsu, forexample, output per worker in non-agricultureincreased almost two times the national average. Atthe other end of the continuum are provinces such asGansu, Guizhou, and Jiangxi, which experiencedgrowth in non-agricultural GNP per worker of only0.6, 1.7 and 2.4 percent, respectively.

Significantly, we observe very strong positive cor-relations between growth in GNP per worker in theaggregate and GNP per worker in non-agriculture,GNP per worker in agriculture, and the pace ofstructural transformation, as captured by the rate ofincrease in the non-agriculture employment. Theserelationships are graphed in Figure 1. Moreover, each

of these growth rates is negatively correlated with theinitial size of the state sector, as reflected in the shareof the state-sector in non-agricultural employmentearly in the reform period (see Figure 2). In otherwords, provinces that entered the reform period withthe largest share of their economies occupied by thestate sector tended to experience the lowest rates oflabor productivity growth (in both agriculture andnon-agriculture) and the lowest rates of labor forcereallocation during the ensuing twenty-five years.Finally, Figure 3, which plots provincial data showingthe state sector’s share in non-agricultural employ-ment for 1978 and for 2000, demonstrates the per-sistence and resilience of the state sector in China’sprovincial economies.

This persistence is suggestive of strong entrenchedstate sector interests at the provincial level that mat-tered significantly for credit allocation, for policytoward the non-state sector, as well as for agriculture(through the need to feed the urban population, etc.).Figure 4, displays the clearly positive relationshipbetween the average share of investment going to thestate sector between 1982 and 2000 and the state sec-tor’s initial share of employment.

China may have succeeded in “growing out of theplan” by the end of 1980s, but has found it muchharder to grow out of the state sector.11 The legacy ofthe state sector has lingered much longer throughaccess to credit for the non-state sector and the lagswith which much needed economic and institution-al reforms have been carried out. More generally, thesize of the state sector mattered for the entire trajec-tory of economic and institutional reform at theprovincial level.

Much is often made of the “natural” advantagesthat the coastal provinces have experienced duringeconomic reform.These are certainly there. But alsosignificant is that for historical reasons—largely relat-ed to China’s pre-1978 development strategy—thestate sector never obtained the same prominence inthese provinces prior to 1978 as it did in others.Interestingly, Guangdong, Fujian, Shandong, andZhejiang ranked 11th, 14th, 17th and 23rd in terms ofper capita GDP in 1978. Jiangsu ranked a much morerespectable 6th. By 2000, these five provinces wereranked 4th-8th, behind only the three provincial-levelmunicipalities of Shanghai, Beijing, and Tianjin inGDP per capita.Whereas the weak pre-reform devel-opment of the state sector seems to have acceleratedreform-era progress in China’s coastal regions, the

50


51


Figure 1. Growth Rates in Chinese Provinces, 1978–2003 (percent per annum)

9

8

7

6

5

4

3

2

1

0

9

8

7

6

5

4

3

2

1

0

3 4 5 6 7 8 9 10

3 4 5 6 7 8 9 10

3 4 5 6 7 8 9 10

Lab

or

pro

du

ctiv

ity

gro

wth

in

ag

ricu

ltu

re

growth rate of GDP per worker

Growth in GDP Per Worker and Labor Productivity in Agriculture in 22 Provinces

40

35

30

25

20

15

10

5

0

-5

Ch

ang

e in

no

n-a

gri

cult

ure

’s

shar

e (p

erce

nt) o

f em

ploy

men

t


Growth in GDP Per Worker and Non-agricultural Employment in 22 Provinces

Lab

or

pro

du

ctiv

ity

gro

wth

in

no

n-a

gri

cult

ure


Growth in GDP Per Worker and Labor Productivity in Non-agriculture in 22 Provinces

52


Figure 2. State-Owned Enterprise (including State Farms) Employment vs. Growth in Chinese Provinces, 1978–2003

8

7

6

5

4

3

2

1

0

Lab

or

pro

du

ctiv

ity

gro

wth

(p

erce

nt)

in

no

n-a

gri

cult

ure

, 197

8–20

03

Non-agricultural Labor Productivity Growth in 21 Provinces

Agricultural Labor Productivity Growth in 21 Provinces9

8

7

6

5

4

3

2

1

0

Ch

ang

e in

no

n-a

gri

cult

ure

’s s

har

e (p

erce

nt)

of

emp

loym

ent,

197

8–20

03

Non-agricultural Employment Growth in 21 Provinces40

35

30

25

20

15

10

5

0

-5

0.2 0.4 0.6 0.8 1 1.2

0.2 0.4 0.6 0.8 1 1.2

0.2 0.4 0.6 0.8 1 1.2

SOE employment / non-agricultural employment (1978)



Lab

or

pro

du

ctiv

ity

gro

wth

(p

erce

nt)

in

ag

ricu

ltu

re, 1

978–

2003

huge levels of investment related to the developmentof the Third Front in the 1960s and 1970s strength-ened the state sector in interior provinces, whichinfluenced in turn resource allocation, policy andgrowth since 1978.Related, several scholars argue thatthe level of FDI in a province is negatively correlatedwith the size of the state sector, and link this to localprotectionist policies in support of state firms.12

LOOKING FORWARD

With a sizeable gap in labor productivity betweenagriculture and non-agriculture, and roughly 40–45

percent of the working-age population still primarilyworking in agriculture, there remain significant futuregains from structural transformation.Total factor pro-ductivity growth in the non-agricultural sector willcontinue to play a major role in determining thespeed of this process, and in the overall rate of growthin the Chinese economy through its indirect anddirect effects.

In this regard, the allocation of credit and invest-ment will be critical determinants of the size of non-agriculture’s future contribution to growth. Morethan forty percent of Chinese GNP currently goes tocapital formation, which continues to be highly

53


Figure 3. Persistence in the State Sector (including State Farms) in 21 Provinces

SO

E e

mp

loym

ent

/ n

on

-ag

ricu

ltu

ral

emp

loym

ent,

200

0

0.6

0.5

0.4

0.3

0.2

0.1

0

Figure 4. State Sector Shares of Investment and of Initial Employment in 21 Provinces

0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1

0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1

Ave

rag

e S

OE

sh

are

of

inve

stm

ent

(198

2–20

00)

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

SOE employment / non-argricultural employment (1978)

SOE employment /non-agricultural employment (1978)

skewed towards the state sector (more than one-halfin 2003). Continued inefficiency in the allocation ofthis investment, as well as the allocation of workingcapital and fixed investment loans, will only slow thegrowth of non-agricultural total factor productivity,and thus the rate at which labor leaves the farm.Themajor culprit here is the significant level of invest-ment financed by the intermediation of fundsthrough the highly inefficient state-dominated finan-cial system. By all indications, China’s two significanttransformations will continue to be linked in thenear-to-distant future.

ENDNOTES

1.The difference in the rate of growth GNP per capita andGNP per worker reflects the fact that workers per capita, orthe total number of individuals working divided by the totalpopulation, increased over this period because of changes inthe demographic composition of the population. This ismost easily seen by recognizing that: GNP per capita =GNP/total population = (GNP/total workers) divided by(total workers/total population).

2.We will use the term primary (non-primary) and agricul-tural sector interchangeably. In point of fact, however, theprimary sector also includes fishery and forestry.

3.Alwyn Young,“Gold into Base Metal: Productivity Growthin the People’s Republic of China during Reform,”Journalof Political Economy, Vol. 111, No. 6 (December 2003),1220–1261.

4.These same restrictions may also affect TFP growth in thenon-agricultural sector because they limit “agglomeration”effects. See Chun-chung Au and Vernon Henderson and

xxxx, “How Migration Restrictions Limit Agglomerationand Productivity in China”, Journal of Development Economics,forthcoming.

5.We show this more formally in a longer version of this paperwhich is available from the authors on request.

6.This does not imply that productivity growth in agricultureplayed no role in structural transformation. Absent produc-tivity growth in agriculture, the relative price of agriculturalgoods may have increased, thereby dampening the effect ofnon-agricultural productivity growth in reallocation.

7.Township and village enterprises contributed 8 percent, andurban collective enterprises 16 percent.

8. Gary H. Jefferson,Thomas G. Rawski, Li Wang, and YuxinZheng, “Ownership, Productivity Change, and FinancialPerformance in Chinese Industry,” Journal of ComparativeEconomicsVol. 28, No.4 (2000), 786–813.

9. Lawrence Lau,Yingyi Qian and Gérard Roland, “Reformwithout Losers: An Interpretation of China’s Dual TrackApproach to Transition,” Journal of Political Economy, No. 108(February 2000), 120–143.

10. Loren Brandt and Xiaodong Zhu, “Redistribution in aDecentralizing Economy:Growth and Inflation in ReformChina,”Journal of Political Economy,Vol. 108, No. 2 (April2000), 422–439.

11. Barry Naughton, Growing Out of the Plan: Chinese EconomicReform 1978–1993 (Cambridge University Press, 1995).

12. See Lee Branstetter and Robert Feenstra, “Trade andForeign Direct Investment in China:A Political EconomyApproach”, Journal of International Economics, Vol. 58,No. 2 (December 2002), 335–358; Mary Amiti and Beata Smarzynska Javorcki, “Trade Costs and Location of Foreign Firms in China,” IMF Working Paper,March 2005.

54


China’s Growth ProspectsTHOMAS G. RAWSKI

Following 25 years of extraordinary growththat raised every indicator of material wel-fare, lifted several hundred million from

absolute poverty, and rocketed China from nearautarchy into unprecedented global prominence,there is no shortage of predictions about China’sgrowth prospects. Forecasts run the gamut fromunbridled optimism to announcements of impendingdisaster.1 Such variation is not surprising. The firstquarter-century of Asian booms, beginning withJapan from 1955, Taiwan from 1960, Korea from1965, and China from 1978, includes many com-monalities, among them rapid growth of output, sav-ings, investment, education, productivity, incomes,exports, and global trade share.This is the “East AsianModel”—the core phenomenon underlying theWorld Bank’s “East Asian Miracle” study.2 Subsequentexperience in Japan,Taiwan, and Korea shows Asia’shigh performance economies diverging sharply afterthe first quarter-century of accelerated growth.

This essay seeks to illuminate the likely trend ofChina’s economic performance over the comingdecades. It ignores short-term instability as well asthe possibility that growth itself, or dissatisfactionwith unemployment, inequality and other concomi-

tants of economic change could incite disruptivepolitical upheaval.

Examination of Chinese data and economicstructures in the context of cross-national studies oflong-term performance reveals a strong case forcontinued rapid growth.Table 1 summarizes factorsthat loom large in the explanation of growth amongOECD economies. Comparison with currentChinese realities is uniformly favorable. Indeed, wemight reasonably expect China’s economy to out-perform projections based on extrapolation frommulti-country studies.n The systems, knowledge, and policies undergird-

ing high growth in coastal areas now reside insideChina’s economy. Tens of thousands of managersand administrators know exactly how the coastalregions prospered. Successful implementation ofthis new knowledge in China’s interior regionscould enlarge future growth momentum.

n Benefits from China’s rich legacy of entrepre-neurship will expand with the continued erosionof barriers to private business. The explosion ofrural enterprise after 1978 despite decades of anti-market, anti-profit education and propagandaconfirms historian Tim Wright’s characterization

55


Thomas G. Rawski is professor of economics and history at the University of Pittsburgh.The author has benefitedfrom extensive discussions with Loren Brandt, Gary Jefferson and Dwight Perkins as well as information and assis-tance from Hepeng Jia,Victor Shih, Shaoqin Zhao and Yifan Zhang, none of whom are responsible for what follows.

Table 1. Implications of Endogenous Growth Perspective for Chinese Economic Prospects

Chinese Situation

Rapid increase - high literacy, secondary & tertiary education growing

Enormous increase - steep rise in trade ratio; #1 destination for FDI

Inflation variability low despite episodes of moderate inflation

Enormous growth; capital formation approaches 40 percent of GDP

Level rising steeply; GDP share now above 1 percent; Multinationalfirms bolster China-based R&D activity

Burden for households low (urban) but high (rural); enterprise burden-moderate (formal rates); moderate to low (actual payment); expectrising tax burdens due to urbanization and welfare demands.

Low since 1995

Source: OECD growth drivers from Peter J. Nicholson,“The Growth Story: Canada’s Long-run Economic Performance and Prospects,” International Productivity Monitor, No.7 (fall 2003), 3-23.

Drivers of OECD Growth(Declining order of impact)

Average years of education

Trade exposure

Inflation variability (negative)

Physical capital

R&D spending

Tax burden (negative)

Inflation level (negative)

of China as a nation with an abundance of “small-time entrepreneurs.”3 Inflows of entrepreneurialtalent from overseas Chinese and returned stu-dents will continue to reinforce the large andgrowing domestic stock of business acumen.

n China benefits from competent public administra-tion sharply focused on economic performance.Several important but perhaps underemphasizedfeatures of public administration deserve attention.• Despite various forms of corruption, malfea-

sance, and cover-up of official wrongdoing, thechief objective of official activity is getting thejob done.This contributes to China’s status as afavored client of international agencies.

• Chinese officials focus on economic perform-ance.4 National leaders have repeatedly jetti-soned elements of ideology and tradition thatinterfere with economic objectives. With theircareer prospects dependent on quantitativescores that emphasize indicators of economicperformance, local officials promote economicgrowth to a degree rarely matched in otherlow-income nations.

• The experience of multiple economic down-turns has taught Chinese leaders at all levels torespond aggressively to negative surprises.When difficulties arise (as in the 1998 econom-ic downturn), leaders examine the situation, actforcefully to cope, and adjust policy if the ini-tial response fails.

We conclude that there is ample reason to expectChinese growth to continue.

What factors might disrupt China’s enviablerecord of sustained growth? We ignore short-termfluctuations, which are certain to arise and impossibleto predict, and focus on longer-term trends.The listof weaknesses that may impose substantial costs onChina’s economy is formidable: it includes inequality,unemployment, pollution, resource scarcity, corrup-tion, risk-laden banks, and an inadequate social safetynet, as well as problems in public health, rule of law,and corporate governance.These defects are not new.None has stalled China’s remarkable growth spurt.Economies with strong growth momentum can surgeahead while dragging considerable excess baggage.China’s steep economic advance may continue unlesssome obstacle cuts to the heart of the growth processrather than merely imposing costs.

China’s economic growth of the past 50 years,both before and during the current reform era, rests

on a foundation of high saving leading to massive, butoften ill-conceived investments. This pattern is notsustainable.The share of national product channeledto directly productive investment is likely to decline.If this happens, overall growth rates will move down-ward if long-standing patterns of low investmentreturns continue.We see the entire complex of issuescontributing to low returns, which includes extensiveofficial involvement in investment decisions, weakand pliable financial intermediaries, and differentialaccess to capital markets favoring state enterprises, asthe leading threat to the continuation of China’s rapideconomic gains.

East Asia’s dynamic economies all depend on highlevels of domestic saving.The public sector served asthe main source of saving during China’s plan era.Asreform unfolded, household savings, largely chan-neled through the banking system, emerged as theleading source of investment finance. Governments,burdened by the legacy of unfunded pension obliga-tions and unrepayable bank loans as well as costly newresponsibilities for environment, infrastructure, andsocial welfare, will continue to consume rather thangenerate savings. The ratio of saving to income forChinese households, already very high, is unlikely torise and may well decrease in response to the grow-ing proportion of elderly citizens, rising educationand health care costs, and greater availability of con-sumer credit. Any reduction in the extraordinarilyhigh growth of incoming foreign investment wouldreinforce the anticipated slowdown in the growth offunds available for domestic investment.

Regardless of trends in the supply of savings, wecan expect a decline in the share of saving channeledinto factories, equipment, business facilities, and otherdirectly productive assets. Similar declines haveoccurred elsewhere in East Asia because of increasedinvestment shares for housing, urban infrastructure,environmental remediation and other public goods.5

In addition, China’s desire to assume a major role inthe global economy, along with its growing need toimport natural resources, ensure that growingamounts of domestic savings will support overseasrather than domestic investment.6

Growth depends both on the GDP shares of sav-ings and of directly productive investment, and onreturns to investment projects. Like other socialisteconomies, China achieved poor investment returnsunder the aegis of central planning. R apid growthoccurred because large investments overcame the

56


drag of low returns.The persistence of the same pat-tern during the reform period has stimulated com-plaints that China relies on “extensive” growthachieved by adding more resources to the productionprocess rather than “intensive”growth based on high-er productivity.

Despite vigorous reform efforts and the hugelybeneficial impact of direct foreign investment, theoverall investment picture reveals a surprising persist-ence of Soviet-style outcomes.This is strikingly evi-dent in Table 2, which shows little change fromSoviet-style seasonality in investment spending, withhuge fourth-quarter spurts giving way to protractedslowdowns in the first half of the new year.7 Figure 1shows the aggregate consequences of wild swings ininvestment spending: seasonal fluctuations in China’sGDP dwarf comparable variations in neighboringeconomies. Despite a quarter-century of reform,these seasonal patterns confirm the ongoing depend-ence of investment spending on the annual cycle ofinvestment plans, credit quotas, and budgetary appro-priations inherited from the pre-reform decades.

Officially managed investments typically generatelow returns. China’s recent GDP growth is only twoto three percentage points above India’s, even thoughthe share of investment in China’s GDP tops compa-rable Indian figures by 15 percentage points. ZhangHanya, Secretary-General of the China InvestmentAssociation, confirms the implication of low invest-

ment returns in China, noting a 50 percent failurerate for investment projects during 1958–2001. Forthe 8th Five-Year Plan period (1991–95),Zhang putsthe failure rate for medium and large-scale projects at42 percent.8 Recent complaints of excessive invest-ment and ineffectual decision-making echo criti-cisms articulated before reform began,often using thesame language.9

57


Table 2. Competed Investment in Fixed Assets Monthly Share of Annual Total (percent)

1975

6.45.16.07.29.17.47.38.98.09.8

24.833.842.6

1990

3.44.95.26.28.67.57.28.78.79.5

30.128.348.3

2000

3.95.35.76.79.57.67.59.49.1

10.325.031.144.4

2002

4.35.66.57.59.88.28.39.99.49.9

20.733.739.9

2003

4.5

6.0

6.5

7.8

10.5

8.6

8.5

9.7

9.3

9.7

18.8

35.3

37.8

Jan/Feb

Mar

Apr

May

June

July

Aug

Sept

Oct

Nov

Dec

Q1 & Q2

Q4

Source: China Statistical Yearbook on Investment in Fixed Assets 1950–1995, 77. ChinaMonthly Economic Indicators, No. 1 (2001), 36; No.2 (2003), 32; No. 12 (2003), 32,and http://www.stats.gov.cn/was40/detail, accessed on March 25, 2004.

Source:Author’s file Comp. GDP&FKF.seasonal.040104.

Figure 1. Nominal GDP: Quarterly Fluctuations in Four East Asian Economies

40

30

20

10

0

-10

-20

-30

-40

per

cen

t

China

Taiwan

Hong Kong

Korea

58


Source:Author’s file steeltop37.Trmod.062103.

Figure 2. Scale vs. Returns at Large Chinese Steel Plants in 2000 (RMB 100 million and percent)

Ret

urn

s: P

re-t

ax P

rofi

t as

Per

cen

t o

f N

et V

alu

e o

f Fi

xed

Ass

ets

Net Value of Fixed Assets (NVFA), RMB100 Million

Median NVFARMB8.6 Billion

Median Return 4.74%

y = -0.0097x + 8.6792R2 = 0.0207

Source:Author’s file Cement/HenanPlants00.061303.

Figure 3. Henan Large/Medium Cement Plants: Scale and Returns in 2000(RMB 10,000 and percent)

RO

I: P

re-T

ax P

rofi

t as

Per

cen

t o

f N

FA

Average NVFA: 6235

Median ROI: 9.0%

y = -0.0007x + 16.933R2 = 0.1451

60

50

40

30

20

10

0

-10

0

500

1000

1500

0

2000

0

2500

3000

0

3500

4000

Net Value of Fixed Assets (NVFA) RMB 10,000)

Comparisons of firm size and profitability in thenational steel industry (Figure 2) and in the cementindustry of Henan province (Figure 3) illustrate thetypical negative association between investmentscale and financial returns. In both cases, the datadisplay a clear pattern in which larger firms earnlower profits.The association between state owner-ship of industry, official management of investmentspending, and dizzying seasonal gyrations leaps outfrom Figure 4, which uses provincial data for 2000to illuminate the strong positive associationbetween high levels of state ownership and largeseasonal fluctuations in regional output.

These observations cannot surprise Chinese econ-omists and government leaders. As former PremierZhu Rongji explained in his annual governmentwork report for 2002, “We need to formulate andimplement plans for the reform of the investment andfund-raising systems as quickly as possible.”

There is no easy blueprint for investmentreform. Two options are available. Table 1 andFigure 2 confirm that past reform efforts focusedon improving investment performance in the statesector have yet to deliver substantial benefits.Recognizing this unwelcome reality, currentreform initiatives emphasize sweeping reduction in

the size of public-sector industry, development ofnew systems for managing state assets, dilution ofremaining public ownership of banks as well asnon-financial firms, gradual expansion of privatesector access to funds available through the bankingsystem and the stock exchanges, and continuingstrengthening of corporate governance in the statesector (where most of the bad investment occurs).

We see the outcome of these new reform effortsas a key determinant of China’s growth trend over thecoming decades. Continued high growth depends onthe capacity of current reform initiatives to erodelong-standing obstacles to raising the returns ondomestic investment spending.

Although the difficulty of reforming investmentsystem is apparent, recent developments include ben-eficial and potentially important changes, such as:n Continued efforts to reform the financial system,

now bolstered by modest but expanding outpostsof foreign capital and ownership.

n New systems for managing state assets, includingaccelerated privatization of state firms outside the196 large companies directly controlled by thecentral government, which eliminated nearly90,000 state enterprises between 1998 and August2004.10

59


Source:Author’s file China_GDP_Q.040704

Figure 4. Quarterly GDP Fluctuation vs. State Sector’s Share in Industrial Output for 30Chinese Province-level Units during 2000

Sta

te S

ecto

r's

Sh

are

in In

du

stri

al O

utp

ut

(%)

y = 122.55x + 29.601R2 = 0.3911

60

50

40

30

20

10

0

-10

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Coefficient of Variation for Quarterly Provincial GDP

n Growing prominence of private business, which isgradually gaining access to sectors (railroads, avia-tion) and funding sources previously reserved forstate enterprises.

n New cooperative efforts to plan regional infrastruc-ture investments,11 suggesting that local govern-ments have begun to curtail their long-standingaddiction to promoting what Chinese observerscastigate as “blind” and “duplicative” projects.Interactions among these reform efforts can mag-

nify beneficial outcomes. Further downsizing of thestate sector has the potential to reduce the current-ly endemic conflict between efforts to fully com-mercialize bank lending and the responsibility oflocal governments to maintain employment infoundering state enterprises. Better alignment ofinterests between local bank branches and local gov-ernments could quickly reduce the flow of softlending and thus ease the task of bank reform.

We conclude that China dynamic economyretains a strong potential for continuing the recenttrend of rapid economic growth. Among numerouspotential obstacles to continued economic advance,only the difficulties surrounding the process of for-mulating and implementing investment projectsappear capable of disrupting the core mechanism ofChinese growth. Japan’s recent descent from high

growth into near-stagnation, which analysts nowattribute to “the unholy alliance between zombies[meaning “companies that are competitively dead,but, sustained by their banks, continue to walk theEarth and give healthier firms nightmares”] andbanks has proved to be one of the most durable, dis-torting and debilitating compacts in modern eco-nomic history.”12

A similarly “unholy alliance” between shambolicbanks and loan-gobbling zombie borrowers couldtip China’s dynamic economy into a Japanese-stylequicksand of declining growth. Chinese economistsunderstand the danger and recognize that rapid andthorough reform of institutions surrounding China’sinvestment system offers the surest defense.Although institutional change is notoriously diffi-cult to track, we can offer a simple metric for fol-lowing the course of Chinese investment reform.

Seasonal indicators offer the best guide to reformoutcomes. Reform success will dampen quarterlyfluctuations in national investment spending andGDP. This has already occurred in provinces that leadChina’s move toward a market system,with beneficialconsequences at the national level. Figure 5, whichplots percentage changes in quarterly nominal GDPat the national level from 1995–1 to 2005–1, showsconsiderable reduction in both the fourth-quarter

60


Source: China Quarterly Gross Domestic Product Estimates 1992–2001 (Beijing, 2003) and subsequent official announcements.

Figure 5. Quarterly Growth of Nominal Chinese GDP 1995–1 to 2005–1 (Percent change from previous quarter))

80

60

40

20

0

-20

-40

-60

Per

cen

t ch

ang

eSeries 1

peaks and the first-quarter troughs in GDP growthduring the past decade. Despite some backsliding inthe past two years, recent results show smaller fluctu-ations than during 1995–98 (for fourth-quarterpeaks) or 1995–99 (for first-quarter troughs).

China’s economy has achieved truly remarkablegains during the past quarter-century. Even so, therange of future outcomes remains wide. While con-tinued growth seems likely, the survival of Soviet-styleinvestment patterns opens the door to less attractivepossibilities. Obscure statistical indicators, especiallymeasures describing the seasonality of output andinvestment, may offer the best guide to expectationsabout the future of China’s giant economy.

ENDNOTES

1. For example, Gordon G. Chang, The Coming Collapse ofChina (New York: Random House, 2001); Charles Wolf etal., Fault Lines in China’s Economic Terrain (Santa Monica:RAND, 2002); Oded Shenkar, The Chinese Century: theRising Chinese economy and its Impact on the Global Economy,the Balance of Power, and Your Job (Philadelphia: WhartonSchool, 2005).

2.The World Bank, The East Asian Miracle: Economic Growthand Public Policy (Oxford and New York: OxfordUniversity Press, 1993).

3.Tim Wright, “Growth of the Modern Chinese CoalIndustry: An Analysis of Supply and Demand,” ModernChina,Vol. 7, No.3 (1981), 325.

4.The response of local officials to the recent abolition ofagricultural tax illustrates the centrality of economic indi-cators within the bureaucracy. In Weinan, Shaanxiprovince, local leaders previously “had to spend 80 percent of our efforts on imposing agricultural tax, which wasthe most important job for us.” Under the new system,“itwill be a great pressure on us that we will be examined interms of rural economic development and increases infarmers’ income.” See Ma Lie, “Township GovernmentsFace Role Shift,” China Daily,April 1, 2005, 5.

5. Spending on urban infrastructure rose from 2.0 to 3.1 per-cent of GDP between 1999 and 2002; see You Wan and Qi

Jianguo, “Long-term Trends and Feedback in China’sEconomy,” Caimao jingji [Finance and Trade Economics],No. 10 (2004), 12.

6.You Wan and Qi Jianguo forecast long-term importdependence for 36 of 45 key mineral products (ibid. 13).Overseas investment by Chinese firms amounted toUS$3.6 billion in 2004, with further increases expected.See http://www.cbc.ca/cp/business/050207/b020718.html

7. Professor Li Jingwen recalls a plan—era slogan:“10-20-30-40” —meaning 10 percent of investment spending in thefirst quarter of each year, 20 percent in the second quarter,and so on. Recent data follow the same pattern, which isunknown in market economies.

8. Gao Mu et al.,“Zhang Hanya: touzi tizhigaige hexin jiushifangquan,” Jingji cankaobao [Economic reference news], July27, 2004, available at jjckb.xinhuanet.com/www/Article/200472794126-1.shtml, accessed on October 8,2004.

9. For example, enterprises were given the right of decision-making in the late 1970s. “However, three decades later,enterprises, state-owned, state-held, or private, still have tofollow government instructions and obtain the govern-ment’s approval in their choice of investments.”By the time proposed initiatives “undergo the tediousprocess before they reach final authorities . . . the bestchance to market products has disappeared. . . which caus-es huge amounts of waste.” See Zhou Tianyong,“De-regulation of Investment Vital,” China Daily,August 9, 2004, 6.

10.Wang Zhongming,“Situation and Structure:Three Levelsof Strategic Adjustment to the State Sector,” Guoyou zichanguanli [Management of state assets], No. 1 (2005), 35.

11.Andrew Batson, “Hong Kong, Neighbor Seek NewLinks,” Wall Street Journal, February 23, 2005, B2B; XuBinglan, “Beijing, Tianjin, Hebei Seek Regional Co-operation,” China Business Weekly, March 7–13, 2005,1, 10.

12.“Dead Firms Walking,” Economist, September 25, 2004,81, referring to work such as Takeo Hoshi and Anil K.Kashyap,“Japan’s Financial Crisis and Stagnation,” Journalof Economic Perspectives, Vol. 18, No.1 (2004),3–26.

61


Since virtually the beginning of China’s eco-nomic reform, analysts have been puzzled bythe co-existence of China’s authoritarian

political system and its dynamic economy. How didit happen that sustained economic reforms and vig-orous growth were compatible with only modestalterations in the political system? Today, althoughChina’s bureaucracy has become much more profes-sional and capable, and institutions have becomemore open and responsive to public opinion,China’s political system is still fundamentallyauthoritarian and hierarchical. Yet despite China’sclosed political system, economic growth hasremained robust. Will China’s continued economicgrowth be possible in the context of this authoritar-ian system, or will economic restructuring begin toforce more fundamental political changes?

The large questions about the relation betweeneconomic and political change, and the ultimatecompatibility of economic and political systems arebeyond the scope of this short essay. Instead, Iemphasize some of the specific short-run economicchallenges that China faces today. I argue that Chinahas reached a kind of turning point in the relation-ship between economic and political change.Whenwe look back over the past twenty-five years of eco-nomic reform, we can identify a number of factorsthat made China’s authoritarian system compatiblewith economic reform—indeed might even havemade an authoritarian system more effective in car-rying out reform than a democratic system.However, most of these factors have now disap-peared, and China instead faces a number of imme-diate and troublesome challenges that are not verytractable to top-down policy solutions. Three oftoday’s most urgent economic challenges—broad-ening and diversifying the financial system, restruc-turing fiscal resources, and improving corporategovernance—all require both better institutions oflocal economic governance, and a further looseningof central political controls in order to achieve suchinstitutionalization.

LOOKING BACKWARDS

During its first fifteen years, Chinese reform con-sisted primarily of the decentralization of authorityand resources almost wholly within the context ofthe existing hierarchical structure.The existing ruleson the exercise of power and property didn’t changemuch, but space was opened up for market-orient-ed and entrepreneurial activity. Incentives weremade stronger and more market-oriented through-out the system, but Communist Party leaders main-tained some control over the overall incentive sys-tem. Most embedded interest groups were protect-ed, and overall, the 1980s reform was a “reformwithout losers.” Under this reform model, contin-ued authoritarian political control at least did notstifle reform, and might even have contributed toeconomic growth by providing continuity and sta-bility for investors, and preventing some kinds ofegregious rent-seeking and corruption.

By the early 1990s, this model of reform had runout of steam, having achieved about all that it could.A shift in reform policy-making, during 1993-94,began to restructure the rules and institutions thatgoverned economic activity.This new policy regimeachieved important successes, especially in the fiscal,financial, and corporate governance spheres.However, in nearly all cases, these achievementswere dependent upon a recentralization of politicalpower. During the 1990s, the authority of theCommunist Party hierarchy was used to restorecredibility and decisiveness to aspects of economicpolicy that had lost those attributes. Measuredrecentralization was carried out, and its objectivesgenerally achieved. The authority of the politicalsystem was used to impose new rules on powerfulinterest groups—for example, in the fiscal reforms of1994, and the banking sector reforms of 1998-1999.An even broader social impact was seen as previous-ly protected groups were forced to bear the costs ofeconomic restructuring, with state enterprise work-ers the group most obviously affected. The new

62


China’s Political System and China’sFuture Growth

BARRY NAUGHTON

Barry Naughton is the So Kwanlok Professor of Chinese and International Affairs at the Graduate School ofInternational Relations and Pacific Studies (IR/PS), University of California, San Diego.

openness to competition forced on China by theDecember 2001 accession to the World TradeOrganization marked the logical culmination to thissequence of top-down commitments.

The recentralization and dynamic use of politicalauthority so evident during the 1990s also plantedthe seeds of its own failure. By drawing powertoward the political center—and in particular, bystrengthening the Communist Party’s ability tointervene directly in economic management—eco-nomic reforms after the mid-1990s achieved suc-cesses but also created new obstacles for furtherreform. Few really independent agencies were creat-ed; the assignment of secure property rights to thosewho controlled public resources did not proceedvery far; and the attempt to restructure the manage-ment of public assets did not achieve breakthroughsuccess. Progress today requires a deeper process ofinstitutionalization that leads to reversal of at leastsome aspects of the 1990s recentralizing package.

FINANCIAL BROADENING

The most widely recognized shortcoming of thecontemporary Chinese system is the feeble condi-tion of its financial institutions. In the simplest pos-sible terms, the Chinese government wants financialinstitutions to stand on their own two feet. It there-fore seeks to give them the financial resources theyneed to escape the legacy of the past, but must thencredibly commit to neither intervene excessively intheir future decision-making, nor to bail them out ifthey fail. Although important steps in this directionhave been taken, the fundamental independence ofthese institutions from political control has not yetbeen achieved. More broadly, China’s financial sys-tem is not very diversified: we can characterizeChina’s financial system as “deep but narrow.”

Financial deepening implies that a larger volumeof savings (relative to income) has been transformedinto investment through the intermediation offinancial institutions. China achieved a rapidincrease in the “depth” of its banking system, asmeasured, for example by the ratio of M2 to grossdomestic product.At year-end 2003, household sav-ing deposits were 89 percent of GDP; M2 was aremarkable 189 percent of GDP. Financial broaden-ing, on the other hand, means that the variety andnumber of both financial market participants andfinancial market instruments have increased. Here,China’s progress has been much more modest.Financial broadening implies that there is greaterchoice for savers and for investors and this allows thefinancial system to more efficiently match up differ-ent uses with various source of funds. China’s finan-cial system is still dominated by banks, and in par-ticular by state-owned banks.

Indeed, the dominance of banks is actually becom-ing more unbalanced. Table 1 shows the transfer offunds through the formal financial sector during thepast four years. Not only is the share of total fundstransferred through the banking system extraordinari-ly large, that share has actually increased annually overthe past four years, from 73 percent to 85 percent.Growth of the stock market has stalled since 2001,while bank lending has boomed with a new influx offunds into the banking system. These are the symp-toms and causes of the thus-far failed diversification ofthe Chinese financial sector.

To be sure, important efforts have been made todiversify the ownership structure of the banking sys-tem itself.Most recently, both the Bank of China andthe Construction Bank have been authorized tobegin a process of Initial Public Offerings (IPOs).These two—the best of the so-called “Big Four”state-owned commercial banks—succeeded in low-

63


Table 1. Sources of Funds Raised in Domestic Financial MarketBank Lending

72.8%

75.9%

80.2%

85.2%

Treasury Bonds

14.4%

15.7%

14.4%

10.0%

Corporate Bonds

0.5%

0.9%

1.4%

1.0%

Stocks

12.3%

7.6%

4.0%

3.9%

2000

2001

2002

2003

Source: PBC, 2002 China Monetary Policy Report, 30; 2003 Report, 13.

ering their NPL ratios and improving their internalauditing and supervision procedures.As a result, they“qualified” for an injection of capital from the gov-ernment. The newly-created Huijin Corporationinvested $45 billion from the state’s foreign exchangereserves and thereby became the owner of these twobanks. Subsequently, the Huijin holding companyreorganized itself, and sought additional strategicpartners, on the way to finding strategic internation-al investors, and then listing on domestic and foreignstock exchanges.The restructuring of Bank of Chinaand Construction Bank are certainly positive devel-opments that contribute to the diversification of thefinancial sector.This process has also been repeatedlydelayed as weak accounting controls and recurrentscandals have continued to shake the banks. Listinghas been delayed, and is now scheduled for sometime in 2005, but only provisionally, and on condi-tion of improvement of controls.

Despite some movement, then, the financial sectorremains deeply troubled. Overall, the state-ownedbanks possess a very large burden of non-performingloans (NPLs), even after many successive rounds ofloan write-offs and capital injection.The risks posedby the high share of NPLs are substantial, primarilybecause overall the banking sector is so large in rela-tion to the Chinese economy. Because China’s bank-ing sector is so “deep,” the burden of funding neededto fix the problem is large indeed. Since 2002,Chinese banks have classified their loans according anew system, which approximates international stan-dards. While the numbers are big, the trends lookgood, at first glance—overall, NPLs declined from 25percent to 21 percent as a share of GDP between2002 and 2003.They further declined in 2004, withthe Bank of China and Construction Bank turning inespecially impressive performances (down to 5.1 per-cent and 3.7 percent respectively). However, uponcloser inspection, the danger is that the rapid growthof total lending not only produces an illusion ofprogress, it also creates a misleading indicator.A larg-er proportion of total lending today consists of recenttransactions (since loan growth accelerated after2002). It takes some time for lending to go sour; alarger share of new lending inevitably correlates witha low NPL ratio.Moreover, the abrupt shift in macro-economic policy and the administration restrictionsplaced on investment projects during 2004 will havea significant impact on NPLs. Inevitably, those eventswill increase the total volume of NPLs, even as they

cause the growth in total lending to decelerate. NPLratios will tend to rise again, creating further prob-lems for Chinese policy-makers and regulators.At thecore of the problem is the lack of diversification inthe banking and financial systems.This lack of diver-sification is related to the slow progress in providing aregulatory framework and secure property rights forfinancial transactions.

RESTRUCTURING FISCAL RESOURCES

China faces substantial long run fiscal challenges.The two most significant future obligations are thefunding required to recapitalize the financial system,and funding necessary to pay for implicit pensionliabilities. However, the total magnitude of futureobligations is not the greatest challenge that Chinafaces. Indeed, following the first round of fiscalrestructuring, China’s fiscal resources have rebound-ed nicely since the low point in 1995, when theywere only 11 percent of GDP following the fiscalreforms of the previous year. Fiscal revenues as ashare of GDP have increased by almost a percentagepoint per year since that time, breaching 20 percentin 2004. Moreover, the economy is growing rapidly.The combination of a healthy revenue base andrapid growth means that overall fiscal adequacy canbe achieved with modest effort.

Instead, the main challenge is to further institu-tionalize the fiscal system.The fiscal reforms of 1994made some progress in distributing authority overrevenues and tax rates to different levels of govern-ment, and different functional systems. Thoseachievements were important in putting China’sbudget on a stable and sound basis. However, theytook place more than a decade ago, and progress hasbeen much less dramatic in recent years.The clear-est example is funding local government activities.The budgetary reforms of 1994, while increasingcentral control, clarified the division of resourcesbetween central and provincial governments. Butthe 1994 reforms were not designed in way to pro-vide adequate funds for the base-level rural govern-ments at the bottom of the budget hierarchy, espe-cially in poor areas. Particularly in rural areas, thesupply of funds to carry out state-mandated pro-grams such as education, local infrastructure, andpoverty alleviation have never been adequate.

In recent years, the Chinese budget has devoted asharply increasing share of budgetary resources to

64


transfers to targeted regions and rural areas in gen-eral. First, the Western region development pro-gram, which began in 2000; and subsequently theNortheast revitalization program, by late 2003, haveaccounted for a rapidly increasing share of totalexpenditures. Moreover, as the Hu Jintao-WenJiabao leadership has made increasing efforts to assistfarmers—left behind by China’s booming urban-based economy—legitimate taxes on farmers arebeing sharply cut back.Twenty-two of China’s thir-ty-one provinces are eliminating the agricultural taxin 2005.To account for the increased expenditures,and decreased local revenue capacity, the fiscal sys-tem has become substantially more redistributive.The central government transfers large amounts offunds to the localities. However, the current systemis quite incomplete. Central to local transfer arerarely rule-driven, but rather correspond to theshort-term needs of central policy-makers.Thus, oftotal Central-local Transfers in 2002, 41 percentwere rebated taxes, 55 percent were discretionary, adhoc payments from center, and only 4 percent wererule-driven, systemic transfers. Many of these discre-tionary payments are earmarked for good purposes,but that, in a sense, is precisely the problem. Thesegood purposes—including local level education,social security, and government employee wages inpoor areas—need to have a stable source in regularrevenues. Much of the funding in the WesternDevelopment Program, for example, goes to plugholes in ordinary administrative and educationalfunding in poor Western provinces. This createsundesirable incentive effects for localities (it is betterto be poor and get national government support),and leaves the funding difficulties of moderatelyadvanced regions completely unaddressed. Recentreductions in the agricultural tax have lightenedburdens on farmers, but have left the unsolved thequestion of how to put rural local finance on ahealthy footing.

The other large future liability is related to pen-sion costs.Today, the national social security system isscarcely reflected in budgetary figures at all.The lackof funding of the pension system matters becauseimplicit pension liabilities are quite large, due to twoextraordinary factors. First, China’s draconian birthcontrol policies have created a compressed demo-graphic transition, and will result in accelerated pop-ulation aging after about 2015. Thus, the share ofaged in China population will increase very rapidly,

and well before China reaches the upper income lev-els usually associated with an aging population.Second, China’s urban pension system has actuallybecome more generous over the past decade, becauseearly retirement has become a primary tool toreduce the work force at down-sizing state-ownedenterprises. In 2001, the average age of retirementwas fifty-one! China’s fiscal system requires substan-tial further restructuring. Long-term needs for localgovernment financing, restructuring financial assets,and funding pensions press on the current system. Ineach of these cases, development of deep and diver-sified capital markets would permit more efficient,lower cost financing of these obligations. The pay-back to such reforms would be exceptionally large.Aclear legal and regulatory framework is necessary tomove away from the current system, which relies toomuch on discretionary power.

STRENGTHENING CORPORATE GOVERNANCE

AND PRIVATIZATION

China is now privatizing. For decades, China pur-sued the transition to a market economy withoutcarrying out significant privatization. But sinceabout 1999, the momentum of privatization hasaccelerated dramatically. According to official fig-ures, from 1998 through the end of 2003, the num-ber of state-owned and state-controlled enterprisesin all sectors declined from 238,000 to 150,000,through a combination of privatization, bankruptcyand merger. The privatization wave is a positivedevelopment for the Chinese economy, and appro-priate to the stage of market transition China hasnow reached. However, privatization thus far hasbeen hampered by the lack of clear guiding princi-ples or a legitimate, publicly recognized rationale.The privatization process, in other words, has goneforward without any clear institutional framework.The result has been a process that is still too slow,non-transparent, and guided by insider interestsrather than publicly-enunciated principles.

The main government body today shaping theprivatization process is the State Asset Supervisionand Administration Commission (SASAC). SASACwas authorized at the 10th National People’sCongress in March 2003, with the mission to “fullyrealize [the government’s role as] investor and owner[tixian chuziren daowei].” Its mandate from the 16thParty Congress (November 2002) was to establish a

65


“new state asset management system in whichauthority, duty, and responsibilities are united, and inwhich management of assets, personnel, and affairs isunified.”1 SASAC sees its primary mission as the pro-tection of the public interest in the administration ofgovernment assets. SASAC’s mission has been seri-ously compromised by two main factors. First, it hasbeen unable to articulate a rationale for privatization,and therefore indirectly contributes to a prolongedand complicated privatization process that in the endcreates more opportunities for asset-stripping, insiderprivatization, and other value-destroying activities.Second, in its attempt to exercise unified control theremaining government assets, it runs directly into thetraditional control over managerial appointments thatis exercised by the Communist Party. This preventsSASAC from uniting the different features of theowner’s rights and responsibilities in a single body.

Among all the areas where SASAC struggles todefine its role, the most difficult and sensitive is inrelationship with the Communist Party in sharingauthority over personnel decisions. When it wasestablished, SASAC was assigned the power toappoint and remove the managerial staff in its super-vised state enterprises. But in fact SASAC has neverachieved unambiguous control of the personnelappointment process.

Moreover, even when SASAC exercises appoint-ment power, it is unclear whether it is acting as anagent of the Communist Party, or has some kind ofautonomous decision-making authority.This is notsurprising, since the control over personnel is themost fundamental instrument of power exerted bythe Communist Party. But this control of personnelreflects a fundamental shortcoming in the reform ofgovernance in the public sector, or in the privatiza-tion process. Reformed corporate governancemeans that the owners, as owners, select the man-agers of firms.They select managers that will carryout owners’ interests.

By contrast, the Communist Party tries to man-age career paths in a way that encourages commit-ment to the broader goals of the Chinese govern-ment, and the Party itself. The Party promotescareers that span individual companies or bureaucra-cies precisely for this reason.We see many examplesof these cross-company career paths in China today.During 2004, top executives at the big three state-run airlines in China were changed.All three chiefswere retired at the same time, and new heads

appointed, sometimes from different airlines. In thetelecom sector, top managers among the three topfirms, China Telecom, Unicom, and Netcom, wereshuffled among firms. Clearly, all these managersanswer to the same principal, and that principal, ulti-mately, is the Communist Party. These are not sim-ply isolated personnel choices adopted to cope withimmediate challenges:This inter-weaving of profes-sionals from various sectors into a single nationalcareer path is deeply embedded in the Party’s strat-egy for the current period.The most recent formalParty meeting (the Fourth Plenum in September2004) stressed the need to improve the Party’s gov-ernance capability.While this indicates a willingnessto make Party personnel decisions somewhat moreopen, more competitive and more professional, it iscoupled with a determination to continue Partycontrol over the personnel process.

CONCLUSION

All the above issue areas share a common feature.Progress in each area requires further institutionaliza-tion of the rights and responsibilities which havealready partially devolved to local actors. In eacharea, past progress has relied on a relatively informaland non-institutionalized mode of policy-makingthat is increasingly out of step with China’s moresophisticated economy. Complex corporations andfinancial institutions increasingly demand clearerlines of accountability, disclosure, and reward. China’spolicy-makers are challenged to provide those rulesand regulations and thus far have responded onlypartially and not yet adequately. What obstructsprogress? In part, of course, progress is slowed by thereluctance of individuals and interest groups whohave achieved substantial wealth and power withinthe existing system. In part, it is the absence of a clearlegitimating principle for wealth and power inde-pendent of Communist Party rule that makes it hardto articulate a set of principles supporting a regula-tory framework. This is particularly obvious in theprivatization process: although the Communist Partylong ago lost its zeal for public ownership, it has beenreluctant to acknowledge any competing rationalesunderneath an ownership system.

If the political system is unwilling to impose lim-its on its own discretionary power, then it is difficultto see how China can create robust economic insti-tutions that it needs. In the financial area, there is a

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significant and widely recognized danger of disrup-tion to China’s long-term growth process.The goodnews is that strong economic arguments in favor oflimiting discretionary power and establishing moresecure property rights may indeed persuade Chineseleaders to accept checks on the power of theCommunist Party. Repeatedly over the last twenty-five years, the needs of economic development havebeen given priority when it was absolutely neces-sary to do so. As Deng Xiaoping famously said,“Development is the only hard truth.” Moreover, ifprogress is made, it will be mutually reinforcing, andmove China rapidly toward a more efficient, middleincome developed market economy. What is atstake is the creation of a virtuous circle at a level ofsophistication much higher than China’s economytoday: broader, more diversified and more transpar-

ent financial markets; stronger, more diverse, inter-national competitive corporations; resolution of fis-cal obligations.These changes are required to vaultChina to the top ranks of world economies.

ENDNOTE

1.“Li Rongrong tan guoziwei jigou shezhi yu zhineng”(Li Rongrong discusses the creation of the State AssetCommission structure and capabilities), Xinhuawang(New China net) (transcript of press conference), May22, 2003, http://finance.sina.com.cn/g/20030522/1413343503.shtml; see also the ImplementingRegulations at PRC State Council,“Qiye guoyou zichanjiandu guanli zhanxing tiaolie” (Temporary regulationson the supervision and management of state-ownedenterprise assets), State Council Order 378, May 13,2003, http://www.sasac.gov.cn/zcpg/zcpg_0003.htm.

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