The Chinese Economic Reform

 

Juan Antonio Fernández

 

 

China is passing through massive transformation; from a command to a market economy, from an economy based on agriculture to one based on manufacturing and services, from one with high fertility and low longevity to one faced with OCDE style low fertility and high longevity, and from an economy that was almost totally closed to one that, today, even before her accession to the WTO, is much more open than most countries at the same level of income. This vast movement of transformation started on a very simple principle frequently stated by Deng Xioaping: “Poverty is not socialism”.  Prosperity was the new face of the socialism according to Deng Xiaoping’s famous dictum: to get rich is glorious. In the past socialism used to mean government planning, for the new China, it means common prosperity.

 

China offers us a unique opportunity to explore the causal relationships among economic, institutional, political, and social forces in an important transforming economy. In China’s economic transition important structural changes are occurring at the state and firm levels, and these changes have radical implications for the structure of economic and social life in China. Gradualism and stability were the foundations of the Chinese reform and continue to be so for the present leadership of the country. For the Chinese leaders economic reform has priority over political reform. They acknowledge that it would be impossible to accomplish anything in an environment of political unrest. The premature introduction of markets where there was neither a culture nor the institutions for dealing with them can have catastrophic effects. And from the results obtained, we can consider the Chinese as one of the most outstanding social transformations in human history, all this within a long period of stable and peaceful social environment, except for the Tinanmen Square demonstrations in June, 1989.

 

We must consider the enormity of the task facing China. Some figures can give a glimpse of the burden of the scale. The country has a total population of circa 1,300 million people distributed among 23 provinces (24 with Taiwan), 4 autonomous regions, 4 municipalities plus Hong Kong and Macau; 18 of those provinces have a population between 90 and 35 millions and they could be considered big countries in their own. China has more cities of 1 million-plus population than the rest of the world combined. Among China’s stated-owned enterprises there are 500 that employ more than 100,000 people, and her economy must create 10 million to 15 million new jobs every year.

 

Given China’s immense size and large population, the state structure is very complex. Authority is fragmented both horizontally (diverse departments) and vertically (diverse geographical levels) through the system has resulted in a negotiated state where local and individual institutions vary in nature depending on the relationship they have negotiated with other parts of the apparatus. Under the provinces, there is a three-level administrative network of prefectures, counties, and cities, and townships and districts. Government and party organizations paralleling one another. There are several levels of administrative levels for public enterprises: central government, provincial level and municipal level. Central and provincial government tend to preside over large, asset-intensive organizations, while medium and small companies tend to be under the control of municipal and district levels.

 

This complex administrative system of government organizations was set in place to mobilize firms and the individuals within them around directives issued from the central government. This system was an administrative decentralized governance structure that allowed the central government to promulgate policies down the hierarchy of government jurisdiction, relaying on local government offices to mobilize organizations and thereby people. The result of these policies was a “nested hierarchy” of government organizations spread throughout the country, each with jurisdiction over a smaller sector of the population. It is a dispersed bureaucratic system in which individuals hold immense capacity to circumvent formal regulations. The political center does not control the system throughout and there is significant deviation from central policy across bureaucracies and at the local level. In some sense, real politics in China is local politics. It is at the local level that problems have to be solved concerning economic policy and social equity.

 

Despite all the complications, several features of the Chinese economy in 1978 made it particularly ripe for change:

  1. The economic disruption of the Cultural Revolution, and that of the Great Leap Forward before, had undone many of the early economic benefits following the funding of the People’s Republic.

  2. China enjoyed the advantages of backwardness. More than two-thirds of the population lived in the countryside. For them, the uncertainties of the reform were less alarming than the difficulties of the present system. Agriculture’s surplus labor meant that rural industry could achieve rapid, uninterrupted growth for almost two decades without facing wage pressures.

  3. Planning was less entrenched in China than it has been in other transitional economies. So when commercial activities were legalized, Chinese entrepreneurs needed little encouragement to expand.

  4. China had always had a strong administrative capacity, especially at the provincial level. So, when reforms required administrative and financial decentralization, provincial governments were able to take on the new responsibilities.

  5. China had a skilled and disciplined labor force. The share of technicians and engineers in the industrial labor force was higher than in many newly industrializing economies of Southeast Asia.

  6.  The Chinese diaspora extended to virtually all corners of the world. Chinese minorities in several Southeast Asian countries had considerable economic power, and they figured prominently in the explosive growth of foreign direct investment in China.

 

The economic reform started in 1979 with a combination of regulation by plans and regulation by the market, to be followed latter by the implementation of the socialist market economy: reform of SOE, finance, taxation, pricing and foreign trade. As to the SOE reform, we can consider four stages: from 1979-83, some experimental initiatives were launched for SOEs: profit retention, performance related bonus and production outside the mandatory plan; from 1984-86, profit remittance was replaced by profit tax and SOEs were allowed to sell their output in excess of quotas on the free market; from 1987-92, the contract responsibility system was introduced with the objective to clarify the authority and responsibilities of the managers; finally, from 1993, the introduction of modern corporate systems has given SOEs further autonomy.

 

As a result of these reforms, there have been important changes in the state-firm relationship at the three levels: economic responsibility has been pushed down the hierarchy, administrative offices have become more economically oriented, and firms have independent budgets and self-responsibility policies. Managers are more responsible now for the economic health of the organizations over which they preside. However, the relatively easier reforms have now been completed. As the reform moves to the next stage and China integrates further into the world economy, there will be significant losers, including those workers and institutions that have formed the core of the CCP socialist system. We are witnessing the emergency of a new economic superpower, but still many questions remain open for the Chinese leaders.

 

The leaders of China face an enormous challenge. The country has survived remarkably well to date and has avoided the various doom-laden scenarios that have been offered abroad.  There is no alternative but to move ahead. Still many challenges: transform the state-owned sector without encountering major social unrest; provide a new framework for urban social welfare and rebuild the rural system; legislate for a growing private economy; find employment for some 200 million surplus laborers in the countryside. This list of challenges could overwhelm a government’s capacity, yet the Chinese leaders must deal with all of them at the same time. In her favor, China has the following advantages: a very large domestic market with great potential, a gigantic amount of cheap labor, high rate of savings, and the Chinese community worldwide. The role of the Chinese government is to make full use of these advantages. Since the latter half of the 90s China’s leadership has moved to a more comprehensive vision of the nature of reform and has begun to adopt a better sequencing for the reform program.

 

Impressive as China’s strengths are, they do not guarantee success. Much will depend on the ability and resolve of the authorities to maintain momentum of reforms. The World Bank in its report on the future of China pointed out several risks ahead. First, the link between banks and state enterprises; as the performance of the state enterprises weakens so do the state banks. Second, the nexus between enterprise reform, labor markets and inequality. Rising unemployment may discourage the government from pursuing state enterprise reforms vigorously. Unreformed state enterprise will go on paying excessive wages to a redundant work force. Again, this will impose a large fiscal burden on society. Third, the delayed enterprise reform could hamper efforts to clean the environment. Lastly, without reforms a broad range of needed public expenditures in health, education, infrastructure, and the environment would be jeopardized.

 

A key component for the success of the economic reform in general, and SOE reform in particular, is the restructuring of the banking and financial sector. In the 80s, financial reform was not really thought of as a part of economic reform. However, in the mid-90s reformers recognized the need for the overhaul of the sector and the necessity of cleaning up the banks’ bad debts. This was given extra urgency, first by the Asian Financial Crisis and then by the impending WTO entry. With the main role of state banks to feed the SOEs sector, they built up a huge portfolio of non-performing loans. Zhu Rongji set in motion a series of reforms designed to free the state banks from local politics, to allow the Central Bank to play more of a regulatory role, and to get the non-performing loans off the books of the banking system.

 

In 1994, the banking system was divided into three types of banks: commercial banks, policy banks and cooperative banks, with a limited but increasing role for private banks. The four major banks remained under the authority of the state but were given greater capacity to make loans on a commercial basis. These four banks (the Industrial and Commercial Bank, the Bank of China, the China Construction Bank, and the Agricultural Bank of China) account for up to 70 per cent of the domestic banking business and they employ together with the Bank of China a total of 1,760,000 people. The Agricultural Bank of China alone has 510,000 employees which makes it the biggest company in the world in number of employees.

 

Capital markets still remain small, the banks being the main source of financing in China. In 1998, with the onset of the Asian Financial Crisis, the reformers were able to push ahead with financial sector reform. First, the reorganization of the branches of the People’s Bank of China along regional lines to reduce political interference by powerful provincial party chiefs in lending decisions. Another measure was to move the non-performing loans off the books of the four major commercial banks and to recapitalize them. Asset Management Companies were created and the capital is provided by the Ministry of Finance. The AMCs are to acquire at face value loans from SOEs. The AMCs, were expected to recover those loans through debt-for-equity swaps. However, AMCs have little power to reorganize the SOEs.

 

Separating state enterprises and commercial banks from government is arguably the most immediate and important of all ongoing reforms in China. Her future lies with competitive and private firms in industry and services. In the financial sector this means government at all levels should stop interfering in the lending decisions of state commercial banks. Banks must begin to build trust, relationships, and information channels with non-state firms. They must establish systems for management information, risk evaluation, creditworthiness analysis, and provision for bad debts. In addition, a developed capital market is needed to allocate resources, diversify risk and raise returns to investors. These reforms should be matched by continuing reform of labor markets: social security system, labor mobility, more information about employment opportunities, better retraining of laid-off workers, and gradually removing restrictions on migration. Similarly, the government could meet environmental objectives through greater use of market mechanisms.

 

More market does not mean less government. It means different government. Government energies need to shift away from direct involvement in productive activities and toward two areas in particular: first, more spending on such priority areas as education, health care, agricultural research, infrastructure development, environmental protection, and support for the disadvantaged groups in society; second, the development of transparent and participatory institutions that promote the rule of law, and a stable economic environment. The World Bank report on the future of China offers a positive vision for the country: China in the 2020 can be competitive, and confident, having eliminated poverty as it is known today and promising a bright and healthy future for its children. It would be engaged with the rest of the world as an equal and responsible in trade and finance, built on modern institutions ands the rule of law. It would be a middle-income country that of the Republic of Korea, enjoying rapid and sustainable growth based on markets and private enterprise. As Mr. James D. Wolfensohn, President of the World Bank Group, recognized in his visit to China in 2002: “The progress since my last visit in 1995 is impressive, and remarkable in many sectors, and a strong signal to the world that with the right policies and determined leadership, real inroad could be made in reducing poverty. The simple fact is that more than 250 million people in the past 20 years have been lifted from poverty here. The problems confronting China have not been totally overcome – far from it – but the magnitude of this achievement in a single generation is such that other countries should learn from it.”

 

The reality is that China’s experiment with market reform has propelled her into the top 10 trading nations in the world. Over the past two decades, China has achieved the fastest economic growth of any national economy. If that growth continues, China could become the world’s largest economy during the first half of the 21st century. The World Bank estimates that by 2020 China could be the world second largest exporter and importer and its consumers may have a purchasing power larger than all of Europe’s. She is becoming the biggest economy in the planet with a population whose main objective in life is to become prosperous. The fact is that China is changing so fast that is difficult to keep abreast of developments. Furthermore, China is a maze of intricacies, complexities and contradictions. As Deng Xiaoping declared in 1985: “(The Chinese reform) is a great experiment, something that is not described in books.”