IntroductionCHAPTER 10: CHINA --REFORM IN PROCESS
contents:
The
"Evolutionary" Approach to Reform
Evolution of the Market
Economy
TOWNSHIP AND VILLAGE ENTERPRISES
CONFORMING TO THE EAST ASIAN MODEL FOR GROWTH
APPENDIX A: THE TRANSITION FROM PLANNED TO MARKET ECONOMY
Goods Markets
Labor Markets
Property Markets
Financial Markets
APPENDIX B: TRANSFORMATION OF CHINESE STATE-OWNED ENTERPRISES
The Chinese Command Economy Prior to Reform
The Legacy of Inefficiency
Internal Management Reforms
Privatization
APPENDIX C: CHINA JOINS THE WORLD TRADE ORGANIZATION (WTO)
Prior to the initiation of economic reforms in December 1978, China's participation in international trade and capital flows was severely constrained. Foreign exchange was under the control of the central government, which used an overvalued currency to support import-substitution policies. Imports and exports were prescribed by an overall plan and were channeled through centralized 'foreign trade corporations'. In 1977 China's share of world trade was only 0.6%, and there was virtually no foreign direct investment in China as their communist system precluded capitalist ownership and operations. China did not borrow significantly from either international agencies such as the World Bank (or commercial banks, which saved it from the so-called Third World Debt Crisis of the early 1980s!); nor was it even a member of GATT, the IMF and the World Bank. China received no significant foreign aid from Western countries and Japan. The legacy of Mao Zedong was still intact: self-sufficiency, ideological purity, and isolation.
Today China's modernization is establishing a dual model. First, it represents the first successful reform of communism and transition from a command economy to capitalism. Second, it is a model of Third World development rivaling the best performances among the East Asian so-called 'miracle economies'. China has studied the success of its neighbors carefully and mimicked their policies. According to the World Bank, some key features of the East Asian approach are land reform that creates wealth in the countryside; a transfer of profits and labor from agriculture to manufacturing; high savings rates to finance industrial investment; low taxes; development of human capital; relatively equal distribution of gains; vigorous domestic competition; and an openness to foreign investment and technology, plus an outward orientation which compels the economy to adhere to global standards of production. China's conformance to these miracle-criteria is examined here.
The "Evolutionary" Approach to Reform2
China adopted an 'evolutionary', or gradual trial-and-error approach to reform of its communist system, in contravention with the accepted approach advocated by most Western consultants. The dominant school of thought was the so-called 'big bang' approach, based on the notion that reforms had to be implemented quickly and according to a comprehensive program. This view was as follows: Without total and immediate reform, resistance presumably would build up over time --discipline could not be maintained among those who suffered from disruptions of the old ways. Furthermore, political and economic liberalism could not be compromised with half-way measures. Remnants of the old planning system would negate partial reforms. This big-bang view prevailed in Eastern Europe and the former Soviet Union; the result of reforms there was very low or negative growth rates during the late 1980s and early 1990s while the new economy was getting on track. With complete abandonment of communist institutions, interconnected enterprises lost their customers and suppliers and went out of business. Layoffs depressed national buying power; firms and individuals made low income and paid little tax. The entire economy in many East European countries collapsed. New institutions take time to be created, and some government direction of the process of building the new market economy would have been helpful, rather than the laissez faire approach that was favored.
China on the other hand began reforms a decade earlier than much of Eastern Europe, without the flood of advice from Western 'experts'. (Although Hungary, Poland and others had been experimenting with partial reforms since the 1960s, the overthrow of communist governments in 1989 meant an immediate embrace of liberalism and discontinuance of the planned economy.) China had no grand plan, only step-by-step changes, often initiated by provincial authorities or individual government agencies, spontaneously and without an established timetable. The key step that was to begin the cumulative process of reform was the elimination of the state's monopoly over the economy --to allow private capitalists to compete with the state, initially in the agricultural sector. Gradually reform was extended to other areas of the economy and to improvements in the performance of state-owned enterprises themselves. The process of change today is irreversible.
The first wave of reforms, initiated by Deng Xiaoping in late 1978, involved the agricultural sector. In 1978 and 1979 the government increased the prices it paid for agricultural outputs, leaving the structure of the communist system unchanged. The second step in agricultural reform, during 1980-84, was to abolish the agricultural communes and replace them with the so-called 'responsibility' system. Food prices were freed, except for grain, and farmers were allowed to put as much on the market as they could produce over the amount the state required for its own procurement.
Under the old commune system, peasants were organized into production teams. Individual incomes were based on work points assigned from rudimentary performance appraisal, but in practice the commune's earnings were distributed according to family size or needs. Thus the incentive to work was weak.
Under the responsibility system, plots of land were leased to households. While land remains state-owned, each peasant family essentially has its own plot of land. Other than a certain quota required to be produced for the state, households could decide themselves what crops to sow or animals to raise. Household income therefore depends on that household's efforts. The linking of effort to rewards resulted in spectacular increases in production.
Since the 1950s farming output per head had stayed level, at best. Freeing food prices and allowing market activity resulted immediately in a significant rise in output and productivity. Three-quarters of China's population were rural peasants, and the net effect of making them rich was to generate wealth that was used to finance industry in the countryside.
Simultaneously, the second wave of reforms was initiated: the open-door policy for foreign investment. This was facilitated by liberalization of foreign trade --allowing enterprises to import and export outside the plan, and decentralization of trade administration from the central government to provincial and lower levels. Initially four 'special economic zones' were set up, three in Guangdong province next to Hong Kong and another in Fujian province across the strait from Taiwan (Exhibit 10-1). These SEZs allowed foreign investors to operate outside the constraints of the 'command economy' --they could acquire property and build their factories, hire and fire, import equipment and export products, just like normal capitalist enterprise. It was necessary for China to pass requisite legislation for the SEZs, for example a Joint Venture Law that allowed capitalist ownership of the means of production, long forbidden in Marxist economies. The open-door policy resulted in the kind of export-led growth that was driving development in the rest of East Asia. Foreign investors primarily exported their products, as the Chinese economy beyond the SEZ was still largely closed (and anyway consumers were still poor).
Foreign direct investment (FDI) in China in 1978 was less than $300 million, and in 1991 FDI was $3.5 billion, with cumulative investment $22 billion. From 1992 FDI really took off -- FDI in both 1992 and 1993 more than doubled the previous year’s figures. In 2002 FDI was $53 billion, exceeding FDI in the United States for the first time. (See Exhibit 10-2 for overall trends.) By 2002 the stock of FDI in China had reached $445 billion, surpassed only by the United States and a handful of West European countries. Foreign investment has thus been China’s lifeblood, as well as the engine of a phenomenal growth in exports from $26 billion in 1985 to $266 billion in 2001. In the 1980s foreign-financed ventures accounted for under 10% of China’s exports; by 2001 that figure was nearly 50%. Foreigner investors are today actively setting up service businesses (earlier investments were almost entirely manufacturing) and even taking stakes in state-owned enterprises. Yaohan, a Japanese firm, has built one of Asia's biggest department stores in Shanghai; American International Group, an insurer, reopened shop in Shanghai after a 43-year absence. These multinational corporations invested in China for the domestic market demand, which today is fueling the regional export boom as well.
Taiwan and especially Hong Kong were the source of the earliest investment with over three-fifths of FDI through the mid-1990s. These investors have relations and good contacts in China (guanxi --connections), and they feel more at home with China's informal ways of doing business.
Exhibit 10-2 also shows how outward FDI from China pales in comparison to the inward flows. However, China is finally becoming a more significant global investor. In the first half of 2002 China’s outward FDI increased 217% from 2001. This FDI has been mainly by large state-owned enterprises which were now competing as commercial enterprises, but some smaller private firms were also among the top investors. Encouraged by the export competitiveness of its refrigerators, Haier Group set up overseas assembly plants for better access to the local market. It aims gradually to build (or buy) global brands. The state-owned firms sometimes invested abroad to give China access to natural resources. For instance, the big three oil firms, Sinopec, Petrochina and China National Offshore Oil Corporation (CNOOC) had invested in 14 countries by 2003. CNOOC is now Indonesia's largest offshore oil producer.
In 2003, China's biggest steelmaker Baosteel was planning the largest foreign manufacturing investment ever by a Chinese firm. Baosteel was negotiating to take a controlling stake, worth $1.5 billion, in a huge steel plant in Brazil. One motivation was to help it avoid anti-dumping actions that had cost it some $150m in lost exports in the previous six years.
Another motivation is to acquire foreign know-how. Huawei Technologies, a telecoms supplier headquartered in Shenzhen, established research facilities in Sweden, Germany and America.
Evolution of the Market Economy
A third wave of reform was largely sustained by the more deliberate steps of the first two phases. A market system was superimposed on industry and displaced the old command economy. This process is still ongoing. Four areas of change may be identified: 1. The role of state planning was reduced, even in state-owned enterprises; 2. market pricing was extended from agriculture to industry; 3. management procedures within state-owned enterprises have undergone a transformation; and, 4. perhaps most importantly, competition was allowed. (Some details on these reforms are elaborated below:)
1. Fewer goods are allocated by plan. The number of kinds of goods distributed by the planners decreased from 700 in 1978 to 20 by 1991. Also higher proportions of particular goods are bought and sold outside the planning framework. As long ago as 1989, 44% of inputs and 60% of outputs for the state sector were sold within the plan.
2. Market pricing was implemented by a dual-track formula (as with agricultural reform as well): a free-market price and a state-set price. Once a farmer or factory delivered the required quota to the state, the rest could be sold at the market price. Market prices gradually displaced administered pricing through an arbitrage process. For example, when market prices were higher than state-set prices (usually the case), production was stepped up, and when low only the quota was met and producers set about producing more profitable goods. When the state paid producers less than the market price, this effectively amounted to a tax on firms selling to the state. For the firm's decisions on production levels, purchasing, and investment, free market prices were the criteria at the margin. In other words, market prices became the relevant ones for marginal production. State-owned enterprises were forced to compete with private firms and with each other to sell on free markets. The state has been able to gradually reduce the goods subject to administered pricing or move the set price closer to the prevailing market price. (See Appendix A for an elaboration on the transition toward market pricing in the broad economy.)
Of course, dual prices led to arbitrage activities by corrupt officials as well, as insiders bought cheap from the state stores and sold dear on the market, or vice versa. The Chinese government has long been notorious for corruption --which can only be stemmed by finally removing the price disparities.
3. Management procedures are discussed within the context of an Appendix B on state-owned enterprises, later.
4. Competition has spread from the introduction of private enterprise, and from devolution of central control.
Provincial rivalry is intense, to share in the spectacular growth in China --since 1978 the fastest growing economy in the world. With decentralization of economic decision making, provinces strive to outdo each other in attracting investment, all hoping to match Guangdong's growth rates (13% a year from 1978 to 2000). Today even remote interior regions imitate the original SEZ formula with their own special investment zones and models of reform.
The biggest spur to market competition within China is the growth of private enterprise, particularly foreign investment and the domestic "township and village enterprises". State-owned enterprises themselves were compelled to become more competitive.
New entry by private entrepreneurs was generally facilitated by the numerous niches of opportunity for smaller firms as the state's monopoly was opened up. The scope for new market entry within the socialist economy was particularly wide because of two factors3: First, most state-owned enterprises were monolithic industries, with relatively few small enterprises present initially. Entrepreneurs, once allowed, could fill gaps left in the overall state apparatus. Second, the price system of socialist economies often deliberately conspires to raise profitability in manufacturing to shift resources in that direction. New entrepreneurs could exploit pre-existing price distortions.
In October 1992 a fourth wave of reform was endorsed by the 14th Communist Party Congress. This phase, called the Socialist Market Economy, is ongoing. It was the precursor to entry into the WTO nine years later, as talks had already began in 1986 to establish the conditions for WTO accession. Negotiations with the USA, Japan and the European Union were ongoing and provided a guide to what reforms were going to be necessary.
One item on the agenda was freer movement of factors of production. Labor is often the most inflexible of factors of production in terms of its global mobility; in China people still needed special paperwork just to move to another province. And interprovincial rivalry leads to protectionism between regions, often involving officials looking for bribes to remove obstacles to commerce.
Infrastructural deficiencies are on the agenda. The railway network is one of the world's smallest per capita, with one of the highest utilization rates for freight traffic; energy prices were kept low for so long that the sector suffers from underinvestment; and human capital has been neglected.
Organs of public administration need more transparency and predictability. China has always been governed by rulers, rather than laws. Arbitrary government decisions raise political risk for business. Accountability and the legal basis for decisions are often not spelled out. Weak laws covering contracts, property rights, etc are impediments to business.
As prices are released from government control, a taxation system is needed. Centrally planned economies do not have regularized taxation systems, rather taxation is implicit in administration of the price system.
The price system allowed the government to concentrate revenues in desired industries. Similarly, government finance in China has suffered as a result of losing its automatic right to direct investment and commandeer the profits of state-owned enterprise, to draw industrial surpluses into the state budget. Thus, price reform by itself entails an erosion in fiscal revenues. Without systematic taxation, taxes are negotiable between central and provincial governments and the enterprises. In the interim, budget reductions are needed.
With a 'big bang' approach, macroeconomic imbalances destabilize the entire economy --as happened in Eastern Europe. Also, existing price distortions and absence of taxes allow enterprises to acquire surpluses that are not viable in the long term, permitting for example overinvestment. Gradual reform of the price system, and allowing constant competitive pressure to move state-set prices in line, minimized the urgency of fiscal collapse in China.
On 1st June 1983 the government replaced profit remission with an income tax system. A tax rate of 55% was set for larger enterprises and a progressive tax schedule for small firms. A rudimentary value-added tax, land-use fees, and other taxes were introduced over time.
Financial institutions need revamping for a money economy, and monetary policy must accommodate a sustained increase in money demand. When supply and demand were matched by government fiat, money played a smaller role --some goods were allocated by coupon. Without a fully functioning market economy, household choice was severely limited. Money incomes were low with a substantial share of income received in the form of subsidies and benefits that were nonmonetary. Money's use as a medium of exchange was thus less than in a capitalist economy, and money holdings were lower. After reform, spending options increased, sometimes requiring savings. Household bank savings have increased from 6% of GNP in 1978 to 46% in 1991, and the high savings rate today allows individuals and firms to invest in financial assets.
Banks are graduating from policy loans to commercial credit decisions and more complicated financial instruments. As part of its reform of state-owned enterprises (SOEs), the government has indicated that the weakest SOEs will be allowed to go bankrupt; but even in the isolated cases where this has happened banks are unable to get much of their money back. Up to 80% of all working capital is from bank loans, and the government has mandated the banks to make new loans to allow the SOEs to pay off the old loans. Thus, widespread bankruptcies are unworkable for banks and unthinkable for a government worried about the political fallout from a sharp rise in unemployment.
The government appears to be reining in eager investment tendencies and credit expansion of local government, and getting a better grip on the rudiments of modern fiscal and monetary policy, with inflation during 2003 less than 1%. However, banks are still compelled to loan to loss-making SOEs, and the currency is still externally unconvertible.
With China’s entry into the World Trade Organization in 2001, the process of reform has become more compelling. Average tariff rates, which were 43% at the beginning of the fourth wave in 1992 and 15% just prior to WTO entry, were projected to decline to 9.4% by 2005. (See Exhibit 10-3.) Although some concessions were negotiated to allow more gradual adjustment, ultimately China must open its service sector including banking and finance, telecoms, and distribution. It is restructuring SOEs and creating social-welfare nets to catch the 5-million people being thrown out of work each year by these SOEs.
(See Appendix C about the impact of WTO membership.)
As a new entrepreneurial zeal was unleashed by the process of such dramatic reform in China, a new form of corporate organization was created by the former communist party cadres and other local leaders. The name given to this unique parastatal creation distinguishes its quasi-private, quasi-state character: the "township and village enterprises" (TVEs). There was no deliberate policy design --Deng Xiaoping later confessed he had no inkling of the rural industrial transformation that would follow the agricultural reforms. There is no doubt, however, that these new profit-seeking ventures within the old communist bureaucracy were the most dynamic force in China's economic revolution --with all due credit to foreign investors. Output of the TVEs grew 30% per annum during the 1980s and their exports increased 65% a year during the last half of the 1980s. Factor productivity was also growing by around 15%. By 1997, TVEs employed 135 million workers and contributed nearly half China's exports. Engaging in light industry, but also competing with the state-owned enterprises in heavy industry, TVEs transformed the countryside into a hive of manufacturing activity.
Ownership of TVEs is often a combination of local-government and private investment. Thus, most of the TVEs are controlled by heads of local government, party officials, and householders who started the business or invested in it. Formal shareholder control seems less important, however, than personal connections (guanxi) in insuring an enterprise will honor the claims on it. Local authorities may collect tax from TVEs, or go so far as to act as a holding company for TVEs in their jurisdiction.
TVEs operate in an environment that is largely unregulated, with neither budget allocations from the central government nor much access to bank credit, and employees have no job security. Managers are profit-motivated and cannot expect bail-outs or subsidy from local government, obviously, because operating results impinge directly on themselves and their community. Local public works, as well as employees' own livelihood, are largely dependent on revenues from TVEs. Earnings may be retained for investment, distributed to partners, or invested in local schools, roads and hospitals.
The Economist relates an illustrative case: "Xiao Shan, a county seat half an hour from Hangzhou, capital of Zhejiang province, presides over immaculate green fields watered by streams on whose banks well-off peasants have begun building houses that look as spacious and comfortable as those of rural France. Xiao Shan is one of the ten richest of China's 2,200 counties. Last year its 1.2m people generated output (excluding services) worth 10.5 billion yuan --the seventh-biggest output, according to the local planners, of any county in China. Of that, 900m yuan came from farming, the rest from industry. Since the reforms began in the early 1980s, industrial output has grown by an average of 30% a year...
"Ten years ago Xiao Shan's output was mainly agricultural, with traditional lace embroidery as the big industrial product. As the decade went on, Xiao Shan shifted into cotton yarn, cloth and shirts. It now makes electrical machinery, universal joints for vehicles and precision presses. At the beginning Xiao Shan was mostly self-contained: it procured raw materials locally, processed them locally and sold the output locally. It gradually expanded its field of operations, first within China and then overseas. In 1981 Xiao Shan exported $15m-worth of goods. Exports have since grown by 35% a year, and now find buyers in 80 countries. Last year exports reached $150m in value, this year $200m." (pp 12-13)
Although TVEs are the second-largest sector of the economy after state-owned enterprises (The Economist 30 Sept 2000), their role may be gradually diminishing. Two major reasons can be identified for the relative decline. First, China's efforts to reduce non-performing loans in the banking system has tightened credit, which was anyway very difficult for the private sector to obtain, especially TVEs which often had not established good credit ratings. But fundamentally, it has to do with the quite unsophisticated nature of these enterprises, under township and village management and control. Like many other conglomerates in developing countries, globalization is forcing a new focus on 'core competence'.
CONFORMING TO THE EAST ASIAN MODEL FOR GROWTH
The World Bank outlined factors that it believed propelled growth in East Asia, which were summarized briefly at the outset of this chapter. China's own model is very similar. Reforms in agriculture sparked the original explosion of wealth and investment. High literacy, resulting from emphasis on primary and secondary rather than tertiary education, has been a major factor facilitating productivity gains. Export orientation and openness to foreign investment helped Chinese industry improve productivity through adopting international standards of technology.
Wealth has been broadly shared because it was the poor peasants who originally benefited from China's reforms. China during the 1980s succeeded in lifting a larger share of its absolutely poor population out of poverty in a shorter period than any other nation. (However, there are uncomfortable disparities among regions and classes of people. The gap in living standards between those who benefited most from reforms and those left behind continues to undermine support for additional reform. Also, rampant corruption reduces societal tolerance for income inequality.)
The question remains: Can China continue in the footsteps of East Asia to actually catch up and become a high-performing economy?
Agricultural growth is constrained by a very low level of arable land per worker. The extent of public ownership of investment, and the fact that China's banking system has financed this investment, create an accumulating problem. Restructuring of the state-owned enterprise (SOE) sector, including the privatization of some enterprises, is a major priority of the government, as is restructuring of the banking sector.
Many Chinese banks have had to write off large amounts of delinquent debts from SOEs. A common suggestion is to isolate non-performing loans in a newly created institution and convert the banks to operate on commercial principles, but the banks lack experience and sufficient capitalization to operate on their own. Anyway there is real doubt the bureaucrats would let them function independently as long as they remain state-owned.
Layoffs have been part of the restructuring of the SOEs, as many were severely overstaffed. This has created unemployment despite an otherwise booming economy. Urban unemployment was estimated at roughly 10% in 2002, with further substantial unemployment and underemployment in rural areas. Unemployment also has been a burden on the government budget, as the government begins to provide social benefits which were previously the responsibility of the SOEs.
Another problem is China's high dependence on foreign investment, and the fact that most exports are from foreign-invested firms. Foreign-invested firms accounted for nearly 50% of exports in 2001. TVEs accounted for most of the rest, with state-owned enterprises only modest contributors despite accounting for about half the output. A large portion of China's industry may not be participating in the external economy, thus not part of the productivity growth.
Despite the onerous problems, China’s progress in the last quarter century has been spectacular, if not a “miracle”. The government first switched to a system of household and village responsibility in agriculture in place of the communist collectives, increased the authority of local officials and plant managers in industry, permitted private enterprises in services and light manufacturing, and opened the economy to increased foreign trade and investment. The result has been a quadrupling of GDP since 1978. In 2002, with its 1.3 billion people but a GDP of just $4,400 per capita, China was the second-largest economy in the world after the US (measured on a purchasing power parity basis).
APPENDIX A: THE TRANSITION FROM PLANNED TO MARKET ECONOMY5
Creating markets to replace direct government allocation is not an automatic or straightforward process. In its ongoing transition process to developing effective markets, China is a model of success --in contrast to some Eastern Europe countries which suffered a great deal from a very painful transition. This Appendix is a summary of progress in various areas.
One of the classic distortions in planned economies is the irrationality of prices. Prices bear little relation to either costs or demand, resulting in misallocation of resources. If prices have no cost basis, profit rates become very erratic. In 1980 profit rates in Chinese industry ranged from 7% to 98%; by 1989 profit rates were between 8% and 23%.
Before reforms, state-owned enterprises were required to sell all output and acquire all inputs through the bureaucracy at state-administered prices. Reforms allowed private competitors to enter market niches, offering goods and services outside the state procurement system; and state-owned firms were allowed to buy and sell beyond quota levels on the emerging free markets.
Goods Markets
Although the Communist Party during the Cultural Revolution had attempted to eradicate any vestige of market practices, by 1978 more than 33000 rural commodity markets had survived. Between 1978-1992 the number of markets doubled and transaction volume soared from under 13 billion yuan to 353 billion yuan. In 1992 coupon rationing for grains and edible vegetable oil, in effect since 1955, was abolished in most urban areas.
In 1984 the government sanctioned the dual-track pricing system for industrial goods. Market pricing did not displace state pricing quickly because there was no pre-existing market outside the state's own distribution system, as had existed in the agricultural sector. Initially a market price ceiling was set 20% above the state price (but abandoned in 1985). By the 1990s the government was able to eliminate planned prices for most machinery and equipment.
In 1992 pricing reform extended to energy. Coal and crude oil had been among the most underpriced commodities, i.e., the ratio of market to state price was high, so bridging the pricing gap was more difficult. The share that producers were forced to sell to state-designated users was cut and a higher state price set. For coal this resulted in 3/4 of all sales at market prices by 1994.
Similarly, passenger fares for air, train and sea transport were doubled in 1989, and railway freight rates were raised by more than a third in June 1992. Prices had been level since the 1950s, and rising operating costs were resulting in large losses in the transport industry. Price reforms enabled firms to invest in improving services.
In summary, between 1978-93 the share of sales at state-fixed prices decreased from 97% to 5% for retail commodities, 94% to 10% for agricultural goods, and 100% to 15% for capital goods.
Concerning traded goods, prior to 1978 internal prices were essentially independent of world prices. For exports, monolithic government foreign trade corporations (FTCs) acquired goods internally at state-set prices and sold them on the world market at prevailing prices. Exports originally were only for the purpose of financing imports of goods that could not be produced domestically under the plan. Imports were sold internally at state-set prices, where the pricing guideline was comparable domestic goods.
By the 1990s, the prices of goods that were imported were set closer to the import price converted to renminbi at the official rate. Thus, domestic prices were influenced by world prices and the exchange rate.
Decentralization of control by government increased the number of authorised foreign trade companies from about a dozen in 1978 to 3700 by August 1991. Elimination of the central government's foreign trade monopoly meant that Chinese exporters could shop for the best price.
Labor Markets
At state-owned enterprises wages are still often set according to official pay scales. Labor turnover was only 0.8% in 1988 in the state sector, partly explained by the broad range of benefits and social services for employees. Pensions are structured in a way that changing companies penalizes employees in their future benefits. Housing provided is also job-connected --quitting means loss of housing as well. Other services like day care, medical care, and sometimes hospital care are provided in facilities owned and staffed by the industrial enterprises. Also, the Chinese government, to protect against large-scale urban unemployment, places limits on their enterprises' ability to reduce overstaffing. This combination of circumstances has actually increased employment levels in state-owned industrial enterprises from 31 million in 1978 to 45 million by 1993.
Only in the countryside, with its flourishing private sector is there a fully functioning labor market.
Property Markets
In the countryside, dissolution of the communes was supplanted by a leasing system to transfer land to farmers. To provide incentives for farmers to improve their land, gradually the government allowed longer-term leases and made them formally transferable. Officially sanctioned markets for leased land emerged in the early 1980s, although informal transfers were more frequent.
Until April 1988, the sale, lease, or "unlawful" transfer of urban land were banned by the Chinese constitution. Real estate markets have since been emerging in the urban areas as the government introduced land leasing, with registration procedures for building rights. Real estate development has been flourishing since the 1990s --in Shanghai 445 land leases were granted in 1994, compared with only 12 between 1988 and 1991.6 Valuation is variously revealed in official lease contracts, unofficial (black market) transactions, prices involved in redevelopment projects, value of land transferred as a result of bankruptcy, etc.
Financial Markets
Under the old command economy, enterprises had their profits largely requisitioned by the government treasury, which in turn reallocated resources according to investment priorities established in the planning process. Banks loans were used primarily for working capital needs. By the 1990s firms were keeping their own retained earnings to finance their own investment, and utilizing bank credit as well. Only major infrastructure and other government projects were still financed through the state budget. However, government officials still fix quotas for the volume of bank loans and often approve particular loans. Banks have accumulated large portfolios of non-performing loans that are routinely rolled over.
APPENDIX B: TRANSFORMATION OF CHINESE STATE-OWNED ENTERPRISES
The Chinese Command Economy Prior to Reform7
Since the introduction of the first Five Year Plan in 1953, SOEs8 were under total control and direction of a central plan which encompassed as much as possible the entire economy. The state was the only investor, owner, employer, and financier. The state planned and directed all its enterprises --providing land, materials, personnel, plant, equipment, capital and everything else for operations. It also set prices regardless of cost or quality. Profits were remitted to, and losses covered by, the state treasury.
Enterprises were under a bureaucratic hierarchy according to industry, starting from central government industrial ministries and extending down to provincial and city bureaus. Decision making alternated between centralization and decentralization --e.g., during the Great Leap Forward of 1958, 80% of SOEs were assigned to local jurisdictions. In either case, enterprise autonomy was never granted. Often there was a problem of administrative conflict in determining enterprise goals --too many mothers-in-law. Levels of bureaucracy grew, and managers became more risk averse, simply reacting to instructions from above.
Efforts were made to prevent emergence of spontaneous markets to match supply and demand. Apart from some markets for consumer products, all markets for material, capital, labor, technology, etc were within state administration. Resources were misallocated, ending up in unneeded stockpiles or causing chronic shortages of the same products in different locations. Shortages of supplies of consumer goods required state-imposed rationing for basic essentials including grain, vegetable oil, sugar, meat, cotton cloth, soap, and others.
Banks were simply an extension of the state, to allocate funds or offer credit at very low interest rates.
Managers were effectively government officials since they were government-appointed. Wage rates were set by the state, and SOEs were not free to allocate income to augment wages according to performance. Even before the egalitarian ideological extremism of the Cultural Revolution, the ratio between the highest and lowest wage in industrial enterprise was only 3 to 1.
The Legacy of Inefficiency
Managerial and organizational development of SOEs was severely constrained under communism. All productive activities were directed by the plan and by administrative ordinance. SOEs became part of the bureaucracy, with little management prerogatives.
The Economist (1992:9) tells the story of a typical SOE: "The Wuhan Iron and Steel Company, 1000km inland from Shanghai on the banks of the Yangzi river, is anyone's worst nightmare of a communist industrial firm. Its 120,000 employees produce 4.6m tons of iron and steel a year, making it China's second-biggest metallurgy company. To reach the blast furnaces, you drive for miles through the acrid air of the company's 'plantation': a city of 300,000 people who depend on the company not simply for a wage but for their housing (the plantation contains 2.4m square meters of residential space), their education (there are 47 schools) and their health care (a 2000-bed hospital). The firm claims, vaguely, to be profitable. This seems improbable, since 80% of its output is sold at government fixed prices and the company sells only 2% of its output itself."
Such firms are predictably inefficient. Besides the fact that their profits were seldom measured by acceptable accounting principles, they are concerned with much broader purposes of social welfare than the simple profit motive. Wuhan Co was compelled by the state to stay in business because so many people are entirely dependent on it. Furthermore, the company management reported to bureaucrats rather than to profit-motivated shareholders. They are geared toward meeting the demands of the bureaucracy rather than customers. Their production goals were quantity targets rather than quality control.
Chinese SOEs can still depend on government financing and subsidies to keep them going despite losses. Non-market financing leads to non-market investment, i.e., investment for returns below the market cost of capital. Overinvestment contributes to the escalation of losses.
However, performance can improve. Forty percent of losses in 1989 were accounted for by coal and oil companies, which had suffered until then from artificially low prices. These and other structural imbalances facing the SOEs are being remedied, especially as a result of WTO membership.
Internal Management Reforms
Management has been changing by necessity to accommodate the new reality of market rather than bureaucratic transactions. To point out how the procedures differ, consider the following areas of management:
marketing-- For buying and selling outside the plan, SOEs needed to manage the '4 Ps'. Market pricing policy had to be developed, obviously. Promotion and advertising became necessary --in the early days advertising was so rare that the general view was often that any product needing advertising must be no good. Channels of distribution outside the bureaucracy were non-existent and offered new opportunities for entrepreneurs to set up outlets, transport, etc. Market competition for products means product quality control becomes important, as does packaging.
finance and accounting-- Since earnings (after taxes) are now retained in the firm, these funds need to be managed. It was typical until recently in China that increased profits did not go to 'retained earnings' because they might be confiscated by the government. Now these funds are used for internal financing of investment. Add external funds raised through banks or other financing, and eureka: financial leverage has been discovered, to exploit a wider variety of investment channels including financial assets. In a broader sense, mergers and acquisitions are possible (with the approval of state owners).
Accounting parameters widen considerably. Before, interest, depreciation, rentals, and many other items of expenditure, etc may simply not have been accounted for.
personnel-- Labor contracts have been developed to replace the old 'three irons': 'iron chair', 'iron wage', and 'iron rice bowl'. In other words, as lifetime employment, equal wages, and social welfare are being phased out, the basis of hiring and work performance is increasingly by contractual agreement that stipulates rights and responsibilities on both sides. This is all the more striking a development in China, with their weak tradition of rule by law.
The state still controls to some extent the total sums and general level of wages, but SOEs can augment wages from income. Thus, bonuses increase with income --pay is being used as an incentive.
Enterprises now hire and fire, promote and demote, more on market terms. Job turnover, especially for managers, is increasing, though lifetime employment still applies for many workers.
Managers are selected on commercial rather than political grounds. Top managers may have to agree performance targets in their employment contract. The Economist (p11) reports that managers have been required to post large bonds (8500 yuan --half a year's managerial salary) that have been forfeited in instances where performance targets were not met. Towards the end of the 1980s, the practice emerged of auctioning top management positions --bidders vied on the basis of promised performance. Thus, instead of auctioning firms (privatization), the government auctions the jobs.
factory operations-- According to Chen(1995), 80% of the industrial sector operates outside the planning system. Thus, production decisions are largely removed from the bureaucracy to the enterprise level. Production planning broadens in scope, ranging from budgeting, to long-term planning and strategy formulation, development of management objectives and business policy, etc. With freedom to pursue the best means for planning, organization and control, SOEs can adopt modern practices.
Where the SOE is still governed by the plan, contractual responsibility is replacing government directives.
Privatization
Privatization has not been the solution of choice in China. Rather, the government hopes the firms will gradually be displaced by the more rapidly growing private sector. Actual transfer of SOEs to private investors would invite rationalization of unproductive operations and overstaffing, and China has not been willing to face the unemployment and de-commissioning of assets that would certainly be entailed (as happened in Russia).
The formula for privatization in more developed economies, such as in Western Europe and some countries of East Asia, is the flotation of shares that can be bought or sold on a share market. Whether these shares are in the hands of private investors or the state itself, freely tradable shares provide the essential means of separating ownership from management --requiring management to improve profitability to maximize shareholder wealth. This formula will not work well, however, if share markets are undeveloped or if the enterprise is such a poor investment that it cannot attract buyers --as in the case of most Chinese SOEs.
China anyway wants to avoid the privatization experience of Russia and much of Eastern Europe. In the absence of willing investors, valuable firms were sold for a song. State assets were looted by management and workers, a process called 'spontaneous privatization'.
A form of privatization has been allowed: takeover by foreign or other non-state investors. A controlling interest usually allows the foreign partners to reduce overstaffing --and often simultaneously raising wages, bonuses and other incentives. Dismissed workers, in theory, should be able to take advantage of the improvement in economic efficiency to get new jobs cropping up elsewhere.
Another SOE in Wuhan is illustrative. Wuhan Cityford Dyeing & Printing was created by the June 1991 takeover by a Hong Kong firm of the former SOE, Wuhan No 2 Dyeing & Printing. The Hong Kong partner agreed to absorb only 1/3 of the workforce, who would be paid around 320 yuan a month (then $58), nearly three times their former wage. Performance-related bonuses and fines for negligent work were instituted. Output was mostly diverted from the domestic to overseas markets. Dismissed workers found new work servicing the new company with catering, shops and guesthouses; others went home to their company housing, now supported by city government.
The gradual displacement of SOEs in the Chinese economy is illustrated by figures in The Economist (“The longer march,” 30 September 2000): In 1978 the SOEs' share of industrial output was 75%, which in 2000 had declined to 28%. However, they still provided 44% of urban employment, 70% of government revenues, and 80% of bank loans.
APPENDIX C: CHINA JOINS THE WORLD TRADE ORGANIZATION (WTO)
REFERENCES
1 Baxter, M. And M.A. Kouparitsas 2000, “What Causes Fluctuations in the Terms of Trade?” NBER Working Paper 7462.
2 Chen Min 1995, Asian Management Systems: Chinese, Japanese and Korean Styles of Business, London: Routledge
3 The Economist, 28 November 1992, "When China wakes: A Survey of China", 16pp
4 The Economist, 13 June 2002, "A dragon out of puff: A Survey of China"
5 Edwards S. 1990, “Capital Flows, Foreign Direct Investment and Debt-Equity Swaps in Developing Countries,” NBER Working Paper No. 3497.
6 Ghosh, M. & J. Whalley 2000, “State-Owned Enterprises, Shrinking and Trade Liberalisation,” NBER Working Paper 7696.
7 Lardy, Nicholas R 1994, China in the World Economy, Washington DC: Institute for International Economics
8 Lardy, Nicholas R, September 1998 China’s Unfinished Economic Revolution, The Brookings Institution
9 McMillan, John & Barry Naughton, "How to Reform a Planned Economy: Lessons from China", Oxford Review of Economic Policy, Vol 8 No 1 1992, 130-143
10 Samsung Economic Research Institute, “China’s WTO Entry and the Impact,” November 2001 Issue Paper, 15 November
Discussion draws on Nicholas R Lardy, 1994: "Introduction" (Chapter 1 pp 1-28), and 1998; John McMillan & Barry Naughton 1992; The Economist, 28 November 1992; and The Economist, 13 June 2002. McMillan and Naughton (1992) McMillan & Naughton p133 Discussion draws on The Economist, 28 November 1992, 11-13; and The Economist 13 June 2002. Discussion draws on Nicholas R Lardy, 1994 pp 8-14. Yuming Fu, "Urban Land in China's Economic Reform", City Economist, Newsletter of Department of Economics and Finance, City University of Hong Kong, August 1996 7. Discussion draws on Chen Min, "The Evolving Environment of the Chinese State Enterprises" (Chapter 8 pp113-118), Asian Management Systems: Chinese, Japanese and Korean Styles of Business, London: Routledge, 1995. The acronym 'SOE' will be used to designate 'state-owned enterprise'.