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China's Economy: 60 Years of Progress (Part IV)

10-09 08:30 Caijing

Comprehensive Reforms, 1994 to 2009. As reforms deepened, a battle between pro- and anti-reform factions became increasingly fierce.

By Wu Jinglian

Related article: China's Economy: 60 Years of Progress 
                     China's Economy: 60 Years of Progress (Part II)
            China's Economy: 60 Years of Progress (Part III)

(Caijing Magazine) Two tracks -- state-based and market-based -- persist in the economy today, suggesting a high degree of inefficiency in public sectors, and that pricing is not entirely based on the market. Remnants of the planned economy permeate, and ways these conflict with China's market economy and private ownership system are becoming increasingly evident.

China's economic reform strategy has shifted from incremental to comprehensive. This is a necessary course for a new era. Primary reform measures have included a "double-track" pricing system as well as bold reforms for SOEs. These reforms have achieved some success and provided crucial contributions to China's rapid development. But due to a variety of factors, implementation of certain measures is lagging, burdening the reform movement. Immense challenges remain.

Reforms for many key industries in the national economy such as energy, telecoms, banking and oil are difficult to implement. Energy prices, interest rates and exchange rates are still tightly regulated by the central government and, thus, cannot accurately reflect levels of scarcity. This negatively influences the efficiency of resource allocation. An even more serious problem is that the central government and state-owned entities still control most of the nation's resources. This is out of line with market economy modes of production. As a result, we see examples of the nation benefiting while the people lose.

Years of experience, through trial and error, have proven that unless reforms are thoroughly implemented, vested interests rise and become major obstacles to progress. This in turn leads to a variety of social problems including corruption, rent-seeking and social inequity. The government is often forced to further deepen reforms to resolve these problems. Now, since reform has reached an advanced stage, delays can no longer be tolerated.

In the mid-1980s, as conflicts between reform and the planned economy intensified, support grew for shifting from a partial market reform policy to more comprehensive reforms. Finally, with leadership support, the policies turned comprehensive in 1986.
Testing the Waters

During this new phase, reform policies extended to state-owned entities, and moved to an urban from rural focus. Measures encouraging a more complete pricing system emphasized market mechanisms, taxation and accounting. The aim expanded from strictly economic to include political reform. These measures made major headway, especially in restructuring ownership rights and establishing a macroeconomic system. However, due to unexpected events and reform-blocking moves by certain vested interests, economic and political reform experienced a major setback. Expectations went unmet, making future reforms even more difficult.

Deng Xiaoping was a firm advocate of incremental reform, but he wasn't satisfied with accomplishments of the early period. While sectors of the economy outside state control could function as a center of support for thorough reform, Deng offered a new reform strategy by pushing for updating SOE reform requirements. In October 1984, the Third Plenary Session of the 12th CPC Central Committee convened and approved the CPC Central Committee Economic System Reform Resolution. The strategy had changed.

In early 1986, then-prime minister Zhao Ziyang called for a complete set of reforms focusing on pricing mechanisms, tax schemes and accounting. By April, the council established an office dedicated to designing and planning economic reforms. This office, under direct leadership from the council and the CPC Central Committee Finance and Economics Leadership Group, drafted the Seventh Five-Year Plan for reform, focusing on pricing mechanisms, accounting, finance and trade. Pricing mechanisms were to adopt methods similar to those implemented in Czechoslovakia in 1967 and '68, using a policy based on a gradual reform course. A new motto was "first adjust, then set free." The plan's first step was across-the-board price adjustments. Later, perhaps in a year or two, the market would gradually be allowed to determine prices.

As for taxation, primary measures included a change from the established revenue sharing to a tax sharing system, along with introduction of value-added taxes.

Deng praised the reform plan and called for its immediate implementation. It was approved by the council in August 1986 and took effect the following January 1. Deng also called for political reforms focusing on separating party and government functions, and letting China's political system adapt to demands of a market economy.

Yet the two tracks remained. Double-track pricing meant a continuing legacy of "state syndicate" government control of resource allocation, creating friction and building pressure. To remove this legacy, a complete set of reforms had to be thoroughly implemented. Deng, because he recognized the importance of economic and political reform, made these top priorities in 1986. He said, "Without accompanying political reforms, we cannot guarantee the success of economic reform, and we cannot continue to move forward with progress. Productivity will be hindered, as will the realization of the Four Modernizations." Regretfully, these reform measures were not successfully implemented at the time.

Academic and government leaders have often held differing views of economic reform. Early on, State Council leaders insisted on a complete reform focusing on pricing, taxes and accounting. But in October 1986, the council shifted to reforming SOEs, implementing the "chengbao" (contract) system over the next two years, and returning once again to the old, two-track method. This sidetracked an opportunity to advance comprehensive reform, leading to an intensification of administrative corruption, inflation and social problems, and it was ended by a market panic in 1988 and political crisis the following year.

Some politicians and academics blamed market reforms for the 1988 crisis and 1989 political turmoil, saying getting rid of the planned economy to make way for a market economy had actually transformed the system to capitalism from socialism. As a result, old ways of thinking were revived. Only after Deng promoted further reforms in a speech while touring southern China in 1992 did the government welcome a new wave for reform and opening up.

A resolution passed by the Third Plenary Session of the 14th CPC Central Committee in early 1994 led to new measures for taxation, finance, foreign-exchange controls, enterprise regulation, social security and SOEs. This was a renewed push for economic reform. At the same time, the State Council launched an experiment in modern enterprise institutional reform aimed at implementing the program on a wide scale after testing the waters. Exchange rate controls were initially the most successful of the reforms, as China reached a goal to manage a floating exchange rate. Measures on finance and taxation also moved ahead, on schedule. But some measures, such as SOE reform, failed to match demands of a market economy.

By the mid-1990s, progress was in place with a new macroeconomic system. Ownership was restructured as well. This was reflected by a noticeable shift in economic activities that had been entirely state-owned. By that time, the proportion of state-owned entities with national economic influence had declined substantially. However, in terms of establishing a base foundation for a market system of property ownership, reform measures had yet to peak. In 1993, even though state-owned or state-controlled entities accounted for less than half of China's gross domestic product, the government and SOEs were still primary allocators of scarce resources. In terms of capital, state-owned entities controlled 70 percent of the credit market. In addition, because of the government and SOEs dominated the economy, it was difficult to implement sound reforms in areas of finance and taxation.

The fundamental reason was that, under the old planned economy, the state syndicate that Vladimir Lenin once referred to in The State and Revolution – also known as Party-State Inc. -- was at the very core of the system. Hence, it was difficult for many to come to terms with a free market system based on private enterprise. Supporters of the old system and those with vested interests continued using all kinds of excuses (including political excuses) to hinder reform and restructuring of state-owned entities. Reform again met significant resistance.
New Century

As reforms deepened, a battle between pro- and anti-reform factions became increasingly fierce. To a certain extent, later reform measures were far more difficult to implement than those from the early period. Most resistance to early reforms stemmed from ideological differences, while later struggles revolved around vested interests. Early reform measures were characterized by Pareto improvements in the economy, whereas later reforms had the potential to damage those with vested interests in the status quo. Promoting political and monopoly SOE reforms meant the government had to point a finger at itself. Because of this, reform attempts reached new levels of complexity, and implementation's pace noticeably slowed.

The 15th National Congress of the CPC in 1997 saw important breakthroughs in terms of state property ownership reform. The assembly mandated restructuring of ownership and established a long-term basis for a new system. It also drafted a constitutional amendment to implement these measures.

The restructuring had three primary components. First, the state-owned economy's scale was to be reduced through privatization, and state capital was to be withdrawn from key branches of the economy. In addition, various methods for accelerating productivity and development through public ownership (as a means of production) would be sought. Finally, non-public sectors of the economy were declared an important part of a socialist market economy, and the development of individual, private enterprises was encouraged.

One clear improvement was the system of ownership, as the development focus shifted to multifaceted enterprises from an exclusive focus on state-owned sectors. Alongside a small number of monopolized industries, private enterprises began occupying more dominant market positions. And in terms of employment, private enterprise became the main force: The percentage of Chinese workers employed by private enterprises reached 72 percent in 2006.

Second, state-owned economic sectors saw reform progress. The main signs of this included SOEs changing from a structure-based system with complete capital control by the state to an enterprise system based on diversified shareholding. Presently, outside the banking sector, most second-tier SOEs have reorganized and become companies in which the government is a majority shareholder. Among banks, the 21st century has seen overseas public listings for four, major state-owned commercial banks so far, providing a solid and necessary foundation for China's financial industry. And share diversification provided a basic framework for a new system of corporate governance among enterprises.

Although China established a basic market economy framework before the turn of the century, the system was still missing a number of key elements. Missing were a functioning financial market and a legal system based on market needs. Hence, original goals for a new economy remained distant. For this reason, in 2003 the Third Plenary Session of the 16th CPC Central Committee passed a resolution to correct certain problems with the socialist market economy. Implementation of this policy met some resistance. And as reforms slowed, a new sense of uncertainty emerged.

Mandates from the 15th National Congress of the CPC and the Fourth Plenary Session of the 15th CPC Central Committee markedly improved the overall balance and distribution of state-owned sectors of the economy, as well as SOE share restructuring. By the early 21st century, most small- and medium-sized SOEs, including various town and township enterprises under government control, had undergone extensive restructuring. Most enterprises became wholly owned or incorporated companies. But the wheels turned more slowly when the reform train reached state-owned monopolies in the oil, banking and telecom industries.
New controversies surround whether certain crucial state-controlled industries should move forward with privatization, or slide back. Some argue the portion of state ownership in certain industries should be increased. In 2003, a group of officials from the State-owned Assets Supervision and Administration Commission announced that a state-controlled economy was a foundation for CPC governance, sparking sharp ideological debate. Even though the CPC position was clarified in 2004, a certain amount of support for this ideology still exists today. After a dispute over the general direction of market reforms in 2004, the media started referring to "increased nationalization" and "new nationalization."

This reverse trend took shape in two ways. Private enterprises allowed to operate in certain sectors of the economy were kicked out. In addition, some wholly state-owned and state-controlled (through majority shareholding) enterprises began acquiring small- and medium-sized private enterprises, strengthening monopolies.

At this time, the central government began administrative intervention in the microeconomic activities of enterprises, increasing macroeconomic regulation.

In the fourth quarter 2003, China's economy began to overheat. In response, central authorities adopted a series of cooling measures, focusing on macroeconomic steps. When an economy overheats, namely in a situation in which aggregate demand greatly exceeds aggregate supply, the government should regulate the economy indirectly, such as by adjusting exchange rate policies and reserve fund ratios according to market conventions. Of course, since China's market reforms were incomplete, further administrative measures such as window guidance for bank credit were needed. Yet these measures should only be supportive and, during implementation, the government should admit limitations and possible side effects.

However, at the time, after analyzing macroeconomic trends, the overall consensus was that China had experienced only a partial overheating. Thus, the government's main administrative measures were aimed only at curbing investment in overheated sectors of the economy such as steel, aluminum and cement. From that time forward, the party's formal guiding principle became "macroeconomic regulation primarily though administrative regulation."

Following this ideology, all levels of government gradually increased their intervention levels and control over the microeconomy, but under the auspices of macroeconomic regulation. This increased the government's abilities and strength in resource allocation, effectively weakening the fundamentals of market-based resource allocation. A trend developed that reflected what Britain's Lord Acton once said: "Power tends to corrupt, and absolute power corrupts absolutely." As administrative power expanded, so did rent-seeking and corruption.

Political reforms also lagged. Deng delivered a famous speech in 1980 that called for a new wave of political reform. At the time, he was launching nationwide rural contracting reform. Six years later, he said it would be very difficult to effectively implement economic reforms unless China also adopted additional political reforms. But Deng's calls went unheeded. A new generation of leaders raised the political reform issue again after his death, at a memorial held in his honor. In 1997, during the 15th National Congress of the CPC, party leaders called for a thorough legal system under socialism. Five years later, during the 16th National Congress of the CPC, political reforms were advocated again. They even raised the issue of certain democratic reforms.

Still, very little progress has been made over the past decade. For example, 13 years passed before certain fundamental principles of a market economy, such as property rights and anti-trust legislation, finally appeared on the national agenda. A society that does not conform to basic, generally accepted legal principles with an independent, impartial judiciary will have trouble obtaining effective contract guarantees. Under these circumstances, those who participate in economic activity only need friends in local officialdom to safeguard property and ensure economic survival. And a lack of political reforms to complement economic reforms gave new impetus to rent-seeking.

Corruption spread rampantly. Independent research conducted since 1988 said property rents account for up to 30 percent of China's GDP, or up to 5 trillion yuan a year. This underscores the divide between the nation's rich and poor and result in China's high Gini coefficient.
Reforms, Round Three

The longer it takes for reforms to be properly implemented, the more potential for conflict between advocates of the old and new systems. Those with vested interests who were allowed to accumulate power and influence have strong motivation to thwart reforms that might damage their interests. China's central authorities do not consider retreat an option. Still, deeper reforms will require more force, as well as practical considerations.

A double-track pricing system can follow one of two development paths. One leads to a market economy based on rule of law. The other leads to crony capitalism. When market reforms are dramatically encouraged, as they were in the early 1990s when prices of certain commodities were opened to the market, and when rent-seeking is substantially deterred and corruption curbed, the public voices approval.

For example, at the turn of the century, when a large number of local enterprises following the Southern Jiangsu Model reformed by trimming operations, coastal economies began to develop rapidly. And when general population living standards rise, in spite of local injustice, satisfaction levels generally increase. On the contrary, when reforms are impeded or policies distorted – as they were during implementation of a Stolypin-style privatization through cronyism -- corruption becomes rampant and the gap between rich and poor widens.

Two solutions are possible in the face of these circumstances. Those that support market and corresponding political reforms think inequity in Chinese society stems from market reforms that have not been fully implemented, and a long lag for political reform. They think some are not only unwilling relinquish power but, instead, are actually increasing economic intervention and trying to suppress the market while engaging in rent-seeking behavior. They say rooting out this problem requires comprehensive economic and political reforms that eradicate the economic base for crony capitalism, while putting legal constraints on authority and increasing public supervision.

Still others have advocated a solution that takes the complete opposite approach, returning to the pre-1976 extreme leftist model of resource allocation. Old system supporters shifted blame for rampant corruption and the unfair resource allocation to market-oriented reforms.

This kind of debate has surfaced many times over the past 30 years. A focal point this time is the reform policy launched by the Third Plenary Session of the 11th CPC Central Committee. Defenders of the old system blame market reform for social problems such as corruption, unequal resource distribution, high medical bills, educational shortcomings, and even mining accidents. They propose turning back the clock and instituting a proletarian dictatorship.

This old-way position, whether the perspective is providing a "diagnosis" or "prescription," is fundamentally flawed. Take the gap between rich and poor as an example. Defenders of the old system claim supporters of market reform also support a wider gap between rich and poor, and that market reforms are the primary reasons for the gap's increase. But facts tell a different story. And concern over unequal wealth distribution is nothing new: China's income gap was a key issue for sociologists and economists who advocated reform in the early 1990s.

But why has the gap between rich and poor risen, and what should be done to resolve the problem? Defenders of the old system categorically assert that the problem was caused by market reforms, and hence they advocate aiming a spear at citizens who through hard work and skill managed to attain decent salaries, with the goal of narrowing differences that separate them from people at lower income levels.

Those who support resolving social problems through reform argue that unequal opportunity is at the root of the income gap problem. Since administrative units of the party and government have power to allocate resources, those close to this power can attain wealth quickly through rent-seeking. Supporters of reform also argue that the widening gap is caused in part by enterprises in certain industries with monopoly power. Based on this analysis, closing the gap between rich and poor could be accomplished by advancing market reforms, eliminating the basis for rent-seeking, breaking up monopolies, and ending corrupt practices that use government authority to do business.

Of course, income gaps occur even in a perfect market system because people's abilities vary. China's dualistic economy, which includes traditionally inefficient farming and an advanced industrial-commercial network, creates an income gap that's more pronounced than under other economic structures.

To fight inequality, the government should take practical steps. The most important corrective measure would be to shoulder responsibility by establishing a social security system that provides basic necessities for low-income workers. The social security system China originally implemented to cover only state-owned entities was inherently flawed. For example, a free healthcare system covered only SOEs and administrative units of the party and the government. Most disbursements were limited to city residents, particularly leading party cadres and government officials. Ordinary workers, particularly farmers, lacked access to doctors and medicine.

After China started opening, the entire system collapsed until 1993, when reforms laid a new framework for nationwide social security. From a modern perspective, this framework is generally feasible. If it were further improved during implementation, the plan could provide an effective safety net. However, it's still not complete. And due to various vested interests, negative attitudes and even outright resistance toward the plan are common. SOE employee "empty account" compensation issues also stand in the way.
Those who misdiagnose the income gap and other social ills may be laying groundwork for even more harm by calling for a return to a total dictatorship. The source of crony capitalism in China is the unrestrained power held by certain factions that lets them intervene in economic activity and allocate resources. Supporters of the old economy want to increase SOE monopoly power and strengthen government's dictatorial power. But wouldn't that provide a systematic basis for an environment open to more corruption, making goals such as income equality impossible to reach?

Supporters of the old system who use nationalism and populism as political tools have had some success in debates over healthcare, education, housing and SOE reform. They've roused emotion, sometimes deceiving people with tricks and ideology. However, a glance at history exposes their strategy. They are proposing a return to an old system that brought immense hardship to Chinese people. Those with reservations about specific methods employed during the reform and opening era should take a rational look at the situation and support comprehensive economic and political reform.

Party and administrative officials have already clearly expressed their positions. In March 2006, in a speech to the Shanghai delegation of the National People's Congress, President Hu Jintao said reform efforts would not abate. He called for continuing to improve socialism with Chinese characteristics that reflects the basic functions of a market-based allocation of resources. And in October 2007, at the 17th National Congress of the CPC, a Central Committee report addressed "which flag to raise and which road to take" while stating, "China's reform and opening up is in line with party and popular sentiments. Now, the trend is conforming to the times. Our course is right, the results and achievements impossible to deny, and there will be no halting or retreating."

Whether China's economy can continue down this glorious path for the next 30 years will depend on how well the nation deals with new challenges.

Wu Jinglian is one of preeminent economists in China. He is a senior research fellow for the Development Research Center of the State Council.

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