China - Macroeconomic stability and industrial growth under decentralized socialism (Vol. 1 of 3) : Macroeconomics

Report No. 7483-CHA China: Country Economic Memorandum Macroeconomic Stability and Industrial Growth Under Decentralized Socialism (In Three Volumes) Volume l: Macroeconomics June 12, 1989 Country Operations Divisior China Department Asia Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a res;ricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  OMRENCY EOUIVALFNTS The Chinese currency is called Renminbi (RMB). It is denominated in Yuan (Y). Each Yuan is 1 Yuan - 10 jiao - 100 fen Calendar 1988 June 1989 US$1.00 - Y 3.72 US$1.00 - Y 3.72 Y 1.00 - US$0.27 Y 1.00 - US$0.27 FISCAL YEAR January 1 - December 31 W.:IGHTS AND MEAES Metric System LIST OF ACRONYMS AIC Administration for Industry and Commerce CASS China Academy of Social Sciences EEC - European Economic Corporation FAW - First Auto Works FEAC - Foreign Exchange Adjustment Center FTC - Foreign Trade Corporations GDP - Gross Domestic Product GNP - Gross National Product GVIO - Gross Value of lndustrial Output IMF - International Monetary Fund MOF - Ministry of Finance NICs - Newly Industrializing Countries PBC - People's Bank of China REER - Real Effective Exchange Rate SAEC - State Administration of Exchange Control SEZ - Special Economic Zone SNA - U.N. System of National Accounts SSB - State Statistical Bureau TICs - Trade and Investment Corporations TVE - Towmship, Village and Enterprise VAT - Value-added Tax  FOR OFFICAL USE ONLY TITLE : China: Macroeconomic Stability and Industrial Growth under Decentralized Socialism CO)UNTRY China '1EGION : Asia Region SECTOR Country Economic REPORT mYE CLASSIFICATION MM/ LANGUAGE 7483-CHA ERA Official Use 6/89 English PUBDATE : June 1989 ABSTRACT : The report is divided into two volumes. The first volume analyzes recent macroeconomic developments with special attention to the reforms that have been responsible for China's rapid growth. It also examines policies introduced during 1988-9 to dampen inflationary pressures that have resulted from high rates of expansion. The second volume looks .at longer term prospects for industrial reform and development. After describing the industrial structure and the changes that have occurred in the eighties, it concentrates on (i) the dynamics of the Chinese manufacturing enterprise; (ii) the factors influencing the integration of the national market; and (iii) industrial strategies that are likely to promote competition allocative efficiency, technological progress and X-efficiency. This documetit has a restricted distribution and may be used by recirp . its only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFmFCIAL USE ONLY Table of Contents Paige No-, EXECUTIVE SUMMARY ......................... i - xi Aims of Reform. . . . . . . . . . . . . . . . . . . . . . . . . L Emergence of Macroeconomic Instability during the Second Phase. ii Framework for Future Policy Actions . . . . . . . . . . . . . . iv Control of Inflation in the Short-run . . . . . . . . . . . . . v Long-Term Strategy. . . . . . . . . . . . . . . . . . . . . . . viii VOLUME ONE - MACROECONOMICS I. MACROECONOMIC OVERVIEW . . . . . . . . . . . . . . . . . . . . 1 'acroeconomic Overview . . . . . . . . . . . . . . . . . . . . . 1 Political Economy uf Reform .... . . . . . . . . . . . . . . 2 g,rowth and its Sources: 1978-88. . . . . . . . . . . . . . . . 4 Inflation ..... . . . . . . . . . . . . . . . . . . . . . . 8 Employment. . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Productivity. . . . . . . . . . . . . . . . . . . . . . . . . . 12 Foreign Trade ..... . . . . . . . . . . . . . . . . . . . . 18 External Borrowing. . . . . . . . . . . . . . . . . . . . . . . 25 Macroeconomic Agenda and Actions. . . . . . . . . . . . . . . . 27 II. INFLATION AND ITS CONTROL THROUGH MONETARY AND INCOMES POLICIES. 30 Reform and inflation Dynamics .... . . . . . . . . . . . . . 30 Section A: 'The Pricing System and the Pattern of Inflation . . 32 Price Patterns. . . . . . . . . . . . . . . . . . . . . . . . . 33 Recent Inflation and its Cost .... . . . . . . . . . . . . . 39 Section B: Monetary Trends and Maaagement . . . . . . . . . . 41 Monetary Policy: Short- and Medium-Term. . . . . . . . . . . . 51 Section C: Incomes Policy .... . . . . . . . . . . . . . . 56 Labor Earnings. . . . . . . . . . . . . . . . . . . . . . . . . 56 III. FISCAL STRUCTURES AND POLICY .... . . . . . . . . . . . . . 62 Background on Fiscal Development. . . . . . . . . . . . . . . . 62 Fiscal Structures . . . . . . . . . . . . . . . . . . . . . . . 64 Fiscal Reforms and Budgetary Dynamics .... . . . . . . . . . 69 Theory and International Practice of Fiscal Policy ...... . 76 Fiscal Policy for the Transition. . . . . . . . . . . . . . . . 80 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - IV. INVESTMENT BEHAVIOR AND DOMESTIC RESOURCE AVAILABILITY. . . . . 85 Section A: Investment. . . . . . . . . . . . . . . . . . . . . 85 Investment Pattern . . . . . . . . . . . . . . . . . . . . . . 85 Investment Planning and Management by the Central Government. . 88 Investment Imperatives of Local Goveyuments . . . . . . . . . . 95 Investment Control and Financing. . . . . . . . . . . . . . . . 96 Section B: Savings .... . . . . . . . . . . . . . . . . . . 101 Structure and Trends. . . . . . . . . . . . . . . . . . . . . . 101 Household Saving Behavior .... . . . . . . . . . . . . . . . 103 The Stability of Savings .... . . . . . . . . . . . . . . . 109 V. INDUSTRY. AGRICULTURE AND LONGER-TERM REFORM. . . . . . . . . . 114 Section A: Industry. . . . . . . . . . . . . . . . . . . . . . 115 Section 5: Agriculture .... . . . . . . . . . . . . . . . . 119 Trends during 1978-86 . . . . . . . . . . . . . . . . . . . . . 119 Emerging Bottlenecks. . . . . . . . . . . . . . . . . . . . . . 121 Food Production Strategy. . . . . . . . . . . . . . . . . . . . 126 Future Policy Initiatives .... . . . . . . . . . . . . . . . 127 .ANNEX A CHRONOLC('Y OF ECONOMIC REFORMS, 1979-88 . . . . . . . . . 129-137 VOLUME II. - INDUSTRIAL STRUCTURE. DYNAMICS AND POLICIES EXECUTIVE SUMMARY ......................... i - ix National Market Integration. . . . . . . . . . . . . . . . . . . i Directions for Industrial Policy ... . . . . . . . . . . . . . iii Role of Small Firms. . . . . . . . . . . . . . . . . . . . . . . v Enterprise Microeconomics. . . . . . . . . . . . . . . . . . . . vii Administrative Environment .................. . viii VI. STRUCTURE OF INDUSTRY. 1 Pattern of Industrial Change .5 Industrial Concentration ....... .. .. .. .. . ... 6 Subsectoral Growth ....... .. .. .. .. . ...... 11 Small Scale Industry ....... .. .. .. .. . ..... 13 Role of the Market ....... .. .. .. .. . ...... 16 Geographical Trends in Industry ... . . . . . . . . . . . . . 17 Industrial Finance and Enterprise Ownership . . . . . . . . . . 20 Equipment and Technology ..... . . . . . . . . . . . . . . 22 Structure and Dynamics in Electronics, Consumer Durables and Steel . . . . . . . . . . . . . . . . . 23 Changing Industrial Contours . . . . . . . . . . . . . . . . . . 29  - iii - VII. CHINESE STATE ENTERPRISES AND THEIR ECONOMICt ENVIRONMENT . . . . 32 Background . .......... ........... ... . 32 Enterprise Evolution . . . . . . . . . . . . . . . . . . . . 33 Labor Markets, Incentives and X-efficiency . . . . . . . . . . 35 Technological Change and Its Financing . . . . . . . . . . . 41 Structure of the Enterprise ........... . 44 Resource Allocation ........ .......... .. . . 48 A Direction for Reforms . . . . . . . . . . . . . . . . . . . . 49 VIII. REGIONAL INDUSTRIALIZATION AND MAPKET INTEGRATION. . . . . . . . 53 Pattern of Industrialization in the U.S. . . . . . . . . . . . 54 China's Regional Development Policies, 1953-79 . . . . . . . . 56 Measuring the Cost of the Interior Development Strategy . . . . 61 Regional Development in China Compared with Other Countries . . 65 Subregional Industrial Policies ..... ...... . . . . . 73 Two Regional Scenarios ....... ....... .. . .. . 74 Integrating Markets ............. . 80- Interprovincial Trade . . . . . . . . . . . . . . . . . . . . . 80 Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 Transport . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Investment . . . . . . . . . . . . . . . . . . . . . . . . . . 94 Tariffs ........................... . 94 Modal Choice ......................... . 95 Strands of a Regional Strategy ................ . 95 IX. ASPECTS OF INDUSTRIAL POLICY.. . . . . . . . . . . . . . . . 97 SECTION A: CHINA ...................... . 98 Legal Rules and Market Development ... . . . . . . . . . . . 98 Industrial Policy .103 Interfirm Linkages .103 Industrial Regulation and Barriers to Entry . . . . . . . . . 105 Price Competition .107 Bankruptcy .109 SECTION B: CROSS-COUNTRY EXPERIENCE . . . . . . . . . . . . . . 110 Antitrust Policy and Administrative Guidance . . . . . . . . . 111 Bankruptcy Law .115 Board of Directors .116 Takeovers .117 A Recapitulation of the Main Points . . . . . . . . . . . . . 118 Technology and Industrial Structure . . . . . . . . . . . . 119 Role of Small Firms .124 Industrial Policy Guidelines for . . . . . . . . . . . 126 VOLUME III - Statistical Annex  - iv- TABLES IN TEXT - VOLUME I 1.1 Sectoral and Demand Linked Sources of Growth 1980-88 . . . . . 6 1.2 Savings and Investment, 1978-8P . . . . . . . . . . . . . . . 7 1.3 Measures of Inflation. . . . . . . . . . . . . . . . . . . . . 9 1.4 Sources of Growth Analysis . . . . . . . . . . . . . . . . . . 13 1.5 Relation between Output and Productivity Growth, 1975-1986 . . 16 1.6 Price Index of Non-Residential Industrial Construction, 1970-85. 16 1.7 Investment in Housing. . . . . . . . . . . . . . . . . . . . . 18 1.3 Exports of Selected Food Items . . . . . . . . . . . . . . . . 20 1.9 Exports of Commodities from China. . . . . . . . . . . . . . . 20 1.10 Imports of Commodities to China. . . . . . . . . . . . . . . . 21 1.11 Real Effective Exchange Rates . . . . . . . . . . . . . . . . 24 1.12 External Borrowing. . . . . . . . . . . . . . . . . . . . . . 27 2.1 Measures of Inflation . .35 2.2 Quarterly Measures of Inflation ..36 2.3 Nationwide Measures of Price and Wage Inflation . . . . . . . 36 2.4 Market Price Indices by Category of Commodity, 1981-87. . . . 37 2.5 Price Dispersion for Selected Products . . . . . . . . . . . 39 2.6 Growth Rates of Monetary Aggregates . . . . . . . . . . . . . 44 2.7 Contributions to Liquidity Growth . . . . . . . . . . . . . . 45 2.8 Contribution to Reserve Money Growth . . . . . . . . . . . . 46 2.9 Monetary Control Ratios . . . . . . . . . . . . . . . . . . . 47 2.10 Share of Loans to Enterprises and Individuals in Total Lending 48 2.11 Sources of Domestic Credit Growth . . . . . . . . . . . . . . 49 2.12 Revenue From Money Creation .... . . ...... . . . . . 49 2.13 Money Demand Parameters .... . . . ...... . . . . . . 50 2.14 Trend in Velocity . . . . . . . . . . . . . . . . . . . . . . 50 2.15 Interest Rate Structure .... . . . . . 52 2.16 Industrial Wage and Productivity Indices. . . . . . . . . . . 58 2.17 Industrial Wage and Productivity Growth Rates . . . . . . . 58 3.1 Structure of Consolidated Government Revenue, 1978-1987 . . . 65 3.2 Developments in Government Revenue, 1978-88. . . . . . . . . . 66 3.3 Structure of Government Expenditure, 1978-88 . . . . . . . . . 67 3.4 Developments in Government Expenditure, 1978-88. . . . . . . . 68 3.5 Budget Deficit and its Financing, 1979-88. . . . . . . . . . . 68 3.6 Changing Fiscal Importance of the Central and Subnational Government Sectors . . . . . . . . . . . . . . . 73 3.7 Simulation of Budget Deficits at Various Rates of Inflation, Real Growth and Interest Rates . . . . . . . . . . . . . . . 83 4.1 Gross Domestic Investment (GDI) as Percent of GDP. . . . . . . 86 4.2 Percent Share of Total Capital Construction Investment . . . . 87 4.3 Proportion of Total Output Under Central Allocation. . . . . . 89 4.4 Financing of Domestic Fixed Investment . . . . . . . . . . . . 92 4.5 Central Government Priority Investment . . . . . . . . . . . 93 4.6 Uncompleted Construction .... . . ...... . . . . . . . 100 4.7 Composition of Saving, 1978-87 . . . . . . . . ... . . . . . . 103 4.8 Gross Domestic Savings, Selected Countries, 1965-88. . . . . . 106 4.9 Household Savings Rates. . . . . . . . . . . . . . . . . . . . 106 4.10 Growth of Financial Savings Versus GDP Growth . ..... . 108 4.11 Rural-Urban Terms of Trade .... . . ...... . . . . . . 109 4.12 Household Savings Rate in China, 1978-87 . . . . . . . . . . . 111 4.13 Financial Asset Holdings of Selected Countries . . . . . . . . 113 5.1 Current and Projected Per Capita Food Consumption. . . . . . . .L20 5.2 Agricultural Indicators. . . . . . . . . . . . . . . . . . . . 120 5.3 Fresh Vegetable Mixed Average Retail Prices in Major Cities, China, May 1985 to February 1988 . . . . . . . . . . 123 5.4 Land Under Vegetables. . . . . . . . . . . . . . . . . . . . . 125  v TABLES IN TEXT - VOLUME II 6.1 National Income by Province, 1986. . . . . . . . . . . . . . . 1 6.2 Provincial Distribution of per capita Industrial Output, 1957, 1965, 1979, 1983 and 1986 . . . . . . . . . . . . . . 4 6.3 Summary Measures of Interprovincial Inequality in Gross Value of Agricultural Output (GVAO). . . . . . . . 5 6.4 Number of Industrial Enterprises . . . . . . . . . . . . . . . 7 6.5 Gross Value of Industrial Output . . . . . . . . . . . . . . . 8 6.6 Gross Value of Industrial Output per Enterprise in l980 constant prices. . . . . . . . . . . . . . . . . . . 9 6.7 Summary Measures of Industrial Concentration of China, Korea and India .... . . . . . . . . . . . . . . .. 9 6.8 Gross Value of Industrial Output in 1980 constant prices, by Branch. . . . . . . . . . . . . . . 11 6.9 Number of Industrial Enterprises by Province . . . . . . . . . 12 6.10 Gross Value of Industrial Output in 1980 Prices, by Province . 13 6.11 Industrial Shares of Township and Village Enterprises. . . . . 15 6.12 Ownership Structure of Industrial Output in 1987 . . . . . . . 18 6.13 Current Liabilities as a Percentage of Networth. . . . . . . . 21 6.14 Totrl Electronics Output Value in Top Four Regions . . . . . . 25 6.15 Share of Rolled Steel Production by Zone . . . . . . . . . . . 28 6.16 Share of Pig Iron Production by Zone . . . . . . . . . . . . . 28 7.1 Time Allocation by Managers. . . . . . . . . . . . . . . . . . 46 7.2 Structure of the Industrial Work Force, 1986 . . . . . . . . . 47 8.1 Personal Capita Income in Each Region as a Percentage of the U.S. Average, 1840-1980. . . . . . . . . . . . . . . . . 56 8.2 Agricultural Growth in Interior Provinces. . . . . . . . . . . 58 8.3 Regional Capital-Labor and Output-Labor Rates for Large- and Medium-Scale Industrial Enterprises in 1985. . . . . . . 62 8.4 Regional Differences in Large & Medium Enterprise Efficiency . 63 8.5 Net Material Product by Province (1985). . . . . . . . . . . . 69 8.6 Structure of Industry by Province in 1986. . . . . . . . . . . 70 8.7 Farm Incomes and Nonagricultural Employment by Province. . . . 72 8.8 Regional Inequality in China and the U.S. . . . . . . . . . . 73 8.9 The Percentage of Commodities Imported from Other Provinces by Commercial Establishmente in Various Provinces and Municipalities in their Total Purchase of Commodities. . . . 83 8.10 Percentages of Main Industrial Products Produced by Coastal, Inland, Eastern, Central and Western Areas Respectively in China's Total Output. . . . . . . . . . . . . . . . . . . 83 8.11 Net Exports by Province, 1985. . . . . . . . . . . . . . . . . 84 8.12 Transport Investment vs Economic Output in China . . . . . . . 87 8.13 Railway and Road Network Density in Selected Countries . . . . 87 8.14 Distribution of intercity Passenger Traffic by Mode China, U.S.S.R., India, Brazil and U.S. . . . . . . . . . . 88 8.15 Distribution of Freight Traffic by Mode. . . . . . . . . . . . 88 8.16 Freight Traffic Intensities. . . . . . . . . . . . . . . . . . 89 8.17 Indicators of Railway Asset Utilization, A Comparison between China, U.S.S.R., India and U.S.. . . . . . . . . . . 90 8.18 Transport Supply Developments. . . . . . . . . . . . . . . . . 92 8.19 Characteristics of Chinese Railway Freight Traffic . . . . . . 93  - vi - GERAPS 2.1 Different Heasures of Inflation. . . . . . . . . . . . . . . . 34 2.2 Price Dispersion for Beer, Tea and Cake. . . . . . . . . . . . 40 6.1 Gross Value of Industrial Output, China. . . . . . . . . . . . 10 6.2 Number of Industrial Enterprises, China. . . . . . . . . . . . 17 BOXES 1.1 Productivity Growth in China .... . . . . . . . . . . . . . 14 6.1 Causality between Agriculture and Industry . . . . . . . . . . 30-31 HAPS IBRD 21483 ..... . . . . . . . . . . . . . . . . . . . . . 2 IBRD 21484R. . . . . . . . . . . . . . . . . . . . . . . . . . 14 IBRD 21485 . . . . . . . . . . . . . . . . . . . . . . . . . . 59 IBRD 15512R3 . . . . . . . . . . . . . . . . . . . . . . . . . 128 IBRD 15525R2 ..... . . . . . . . . . . . . . . . . . . . . 138 The Report was prepared by a mission that visited China in June 1988. Mission members were Shahid Yusuf (Mission Leader), Gerd-Peter Dittus (AS3CO), Barry Naughton, Dwight Perkins (Consultants), Gyorgy Szapary (IMF), and Tejaswi Raparla (AS3CO). Background papers for the report were prepared by Thawat Watanatada (AS3TE), Peter HarrNld (AS3CH), Andrew Feltenstein, Dorothy J. Solinger, Renee Schwartz and Robert H. Field (Consultants).  Execuitive Summary Aims of Reform 1. China achieved respectable growth rates in the pre-reform era but the economic gains came at a very high cost in terms of investment and labor input. The principal goal of the reform is to improve on past growth performance and to do so largely through an increase in efficiency. The strategy being evolved has a number of strands, of which the following deserve mention: * Ever since the late fifties, China has accommodated a measure of provincial autonomy within a system geared to central planning and administrative allocation of resources. Starting with the household responsibility system in the rural sector, the approach taken in the eighties involves a dispersal of decisionmaking powers as well as control over resources to lower ranked economic units. With markets multiplying, farmers along with an increasing number of industrial enterprises are acting with reference to price signals rather than plan directives. Layers of bureaucratic controls, that stifled initiative and interfered with the efficient use of resources, are being stripped away. * A planned economy in which no effort was spared to maximize capital accumulation provided the populace with the basic necessities but gave low priority to the widening of consumption opportunities. Over time, this dulled the desire to work hard or to innovate. One of the central tenets of the reform drive is the importance attached to expanding consumption possibilities so as to restore incentives eroded by years o' austerity. * Technoio3ical advance is a third strand. An inward orientation, neglect of industrial research and the preoccupation with the volume of production meant that technology lagged. In many important fields, China is still producing and utilizing 1950s vintage technology long ago abandoned elsewhere. The reform program has sought to multiply trade links and establish channels through which Chinese producers can obtain foreign technology. The growing commercial bias of enterprise activities, the significance attached to profitability as a decision rule together with the rising prominence of free markets, are also helping to shift the focus from the sheer volume of output to such market concerns as quality and technology. * Under pre-reform central planning, enterprise relationships were determined by the hierarchical structure of supervising ministries and tended to be vertical in nature. Reform is attempting to break down the severe compartmentalization that resulted. Enterprises are being encouraged to forge horizontal links across sectors as well as geographically. * Provincial autonomy and the segmenting effects of ministerial hierarchies meant that the country was divided into a large number of subeconomies each more or less independent, with most of the trade being restricted to a few, bulky, raw materials and intermediate products. A cellular pattern of development involved a considerable sacrifice in terns  - ii - of efficiency. Industrial location was not guided by comparative advantage; scale economies remained unexploite.'; and the potential of the vast domestic market to generate trade and coi.c,> tition was neglected. A dismantling of some controls and the amergence of new marketing networks, especially in agriculture, is bringing down a few of the barriers to the flow of goods and factors across the country. Regional markets are emerging. Eventually, through institXtioital change, legislative action and investment in infrastructure, these wcould expand and coalesce into a national market. Emergence of Macroeconomic Instability during the Second Phase 2. Agriculture responded immediately to the measures introduced in the late seventies and provided a powerful impetus to growth until 1984. Industrial reforms, put into effect from about 1983-84, gave an equally strong stimulus and during 1985-88 most of the growth impulse came from the vigorous expansion of industry. Over the past eleven years, China has averaged a growth rate of more than ten percent and there is no apparent slackening in the momentum. Unprecedented rates of sustained GDP growth have been matched by a substantial increase in domestic savings that have helped maintain resource balance, and except for the period 1985-86, minimized China's reliance on foreign capital to meet industry's enormous appetite for investment. 3. Rapid expansion of the national product has raised living standards throughout the country. Because of changed relative prices for agricultural products, the rural four fifths of the populace has participated fully in this new prosperity. Industrial wages, bonuses and benefits in kind also appear to have forged ahead. Altiough the detailed statistics are lacking, it would appear that economic gains have been widely dispersed. 4. From the very start of the reform program, it was apparent that decontrolling a planned economy subject to chronic shcrtages, in which many prices were seriously out of line from "true" scarcity values and where strong latent demand pressures from enterprises as well as consumers lay beneath the surface, was beset with risks. The dangers of macro- instability were particularly serious if the economy were to be operated at near its maximum potential. During the first five years of the reform a combination of factors helped keep macroeconomic disequilibria at bay. The average growth rate between 1980 and 1983 was lower-averaging 7.6% per annum. Reforms were concentrated in the agriculture sector and food supplies expanded at a brisk pace which had a dampening effect on prices. This was a period when light industry took the lead and there was a growing availability of consumer goods to satisfy househcld demands. Consumption demand provided the fuel for growth and mostly paid for itself through improved incentives for productivity growth. 5. When the focus of reform shifted to state enterprises after 1983, the situation changed quite dramatically. Industrial reform freed enterprises from some of the checks that had been imposed upon them; they were permitted to retain a portion of their profits and were given wider latitude in deciding how to spend them; profit incentives and market prices began to exert a greater influence on their behavior; and enterprise investment which had once been regulated through the government budget  - iii - became dependent on bank financing. Further, the central government transferred more of the planning and industrial management functions to provincial and lower levels. 6. Industrial change on such a scale is bound to cause macroeconomic strain but certain features of the reforms worsened the danger of instability. Enterprises were given more independence and the option of participating in free market trading but they were not simultaneously subjected to the rigors of market discipline and accountability which encourages prudence. Because budget constraints on most state and collective enterprises remained soft, the reforms introduced an asymmetry: enterprises had greater freedom of decision but the penalties for poorly conceived production and investment decisions remained relatively Jnsignificant. Moreover, the unreformed pricing system interfered with socially efficient investment decisions. Second, decentralization encouraged the provinces to aggressively pursue their own industrial ambitions and exploit fully the financing avenues provided by the reform of banking. Without a national industrial strategy to coordinate provincial objectives and spending, or price reform to signal which investments were socially beneficial, this has resulted in much duplication and a waste of capital. 7. These three factors taken together: greater autonomy for enterprises and the absence of credible hard budget constraints; the lack of a unifying national industrial policy; and the opportunities afforded by a decentralized banking system for raising funds, produced a tremendous surge in capital spending. And remaining distortions in the pric;e system meant that a considerable volume of this investment was directed toward relatively low productivity projects. 8. Growth accelerated to over 11% p.a. between 1984 and 1988 pushing the economy to the limits of its productive capacity. Where consumption had been the main source of growth in the early eighties, industrial investment moved decisively into the lead after 1983 supported by an expansionary credit policy. By absorbing the bulk of investable resources, industry compromised the development of energy and transport infrastructure tightening bottlenecks that already existed. With many commodities being traded on free markets and the majority of prices now permitted to move within bands, conditions of chronic excess demand accommodated by a rapidly growing money supply have resulted, inevitably, in rising prices. Because grain production has stagnated and the output of other high value food items has lagged behind demand, food prices soared during 1987-88. Premium consumer durables have also become relatively more costly. 9. The cellular nature of the Chinese economy and the uneven incidence of residual price controls has meant that rates of inflation across the country are highly uneven and the seasonal amplitude of agricultural prices can be very significant. Nevertheless, inflationary tendencies have become very pronounced over the past eighteen months. As they impinge most strongly on wage goods, urban dwellers earning only partially indexed incomes, have begun agitating for higher wages and bonuses. During 1988, wages increased by over 25%, bonuses at even higher rates, which may have added more fuel to inflation, introducing a wage push element into the Inflationary spiral. The government announced in September 1988, a postponement of price reforms until such time as macroeconomic stability hcs been attained.  - iv - Framework for Future Policy Actions 10. As was indicated above, a planned economy in which resources are tautly stretched is in danger of entering an inflationary spiral as it attempts to move towards a market oriented system. Chinese reforms, while amply delivering on the promise of growth, have run afoul of inflation because the direction of change has begun to drift away from the objectives. Productivity increase that would diminish the strain on the economy's resource base is materializing slowly because price adjustments, national market integration and the creation of competitive environment in which relatively autonomous firms behave as responsible economic actors, are behind schedule. Investment spending has raced too far ahead, aggravating demand pressures and the severity of energy as well as transport bottlenecks. The authorities at the central as well as the provincial levels have been too ready to accommodate capital spending through credit expansion, thereby injecting an excess of liquidity into the system. Thus growth since the mid eighties may have been too rapid; it is investment led; consumer goods industries, marketing and services have not absorbed the resources they required (in 1988, light industry did expand faster than the heavy manufacturing sector by a small margin); and the decentralized financial network was overly generous (under political prodding) in responding to the demands for credit from enterprises. 11. A history of industrialization under socialist planning points to structural features that pose adjustment problems as enterprises are exposed to the market. Among the most important are (i) the status and authority of enterprise managers; (ii) accumulation of human capital within firms; (iii) the current obligations of enterprises to their employees and their eventual displacement by new contractual relations; and (iv) issues pertaining to enterprise ownership which affect autonomy, as well as the nature of budget constraints. Until these problems have been resolved, market discipline may remain somewhat ineffectual; the economy would be susceptible to macroeconomic instability; and gains in productive efficiency may accrue slowly. 12. Heading China's policy agenda are two items: one is to curb inflationary pressures running rampant through the' economy, in as short a time as possible with ths minimum sacrifice of growth and without resorting to a panoply of new controls. Second, the country needs to safeguard its long run prospects of modernization. It must avoid stop-go cycles precipitated by future bouts of inflation that could sour expectations and sap growth momentum. 13. The solution to both of these must be sought through macroeconomic policies juxtaposed with long-run development plans for the production sectors. Unless the intense investment hunger can be blunted and provinces induced to adhere to common development goals, the demand for credit will remain strong as will the political pressure on banks to grant credit even if it means violating ceilings. At the same time, the central government's fiscal strategy can be tailored to contain aggregate demand pressures, while monetary and interest rate policies can do their share in controlling the growth of liquidity.  - v - Control of Inflation in the Short-run 14. Inflation imposes a number of costs: those on fixed incomes find that their economic circumstances are impaired; further, the efficiency of market signala for allocating resources is lowered. This is of critical importance in China's case. Curbing inflation is a prerequisite to the success of price reforms. 15. Causes. Inflation is a complex phenomenon, and supply and demand factors are closely interlinked. Nevertheless, it is possible to trace the process in China to a few main factors: * Urban reforms in 1984/85 increased enterprise autonomy with respect to spending decisicns, and enlarged their share of resources by permitting profit retention and enlarging access to a less constrained banking system; * Monetary growth that is related to the restructuring of the financial sector in 1984. This entailed loss of monetary control, as it took time for the PBC to disengage from its commercial banking activities. The announcement that future central bank lending would be calibrated with levels reached in 1984 prompted specialized banks to substantially expand lending to enterprises; * The low cost of funds and soft budget constraints induced enterprises to borrow without restraint for investment purposes. The investment ratio climbed to almost 39% of GDP and a pattern of spending and of &Inancing was established that has proven difficult to break. * Since early 1988, demand pull pressures have been joined by cost push, as enterprises have exploited their newly gained independence to the fullest by granting workers lavish increases in wages, bonuses and payments in kind. 16. Macroeconomic Strengths. China, unlike many other countries confronted with spiralling prices, can restore stability without a significant sacrifice of growth. There are a number of reasons why the current difficulties should not deter the authorities from tackling the reform issues that have been temporarily deferred by inflationary pressures. First, with growth in GDP exceeding 11% during 1988, demand management for the purposes of inflation control need not be overly constrained by the threat of stagnation or the fear that the economy might lose its forward momentum. Investment could safely be scaled down so as to take the edge off demand pressures. It is when inflation is combined with low rates of growth that stabilization policy becomes a difficult exercise. 17. Second, the economy is at a point of resource equilibrium which makes it possible to use trade policy more aggressively for the purposes of stabilization. In other words, the pressure on domestic resources can be eased somewhat, by increasing imports or moderating the export drive. This can be done without China encountering external financing difficulties which have hamstrung other co-untries who are forced to stabilize in the face of debt servicing constraints. China has access to a cushion of resources that can facilitate the task of restoring stability.  - vi - 18. Third, an extended period of price stability and public fear of economic chaos have instilled attitudes that would pouyerfully support attempts at curbing inflation. Any determined government efforts to contain inflation are likely to be backed by the expectations of wage earners and producers for whom price movements during recent months must appear to be an aberration. The buying spree that erupted during the third quarter of 1988 quickly came to an end once the authorities made it clear that they intended to bring inflation under control through the coordinated use of monetary, interest rate and expenditure policies. 19. Fourth, China possesses an extensive apparatus for monitoring prices, wages and the spending decisions of most industrial units. Decentralization might have dispersed the powers of monitoring and control but the apparatus to ensure that changes in prices and wages conform to certain guidelines remains in existence. Many market economies that have sought to escape from an inflationary spiral have relied on short-term price and wage ceilings. But enforcement has always posed major problems. In China, the means of applying such policies are far better developed, and can still be used effectively. A rigid indexation of wages to the consumer price index that seriously complicates stabilization Li some of the Latin American economies, is also absent in China. Payments made to workers to compensate for the rising costs of living are subject to government discretion and are not automatic. 20. Fifth, what is true of prices and wages is also true of a wide range of investment decisions. While enterprises now have greater discretion on spending matters, the larger firms that do the bulk of capital construction and vpgrading investment are closely supervised by ministries, industrial bureaus and corporations. Once again, the capacity to regulate investment spending for the purposes of demand reduction, in a highly discriminating fashion, is far in advance of other countries. 21. Finally, there is abundant slack in the urban labor market as well as product markets. In countries experiencing high growth, where the rates of unemployment decline to extremely low levels, this tends to introduce significant cost push pressures into the inflation process. From the evidence at hand, it is difficult to infer that the wages and bonuses paid by Chinese enterprises are being driven by labor scarcities, although it is undoubtedly the case that certain skills are in short supply. It is widely reported that industrial capacity is underutilized because of energy and transport constraints. To the extent that these can be eased, supplies of consumer and other goods can be augmented substantially without much additional investment. 22. Policy Actions. In its efforts at stabilizing the oconomy, the government can use a number of instruments: e The most powerful means at the government's disposal even under conditions of economic decentralization is administrative controls over enterprise investment. However, these must be used sparingly, as a drastic reimposition of checks on enterprise decisionmaking could undo much of the good achieved by the reforms. The postponement or elimination of projects must also be done with an eye to the immediate benefits in terms of reduced aggregate demand, but as far as possible these must be balanced against the  - vii - longer run implications for industrial development. The government's intention of cutting state investment by 50 billion yuan in 1989 (assuming that it affects the flow) could have substantial deflationary effects and must be carefully implemented so as to strike the optimal tradeoff between inflation and growth. * The decision by the monetary authorities in the third and fourth quarters of 1988 to restrict lending by the People's Bank of China (PBC) to the specialized banks; to curtail and closely monitor the extension of temporary credit by the branches of the PBC; and to require a monthly accounting by the PBC's branch network, thereby ensuring stricter adherence to targets, should facilitate demand management if these measures can be enforced for a sufficient period of time. As the free reserves of the specialized banks have fallen to relatively low levels, slippages that blunted the efficacy of monetary actions in the recent past can be avoided. The increase in lending and deposit rates in October 1988 and again in January 1989 can, on the margin, be expected to moderate spending behavior of enterprises as well as households. If current levels of inflation persist, a further slowing of the growth in base money and an adjustment of interest rates may be required, although the effects on production will have to be carefully weighed. * A strong push for exports, by diminishing domestic supplies of premium consumer durables and certain food items, may have worsened inflation. A t'.ghtening of the access to imports over the past years might also have produced similar results. Inflationary trends could be dampened by the active use of trade policy. Increased imports of selected goods that are most subject to price pressures, would be a useful adjunct to stabilization policy. Import controls were relaxed in the last quarter of 1988 to ease shortages of intermediate products and raw materials resulting from a higher than anticipated expansion of the economy. - Announcements by the authorities during June 1988 that some increase in prices - possibly double digit rates of inflation - may have to be tolerated while relative prices were being adjusted, induced people to try and convert depreciating money balances into goods, thereby worsening inflationary pressures in the third quarter of 1988. Workers began also to demand and receive larger wage hikes to offset the rising cost of living. Once, the government reaffirmed its c^mmitment to price stability and increased rates on savings deposit, the flight from money was reversed although wage demands remain strong. Over the period 1988 to mid-1989, real incomes of the industrial workforce have been rising faster than productivity. For the purposes of short-term stabilization, firmer wage guidelines from supervisory departments and a more determined effort at collecting taxes on excess bonuses, are desirable. * Although budgetary deficits have stimulated demand and the public sector deficit reached 2.5% of GNP in 1988, their effects over the pariod since 1985 have been relatively minor. As borrowing from the PBC has been entirely displaced by bond placements with the specialized banks in 1988, the inflationary potential has been lessened. A narrowing of the deficit in 1989 is likely as capital spending and inflation (which influences government expenditures) fall but a start at introducing medium- term measures to strengthen revenue elasticity, should be high on the macroeconomic agenda.  - viii - 23. Deflation must be measured out in small doses. The rate of growth in demand needs slowing but a firm policy consistently applied rather than a sharp contraction is the approach best calculated to avoid a succession of stop-go cycles and prepare the ground for continued reform. Long-Term Strategy 24. Industrial Policies. The share of industry in GDP is higher than in most countries and a manufacturing base has been established in even the poorest provinces, but industrialization has evolved with little attention to regional comparative advantage; interindustry linkages are sparse; the transport network is inadequate; subsectoral concentration ratios are generally low; most enterprises operate on a modest scale, often with obsolete technology; and interregional competition is fairly weak. These factors combine to depress productivity. 25. A series of steps are needed to set industrial development on an appropriate path. Efficient allocation of industrial resources requires the following: * A coordination of provincial investment plans to avoid duplication and a geographical deployment of industry with reference to evolving comparative advantage. The formulation of the 8th Five Year Plan offers the central government a fine opportunity to articulate industrial policies that reinforce market integration. As long as each province pursues its own narrow self interest, resources will be wasted, investment will remain too high and gains in efficiency will be slow to materialize. o Market competition must be increased, by lowering administrative entry barriers to new producers; by stimulating interprovincial trade; and by permitting greater competition from imports. Creating a national market in which goods flow freely, calls for legislative action to remove impediments to interprovincial trade; investment in transport and in marketing infrastructure; and the emergence of large firms that operate on an economy-wide scale. * The close links which still bind most collective and state enterprises to industrial bureaus and ministries need to be weakened and ultimately severed. Enterprises should not only be given real autonomy but also shoulder the responsibility that is part and parcel of market freedom. The risk of failure must be real and a part of the costs must be borne by owners as well as employees. This requirep a rethinking of ownership conditions. * Rational enterprise behavior and efficient resource use require a strengthening of enterprise management, a substantial upgrading of technical skills and flexibility in using labor resources as well as in defining the structure of compensation. 26. Alongside these, a national industrial strategy must tackle a number of related matters that will help secure growth, efficiency and technological dynamism.  - ix - * Industrial progress is likely to be dependent on the pull exerted by a few leading sectors. These must be identified and supported through financial, fiscal, trade and education policies, so that they realize their technological potential and spread linkages throughout the economy. * In many subsectors, mergers and consolidations driven by market forces, should bring into existence a core of large dynamic firms that can fully utilize scale and scope economies. * Markets, competition and efficiency all depend on the rationality of the price mechanism. Without selective price adjustments in some areas and a widening role for free market prices, investments may be misdirected and productivity gains could remain elusive. An important next step might be in the area of energy and transport prices. Energy is in short supply and is still used wastefully. This imposes tremendous costs. Not only does much industrial capacity lie idle because of insufficient electricity, but also the demand for coal monopolizes much of China's limited rail transport facilities, crowding out the interprovincial transfer of other goods. Meanwhile, the tariff structure for the different transport modes discourages the use of water and road transport. Adjusting energy and transport prices would lead to a significant advance in efficiency. It would cut down investment in energy intensive projects, increase capacity utilization and make it possible to use the transport system to strengthen trade links between provinces. * Sizable gains could be had from a removal of barriers to the circulation of capital, labor and market information tbroughout the economy. Financial flows have commenced but intrafirm labor movement is limited and much information still moves along vertical ministerial channels. Reforms in these areas must be included in the industrial strategy. 27. Industrial actions require an appropriate macroeconomic environment in order to be successful. As recent experience has shown, an expansionary monetary policy, and an overly rapid deterioration in central government revenues interacted with the reform effort to release the forces of inflation. Careful management of effective demand will always be important but it is especially critical during the transitionary phase of reforms. 28. While industry will remain the leading sector over the foreseeable future, agriculture will need continuing attention so that the country can satisfy its changing requirements for food and industrial raw materials in most part from domestic sources. Neglect of rural infrastructure and soil productivity has influenced grain production. For a variety of reasons, farmers have also been unable to respond fully to the demand of increasingly affluent urban consumers for meat, vegetables end fruit. The potential exists to meet the government's targets for the mid 1990s, but aside from investment in irrigation and water conservancy, farmers might need firmer assurances regarding leasehold rights, stronger price incentives and more by way of technological assistance.  x 29. Fiscal Poliv. For the purposes of short-term stabilization, fiscal policy is a less flexible tool than either administrative controls or monetary policy, because considerable planning, negotiation and institutional changes must precede large cuts in government spending or the raising of appreciable amounts of additional revenue. 30. Over the longer term, fiscal strategy should have the following aims: * develop a tax system that satisfies the canons of simplicity, efficiency, equitv, and revenue elasticity. * a sustained effort should be made to trim subsidies in conjunction with reforms of prices and the industrial sector. * Although caution is required in viewing tax effort (i.e. the ratio of tax revenues to GDP) in normative terms, China is still respectably placed compared to other countries. But there has been slippage in recent years, in part because tax contracts negotiated with provinces and enterprises were not indexed in anticipation of rising inflation. This trend needs to be reversed. A gradual move to a consumption based, high-rated VAT would ease some of the revenue constraints. It would be an appropriate step for a country of China's level of development; and it would be in line with trends elsewhere in the world. Both the maintenance of revenue elasticity as well as the effective conduct of fiscal policy requires a strong apparatus at the center for planning and monitoring the government's efforts at raising revenue. The resources at the disposal of the recently created State Administrative for Taxation are not yet adequate to the task and will need to be augmented. e Simplicity is a worthy objective but difficult to achieve. Countries with a few taxes usually have impenetrable tax laws that provide endless opportunity for legal conflict, evasion and tax bargaining. However, China's tailored contract responsibility arrangements, by injecting myriad variations does render the system somewhat opaque and it is this aspect of taxation that should be replaced by a system of rules, commonly employed in other countries once the recently negotiated contracts mature in 1990-91. * Since 1986, the shift to tax contracting with its low marginal tax rates provides enterprises with the maximum incentive for profitable expansion. Unfortunately, it also promotes evasion by enterprises and concealment by the provinces who are suspicious of the central government's intentions. It will require some ingenuity to develop a better system, which is also simple, so long as the current pattern of relationships continues to prevail. The Government's plan should be to evolve cooperative arrangements with the provinces that will make possible a coordinated fiscal strategy, develop the administrative machinery needed to raise the level of fiscal centralization, and subject revenue sharing to the discipline of uniform and binding rules. 31. Monetary Policy. Fluctuations in the growth of the money supply that have been observed in the eighties can be destabilizing and in the future, demand management might aim to avoid such shocks. Improving the coordination between monetary and fiscal policies would certainly be  - xi - helpful. A closer monitoring of likely developments in the real sector could also make it possible to defuse crises before they become too serious. The research on links between money and prices conducted in the industrial economies suggests that the relationship is variable. Further, recent experience in China suggests that a tightening of the money supply depresses production in the state sector after a short lag. A fixed rule for monetary expansion is not an answer to problems of stability whether in the short or in the medium run. During the next few years, when new institutions will be emerging and financial market ties proliferating, the PBC should conduct a stable monetary policy tailored to the rapidly unfolding developments in real and financial .-ctors. 32. Rather than attempting to employ interest rates for the purposes of short-term demand reduction, the governmo'nt might aim instead for a step-by-step increase in the level of lending rates. Within a 2-3 year period it should be possible, with the minimum of disruption, to institute a rate structure and a system of interest management that allows the monetary authorities to use interest costs as a flexible tool for controlling demand. The manipulation of the money supply (through open market operations or repurchase agreements) would exert a more powerful influence on aggregate demand nationwide if mechanisms for transmitting the effects of PBC policies were better developed. China has made a beginning with an interbank market but interbank transactions are still at a very early stage. Similarly, financial markets exist on a provincial, or at best, a regional scale with the minimum of interlinkages. For these reasons monetary policies initiated by the central authorities have uneven consequences and may influence demand with uncertain lags. Integrating financial markets and deepening interbank linkages could add to the forcefulness of monetary measures and over the medium term, diminish the reliance on direct credit controls. An efficiently functioning interbank market would, in addition, provide the PBC with information on pressures in the financial system and if it contains provisions for issuing bills, create another avenue for open market operations. 33. The PBC could be extended a measure of formal autonomy as regards budgeting, audit and appointments, but it is doubtful that these alone will give the agency a more meaningful role in the sphere of stabilization policy. ithe PBC can acquire an independent voice when government agencies at all levels, financial entities and enterprises realize the costs of inflation and look towards the PBC to present their case. There are several major distributional issues to be resolved before that stage will be reached. Until then, the expedients proposed by the central government of appointing PBC branch managers directly drawing on personnel that do not belong to the particular province; and closer monitoring by the headquarters, should be implemented with the greatest possible speed and vigor. 34. A program for stabilizing prices during the course of 1989, using administrative and monetary instruments alongside price controls, has been defined. Once it takes effect, the government could push ahead with the reforms related to macromanagement, enterprises and the price system, so as to assure steady growth and defuse the threat of recurrent stop-go cycles.  I. Macroeconomic Overview 1.1 The active pursuit of economic reforms began ten years ago.l1 It started on a modest scale in the poorer areas of Athui, Sichuan and Guangdong with the piecemeal dissolution of collective agriculture.2/ By the mid-eighties virtually all agricultural production, including deliveries to the State, were contracted to households faming parcels of land on leases of 15 years or more. Communes, brigades and teams that had organized farm activity in minute detail so as to meet plan targets were reconstituted as local (township and village) government units having only indirect responsibility for economic activities. Rural markets, absent for decades, reappeared with official blessing, permitting peasants to trade their surpluses of meat and vegetables. As rural purchasing power rose, farmers began using their new freedom to diversify into light manufacturing. Local authorities quickly realized that industry promised employment and revenues so after some hesitation, they gave such activities their unstinting support. Between 1978 and 1986 agriculture grew by nearly 82 p.a., validating the leadership's faith in management through quasi-markets and preparing the ground for industrial reforms. 1.2 Following experimentation with enterprise autonomy in the early. eighties, the enterprise responsibility system was formally introduced in 1984 and China took a decisive step on its journey from central planning to an eclectic, market oriented, socialist commodity economy. Then, in 1986, China switched to the contract management system, and contracting has penetrated deep into the urban economy which is now trying to master the institutional complexity of markets and a multi-tier pricing system. Meanwhile, the state is learning to manipulate the indirect levers with which this hybrid system must be run. This is a difficult period, fraught with considerable risk. Other East European countries have walked this tightrope: attempting to achieve market discipline while holding on to certain vestiges of planning and socialism. Hungary, after a successful start fell afoul of resource imbalance and slow growth. Yugoslavia is still struggling to cope with the macro- conomics of self-management even as a steepening inflationary spiral complicates macroeconomic policy. How quickly China completes the transition to a mixed economy that will deliver on the promise of the four modernizations program depends on the skill with which the authorities stabilize an overheating economy and direct future industrialization. 1/ The Chinese objective is to become an economic power of the first rank by the year 2000 through the modernization of industry, agriculture defense and science and technology. The strategy is often referred to as the "four modernizations," an idea first broached by Zhou Enlai in 1975 which became the touchstone of government efforts after 1978. 2/ Agrarian Radicalism in China, 1968-81, by D. Zweig, Harvard University Press, 1989, pp. 169-70; and "The Household Responsibility System in China's Agricultural Reform,' by Justin Yifu Lin, Economic Development and Cultural Change, Vol. 36, No. 3, April 1988 supplement. On the merits of individual over collective farming, see, The Political Economy of Collective Farms, by P. Nolan, Westview, 1988.  - 2 - 1.3 This chapter first sketches the political economy of the reform program and against this backdrop provides an overview of macroeconomic developments in the eighties, giving special attention to the 1987-88 period. Price trends and demand management using monetary and incomes policies are examined in Chapter II. The role of fiscal policy as regards resource mobilization and macro-stability is the subject of Chapter IIl. Factors influencing investment behavior are explored in Chapter IV. This chapter also treats the dynamics of saving performance and the likely persistence of high savings into the future. The final chapter of Volume I discusses the state of agriculture and industry; analyses constraints on growth; and considers the prospects for further gains in efficiency througk price and other reforms. Chapter V serves as a bridge to Volume II of the report that is concerned with industrial change and the integration of the national market. Political Economy of Reform 1.4 Armed with hindsight it is easy to see why a major shift was required in the running of the Chinese economy. Central planning in such a large country was always problematic and the Cultural Revolution rendered it more difficult. It grievously damaged the machinery of government. The organizational integrity of both the bureaucracy and the Party were compromised. Although administrative decentralization had been practiced during the years of the Great Leap and was under discussion once again in 1964, the decade stretching from the mid sixties to the mid seventies witnessed a significant fragmentation of administrative authority, with the provinces gaining at the expense of the center. Statistical work ground to a complete halt for three years starting in 1966. Staff were disbanded, material burned and the activity of accurate reporting cast into disrepute. It took time to recover from these wounds. Starved of factual information, economic control from Beijing moved into the realm of qualitative guidelines with provincial authorities taking over the detailed, routine managerial tasks.3/ 1.5 External and internal developments intervened to strengthen the forces of change. After the mid seventies, the need for a garrison state to deter foreign military aggression was far less acute. China could begin concentrating on purely economic goals. It could limit the growth of military expenditures and devote more funds to consumption (see Chapter III). Industrial dispersion geared to defensive purposes and transport investments driven by military exigencies could all be subjected to economic rationality and the imperatives of market integration. 3/ A slow rehabilitation of the statistics gathering apparatus commenced in the early seventies. But as recently as 1981, the State Statistical Bureau had a staff of just 193 professionals. China's Political Economy, by C. Riskin, Oxford University Press, 1987, Chs. 6 and 7 and p. 282. See also China: Socialist Economic Development, World Bank, 1985, Vol I, The Statistical System. A Statistics Law was passed in 1983 calling for the creation of an independent nationwide statistics gathering network and establishing guidelines to safeguard the accuracy of the data collected. By the end of 1987 government statistical units at the county level or above employed a staff of 54,000. The slow spread of computers has meant that over half of the county bureaus lack a microcomputer, although city, provincial and central offices have at least one.  - 3 - 1.6 While the external as well as domestic circumstances noted above were conducive to reform, it is the belief that Chinese socialism can escape poverty only through pragmatic search for results that has animated the four modernizations program. Socialist theory is being reinterpreted in order to cut new paths for practical experimentation leading to market centered development. The dictum being followed is "Take one step and take one look." In short, make progiess but with due care.41 1.7 A major economic reform is shaped by political contingency. Given China's past history, change is occurring in a ':harged political environment and it is impossible to comprehend the policy formulation process or the tentativeness of actions taken to date without a sense of the basic political parameters. To drastically change economic direction, strong political coalitions are needed. To win a broad base of political support with the minimum of economic disruption, the Center tacitly approved the testing of the household responsibility system in a few provinces and then formally adopted it in 1978. Greater freedom and higher prices brought prosperity to the rural economy and created a national sentiment favoring the reform effort. 1.8 In post-Cultural Revolution China much power had percolated into the hands of provincial authorities. Beijing could propose but it was up to provincial administration to dispose. Winning province-level support for continuing change thus entailed a further transfer of power.51 Influence over fiscal resources and investment funds was the most tangible Liducement for provincial backing and it has greased the wheels of reform since the mid eighties (see Chapter III). Aside from cementing alliances, this move drained crucial influence from the bureaucracy with a deeply vested interest in centralized management,6/ and is paving the way for a transformation of the 4/ "China after the 13th Congress," S.R. Schram, China Quarterly, No. 114, June 1877, pp.180-3. 5/ "Assault on the Reforms: Conservative criticism of political and economic liberalization in China, 1985/86," L.R. Sullivan, China Quarterly, No. 114, June 1988. The forces behind the cycles of centralization and decentralization observed in China over the past century are ably analyzed in "The post-Mao reforms in historical perspective", by P.A. Cohen, Journal of Asian Studies, Vol. 47, No. 3, August 1988. 6/ The Hungarian economist Janos Kornai maintains that the progress of reform in socialist countries depends on the wi'llingness of the bureaucracy to refrain from interfering with the workings of the economy. Parallel developments to those in China occurred in the Soviet Union from the mid to the late fifties. There was a steady devolution of responsibility from the center to the republics and an increase in the latter's budgetary share. See Outside Moscow, by Donna Bahry, Columbia University Press, 1987; pp. 26-27, 51. Gorbachev's strategy has also entailed giving the local authorities a greater say on expenditures and combining this with selective appointments to win political support for reforms. Opening up the Soviet Economy, by Jerry H. Hough, Brookings, 1988, pp. 30-31.  - 4 - bureaucracy into a professional civil service.7/ Furthermore, the political weight of the large and enthusiastic rural populace and more independent provincial leaders enabled the reform minded leadership to divert resources long monopolized by the military into economic sectors (see Chapter III). 1.9 Decentralization of economic authority wins provincial political adherence and creates multiple focii of initiative, but it stores problems for the future. As in Yugoslavia, the transfer of economic authority to enterprises has become lodged in provincial bureaucracies, which are emerging crypto-states within the Chinese polity.8/ Their fiscal gains give them independence even as they constrain the Center's fiscal options. Monetary as well as industrial policy is increasingly in their grasp, forcing the central government to negotiate interminably for the sake of coordinated industrialization, reflecting nationwide comparative advantages. Mounting investment pressures and the upward march of inflation have signalled the onset of fierce competition for resources between provinces over which the center can exercise only ultimate and draconian checks. All obvious solutions, within a sociplist economic context, lead back to bureaucratic centralization--fiscal, monetary, industrial and of course political.9/ These the reformers find unpalatable. To thwart expectations so recently sharpened could destroy morale and dissipate the gains made. Yet decentralism that is not brought under the roof of a new economic consensus and a framework of rules could precipitate disequilibrium and industrial stasis. Markets, the price m:echanism and the autonomy of economic units would all be thoroughly discredited. These tensions cannot be defused by Beijing alone. However, a point has niow been reached when enough participants have a stake in the unfolding of reforms for China to achieve growth with stability, if the government takes the initiative in defining a macro-industrial strategy that is convincing as well as interregionally equitable. Growth and its Sources: 1978-88 1.10 An industrial and infrastructure base developed during the pre-reform period served as a springboard for the era of high growth that commenced in 1977. At first, rural reform provided the impetus. Except for 1980, when weather conditions curtailed production, agriculture with a one third share of GNP led the economy, accounting for between 402 and 602 of GDP growth during 7/ Currently all levels of the government employ 4.2 million people of which one half million work for the central and provincial administrations. Plans call for a civil service system to be introduced at the central and provincial levels by 1992, extending to all other levels by the end of the century. 8/ Communism and Development by R. Bidelux, Methuen, 1985, pp. 177-188. 9/ Reformers have to resist the strong tendency to seek a cure for the stresses experienced during the transition to a mixed economy, by reasserting central controls. A dialogue between Kenneth Galbraith and Stanislav Menshikov on the Soviet Union under Gorbachev highlights this tendency. Capitalism, Communism and Coexistence, by J.K. Galbraith and S. Menshikov, Houghton Mifflin, 1988.  1979-82. A bumper grain harvest of 407 million tons in 1984, a year during which rural output rose by 12.3Z, conclusively underlined the success of agricultural reforms and helped shift the focus of policymakers towards industry. Although the primary sector far exceeded expectations, strains were already evident elsewhere in the economy. Warehousing, transport, milling and marketing facilities could not accommodate the avalanche of grain, a part of which went to waste. Nor could the country's consumer industries satisfy the surge in demand for goods from the increasingly affluent rural inhabitants. This was reflected both in the retail price index that rose by 9Z in 1985 and in the insatiable appetite for imports, liberalized so as to absorb demand pressures. 1.11 The mid-eighties marked a watershed in the reform drive. A new phase commenced; new goals were adopted; and the economy was faced with a fresh configuration of constraints. Industry, which for two years had been pulling ahead of agriculture, was firmly established as the leading sector in terms of both size and future potential. By allowing enterprises to retain a much larger share of profits; by enlarging their latitude in the disposition of resources; and by introducing contracting into the field of industry, the government unequivocally committed itself to the immense task of industrial reform. It relinquished direct control over a substantial volume of resources. Government revenues that had amounted to 34% of GNP in 1978 declined to 202 of GNP by 1988 (Chapter III). Industrial growth was also supported by a relatively liberal expansion of credit which accommodated investment demand. Between 1984 and 1988, broad money grew at an average rate of over 27? p.a. which has worsened inflationary pressures, a point analyzed in Chapter II. 1.12 An acceleration of growth, which began in 1982, continued through 1988. The GDP grew at an average Af slightly over 8Z during 1978-83. It expanded by over 112 p.a. in the period 1984-88. A quarter of the growth in 1983 stemmed from agriculture, only 142 in 1987. Thus, the period since the mid-eighties shows the waning effects of agriculture reforms, exceptionally strong performance from industry--especially the township and village enterprises--which provided much of the growth momentum (502 in 1983, 93? in 1987) and a slackening of the service sector (Table 1.1). The expansion of services is not fully captured by Chinese national income statistics. 101 10/ An assessment of China's national income accounts using the 1985 industrial census and physical data on agricultural output reveals a high degree of internal consistency. Two problems remain. The use of overlapping price indices for 1952, 1957, 1970 and 1980 to construct a constant price index for industrial output, exaggerates the increase in production--a LasPeyres type bias, also known as the "Gerschenkron effect." The exclusive use of the 1980 index would yield superior results. While this procedure imparts an upward bias to GDP growth, the incomplete statistics on the expanding services sector--which includes transportation, construction and commerce--understates the true rate of growth. Whether the two are self cancelling is difficult to determine. It is also possible that the capital deflators lend an upward bias to the share of investment in GDP. Problems posed by price weights, deflators and index number biases in centrally planned economies are analyzed in, Dollar GNPs of the U.S.S.R. and Eastern Europe, by Paul Marer, Johns Hopkins Press, 1985, pp. 166-9.  - 6 - Agricultural production rose by an average of 3.8Z p.a. between 1985 and 1987, with a gradual recovery in grain output to 4G4 million tons, very close to the 1984 peak. Inclement weather during 1988 resulted in losses of grain, push.ng the total harvested down to 394 million tons. However, the robust performance of other farming subsectors hei)ed sustain growth estimated to be close to 3.5?. After expanding by nearly 222 in 1985, stabilization policies slowed the increase of industrial output in the following year. Growth rebounded to 16.5Z in 1987 and rose to 20.7? in 1988 with light industry leading heavy industry by a small margin. Sub- sectoral growth rates in 1988 showed wide dispersion. Transport equipment, machine tools and certain consumer items such as TVs, washing machines and bicycles did extremely well. Other industries, dependent on supplies of scarce raw material such as cottor, wool, coal and iron ore performed poorly by comparison. Cloth, silk, pig iron, steel and fertilizer regiscered fairly low rates of increase. Overall GNP growth in 1988 was 11.4Z. Table 1.1: SECTRAL M DAND LDED SOURCES OF GROW 19811-8 1980 1981 1982 1988 1964 1986 1986 1987 1988t" GDP growth rate 8.80 4.91 8.80 10.20 14.60 12.70 7.90 9.40 11.2 Agriculture -1.71 6.40 11.10 7.90 12.80 8.40 8.40 4.70 8.2 Industry 12.26 2.28 7.80 11.20 16.80 21.70 11.40 16.50 20.7 Services, etc. 8.19 8.86 7.46 11.68 18.89 8.86 6.44 -8.42Lr -9.2/b Contribution to GODP growth In percent Agriculture -9.02 41.71 40.98 26.70 27.6f 8.68 12.68 14.01 Industry 84.69 22.27 41.46 60.87 52.65 81.14 74.00 92.98 Services 24.44 86.02 17.67 28.48 19.89 10.88 18.42 -8.98 Tot l 100 100 100 100 100 100 100 100 Contribution to GDP growth In percent Total consumption 96.49 76.88 88.92 67.45 48.22 18.89 25.62 10.67 Gross domestic Investment 8.02 -10.90 67.84 48.06 88.16 105.84 42.74 87.04 Exports of goods A NFS 17.29 24.17 1.18 8.98 6.04 18.78 11.54 14.15 Imports of goods A NFS -18.80 11.87 4.60 -17.49 -12.41 -48.01 20.20 8.16 Tota l 100 100 100 100 100 10O 100 100 /o Preliminary estimates. b As incidated In Footnote 10, the estimates for servine sector are biased downwards quite severely. Hence, the contribution to growth may not be fully captured. Source: Staff estimates.  1.13 Once reforms had taken hold in the late seventies, gains in consumption spearheaded the growth of GDP. Total consumption rose by 7.5Z over the six year period from 1S78-1983. But by 1984 investment had once again regained its place as the principal source of demand Consumption increased by a mere 3.5Z p.a. in 1985-86. In 1987 it grew by less than 22. Essentially much of the quickening in growth from the mid-eighties was achieved by "extensive' means, that is, through greater capital accumulation. This trend is also captured by the ratios of investment and saving to GDP (Table 1.2). Consumption as a percentage of GDP hovered around 70X through most of the seventies. In 1978, it had dropped to 66Z. Thereafter, it rose once again to 702 by 1981 before declining to 69Z during 1982-83. A four year slide brought the consumption ratio to its lowest point in over two decades. In other words, China's ratio of savings to GDP in 1987 was nearly 38Z and the highest it had ever achieved. Preliminary ?stimates for 1988 suggest a flattening of the trends. Real consumption riose by 10% which is less than the expansion of GDP but a considerable departure from the performance of the past three years. Investment grew by about 15-162 so that the savings investment balance slipped slightly into negative with savings equal to 36.02 of GDP and investment amounting to 39%, the gap equivalent to about 1.02 of GDP being financed through foreign capital inflow. The savings and investment ratios must be treated with some caution. The spread of the underground economy means that the denominator is being underestimated. Second, enterprises are prone to misclassify consumption items as investment. And the price deflators used give an upward bias to the estimates of investment. Table 1.2: SAwIN5 AND NViESTT, 197m8- =-- ~(percent of GDP) 1978 1979 1980 1981 1982 1988 1984 1966 1986 1987 1989 Savings as percent of GDP 86.6 88.7 80.9 29.6 81.1 81.0 82.9 84.6 86.9 87.6 88.6 Investment as percent of GDP a8.2 86.0 82.2 29.2 29.1 29.6 82.2 38.8 88.8 87.6 89.0 Reliance on foreign savings 0.6 1.8 1.4 -0.8 -1.9 -1.4 -0.7 4.3 2.9 0.0 -0.5 Source: World Bank and IMF staff estimates. 1.14 A glance at the resource balances over the past twenty years indicates that national savings equalled domestic investment in all but a few years. During 1979-80 a combination of falling saving rates and somewhat above trend levels of capital spending resulted in current account deficits o' a little over 1% of GDP. A much larger deficit equal to 4.32 of GDP appeared in 1985 because of the tremendous leap in investment that followed on the heels of industrial liberalization. The resource gap was halved in 1986 by compressing consumption and more or less eliminated in 1987 by taking the ratio of consumption to GDP down another two percentage points. A small resource deficit reappeared in 1988 as investment continued to bound ahead and there was a marked spurt in consumption.  - 8 - 1.15 The aggregates suggest that the second phase of the reforms, beginning in 1984, primarily affected industrial investment. Because savings lagged there appeared an imbalance which was removed by tackling the growth in consumption. A closer look at savings behavior indicates that adjustment efforts have weighed most heavily on households (see Chapter IV, Table 4.7). Put in a somewhat different way, the balancing of resource demand with domes- tic supplies is the outcome of a continO'ng tl'ward trend in household savings. These rose from 102 of GDP in 1983 to over 172 of GDP in 1987. Enterprise savings reached 16? of GDP by 1987 from 15? in 1983. Superior enterprise performance mirrored a deterioration in budgetary savings as profit retention by firms reduced the government's revenue take, and current expenditures climbed primarily as a result of mounting subsidies. As a share of GDP, revenues dropped from 282 in 1983 to 232 in 1987. They fell to 19Z of GDP in 1988. Inflation 1.16 In tautly run, shortage ridden, planned economies, the urge to invest on the part of enterprises is very strong. Cheap capital and soft budget constraints only sharpen the appetite to accumulate. Reform has given Chinese firms more command over resources and loosened the grip of bureaucratic controls on their activities, without significantly increasing accountability for losses, or the cost of capital or even the discipline exerted by market competition. Moreover, decentralization has generated a race to industrialize between the provinces, each of which is trying to gain a larger share of resources. Investment has soared in state, collective and township enterprises alike. It seems almost impervious to directives from the state or taxes on construction and it acts to reinforce expansive policies in a range of producer goods industries.11/ During 1988, the central government was able to exercise a degree of restraint on those segments of capital spending by state enterprises that drew upon budgetary resources, but it failed to check investment from the enterprises' internal funds or that financed through the banks. As the demand for capital seems once again to be pulling ahead of the supply generated through domestic savings, the administrative restrictions on investment proposed by the government for 1989 (discussed below see para 1.38) may be necessary to ensure that the resource gap does not widen. 1.17 Rapid growth through much of the eighties has begun to destabilize prices. Inflation flared briefly in the late seventies but was soon contained. It reappeared in 1985, when demand pull pressures became especially acute. With slower growth in 1986, inflation abated somewhat but by late 1987, with economic expansion pushing beyond 102 p.a., prices began to spiral upwards (Table 1.3). The retail price index which had registered an increase of 6? in 1986 rose by 18.5% in 1988, while the inflation in market prices went from 8? to nearly 351. 11/ The prevalence of investment hunger in East Europe and its causes are discussed in "The Hungarian Reform Process: visions, hopes and reality,' by Janos Kornai, Journal of Economic Literature, Vol. 24, December, 1986; "The Dilemmas of A Socialist Economy: The Hungarian Experience," J. Kornai Cambridge Journal of Economics, Vol. 6, 1980; Modern Soviet Economic Performance, T. Buck and J. Cole, Blackwell 1987, Chs. 3 and 4.  Table 1.8: MEASURES OF INFLATION 1979 1980 1981 1982 1988 1984 1905 1986 1987 1988/! Retail prices 2.0 6.0 2.4 1.9 1.6 2.8 8.8 6.0 7.8 18.6 Market prices -4.6 2.0 6.6 3.6 4.1 0.8 16.9 7.7 15.8 28.7 Construction costs 8.7 8.8 13.0 6.8 12.2 13.3 9.6 12.7 16.9 - ONP deflator 4.0 8.6 1.9 0.1 1.8 5.0 9.0 4.7 6.4 - /a preliminary estimates Source: Statistical Yearbook 1988, p.692, p.700 and p.524, for 1979-1987; and China Statistics Monthly, p.61 from The University of Illinois for 1988. Note: Construction costs do not include land costs, demolition and removal expenses, and investment In outdoor supplemontary projects. 1.18 Investment was the major contributor to aggregate spending during 1985-7. It was supported by an expansionary monetary policy which accommo- dated the capital expenditures of enterprises. Broad money increased by 41Z in 1984 and, after a slowdown in 1985, it averaged over 27.02 p.a. growth in 1986-8. This pace was maintained through the first half of 1988. There was some slowing in the third quarter but the financing of the harvest stimulated money demand in the final quarter of the year and induced the People's Bank of China (PBC) to increase the supply of funds. 1.19 The share of construction in fixed investment is about two thirds and this is one of the sectors that has felt the full brunt of investment spending. shortages of construction materials and skills have become steadily more acute and led to a worsening of inflationary pressures. Construction costs rose by 13Z p.a. between 1983-87, well ahead of the retail price index and somewhat in excess of the market price index as well (Table 1.3). Needless to say they accelerated sharply in 1988. 1.20 Over the past eighteen months the trickle down of growth into higher earnings has spurred consumer spending on foodstuffs and, more recently, certain durables. Changing expectations regarding price trends and the view expressed by senior officials in June 1988 that China might have to tolerate inflation while price reforms were being implemented, induced people to modify their spending pattern. Because the supply of quality food items such as vegetables, fruit and meat was slow to respond, food prices climbed steeply during the second and third quarters of 1988. A weak integration of the national market which interferes with the distribution of pork and vegetables exacerbated local shortages (Chapter VIII). And poor grain harvests added to price pressures as it had in 1980 and 1985.  - 10 - 1.21 Although the forces of demand pull abetted by monetary actions and shifting expectations are the major culprits, price movements are also linked to the removal of controls on a wide range of prices and a partial restructuring of relative prices. 1lhere once the vast majority of prices were set by central or local agencies, they are now determined either by the market or through bilateral negotiations between enterprises and price bureaus. Thus, possibly one half of the increase in prices through 1987 could be ascribed to adjustments in relative prices and the balance to pure inflation (see Chapter II, para. 2.18). A higher proportion of price changes in 1988.-possibly two thirds--are purely inflationary but precise calculations are difficult. Suffice to say that a lifting of price controls has had a hand in the inflationary process by permitting relative price movements; by enabling producers to take advantage of the sellers market; and by engendering expectations of inflation that have strongly influenced wage demands and spending patterns in 1988-9. 1.22 Accelerating inflation during 1987-8 has resulted in a backwash of distributional effects that are arousing discontent among vocal segments of the urbar. populace, especially those on fixed salaries such as state employees and teachers. A point may have been reached when the paini inflicted by rising costs of living begins to obscure other gains from reform. Any system of prices will perform the work of allocation most efficiently if it is broadly stable (i.e. inflation is maintained at single digit rates)--"it is allowed to acquire to some degree the sanction of custom [and] not at frequent intervals being torn up by the roots".12/ The immediate objective of the government's macroeconomic strategy must be to dampen inflation without a sharp reduction in the growth rate. Some moderating of the pace of economic expansion is an essential element of a stabilization strategy as the current rate of growth is straining the country's resource base. But growth in the 7Z-8 p.a. range is needed to sustain support for further reforms; satisfy employment goals; and to stimulate productivity which is vital from the standpoint of both price stability and future development. Employment 1.23 Reform and demographic forces are opening fissures in the labor market long accustomed to full employment through administrative fiat. In parts of the country the switch to rural household contracting has uncovered a reservoir of disguised unemployment estimated in the tens of millions. Similarly, many urban enterprises that are becoming more profit conscious and beginning to exercise their autonomy are also anxious to reduce overstaffing. Statistics released by the authorities indicate that some 30 million out of an urban labor force totalling 133 million in 1988 could be classified as having 121 The Crisis in Keynesian Economics, by J. Hicks, Blackwell, 1974, p. 79. Price reform is of vitdl importance in China and can promote factor productivity. However, ascending rates of inflation could easily become a major macroeconomic roadblocl- as well as a political liability.  - 11 - low or zero marginal productivity. They are carried on the books at an annual cost of 60 billion yuan.13/ The losses from disciplind, weakened motivation and chronic organizational slack could be as large. Most workers are allocated to enterprises by local labor bureaus. Neither party as yet has such choice in the matter and appointment still virtually assures tenure the so-called "iron rice bowl". Firms 3ometimes find overmanning an asset because production peaks are easier to accommodate and requests from city authorities for assistance can be met with minimal disruption. The negative side of the ledger is far more imposing. Enterprises are weighed down by the direct wage costs of employment and the indirect costs of providing housing and services. The problem of x-inefficiency in a slack work environment is a separate burden that inevitably drags down the quality of effort and labor productivity. 1.24 Contract employment is the Chinese approach to maintaining discipline while introducing flexibility into the urban labor market. In the long run, alongside complementary changes in education, social welfare, access to housing and labor laws, it might well transform labor relations and productivity. However, initial results have been less than satisfactory. Capital intensive enterprises using skilled labor are unwilling to hire expensively trained employees. They are skeptical over hiring on contract and when they do are likely to ,lace entrants in long-term, de facto, tenured jobs. Other enterprises find that contracted workers are suitable for some assignments only. Segregation as well as invidious comparisons between benefits enjoyed by those feeding from the iron bowl and those on 3 to 5 year contracts, damage worker solidarity.14/