China - Internal market development and regulation

Report No. 12291 CHA China Internal Market Development and Regulation March 17, 1994 Country Operations Division China and Mongolia Department East Asia and Pacific Regional Office FOR OFFICIAL USE ONLY I0 ,. . v ~- 5, c' ' 'N~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~1 MI1CROGRAPHICS Report No: 12291 CIIA Type: SEC Document offheWoMW'anI~ This docuiient has" a ebictedIuinadmybeue ywm~ol iihe e1act pidaI- f. lb c'ntew. ''ay0't ot6 'e di~~cIo~ed w d&aCtb'w r.' '* .-. . '' .. . ~~~~~-~: .. .3  CURRENCY EQUIVALENTS Currency Unit: Yuan (Y) (Nominal Official Period Average Rates) Year Yuan (Y) per US$ 1992 5.52 1991 5.32 1990 4.78 1989 3.77 1988 3.72 1987 3.7r 1986 3.45 1985 2.94 1984 2.32 1983 1.98 1982 1.89 1981 1.70 1980 1.50 1979 1.56 1978 1.68 FLSCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System  FOR OFFICIAL USE ONLY ACRONYMS AND ABBREVIATIONS ASEAN Association of South-East Asian Nations CASS Chinese Academy of Social Sciences CFSRRI China Economic Systems Reform Research Institute CFA Communaut6 Financiere Africaine CFMC Commodities Futures Management Commission CFTC Commodities Futures Trading Commission CNCC China National Coal Corporation CNFMGC China Non-FerrouG Metals General Corporation COV Covariance DRC Development Research Council EC European Community ECU European Currency Unit ETDZ Economic and Technical Development Zones FEAC Foreign Exchange Adjustment Centers FIMBRA Financial Intermediaries', Managers' and Brokers' Regulatory Association FSU Former Soviet Union FTC Foreign Trade Corporation GITIC Guangdong International Trust and Investment Center GDP Gross Domestic Product GNP Gross National Product GPAIC Guangdong Province Administration of Industry and Commerce GVIO Gross Value of Industrial Output GVO Gross Value of Output LAUTRO Life Assurance and Unit Trust Regulatory Organization LME London Metal Exchange MME Ministry of Materials and Equipment MOC Ministry of Commerce MOFTEC Ministry of Foreign Trade and Economic Cooperation NAFTA North American Free Trade Association NTHS National Trnmk Highway System OEC Office of Economic Cooperation SAIC State Administration of Industry and Commerce SCETO State Council Economic and Trade Office SCRES State Commission for the Restructuring of the Economic System SEZ Special Economic Zone SHME Shanghai Metals Exchange SIB Securities and Investments Board SME Shenzhen Metals Exchange SOEs State Owned Enterprises SPC State Planning Council SRO Self-Regulatory Organizations STICERD Suntory-Toyota International Center for Economics and Related Disciplines TVE Township and Village Enterprises UK United Kingdom USA United States of America Thds doment has a restricted distn1ution and may be used by recipient only in the perfom of thidr I official duties. Its contents may not otherise be disclosed without Wodd Bank authoion. l  CONTENTS Executive Summary .................................... xi Market Senatonand Market Developme .................. 1 A. Introduction 1 Factors Affecting Internal Markets 4 Objectives of this Report .5 B. The Potential Benefits of Internal Free Markets. 7 Forms of Regional Integration. 7 The Case for Regional Integration. 8 C. Market Strcture in China .12 Annex 1.1 Calculadtion of Regional Structural Difference Coefficients ...... 16 2 Rect Evolution of China's Internal Markets ........ ............. 20 A. The Impact of Price Reform .20 Assessing Price Efficiency: Plan and Market Prices .22 Assessing Price Efficiency: Regional Price Differentials 24 B. Interrgional Domestic Trade .26 An Analysis of Domestic Trade Flows ...... .......... 29 C. Factor Mobility: Capital .32 Factors Affecting nterprovincial Investment .32 Profit Retention and Taxation .33 Tax Concessions in 'Zones' Established by the Center .35 Tax Concessions in 'Zones' Established by Localities .36 Other Tax Concessions by Localities .37 Regional Cooperation Zones .38 Procedures and Practice .38 Summary: Tax Policy and Regional Capital Flows .39 An Analysis of Evidence .40 The Banking System: Interbank Borrowing and Lending 43 The Banking System: Payment Clearance and Settlement 45 Capital Markets .47 D. Factor Mobility: Labor .47 B. Foreign Exchange Mobility .53 Recent Changes .55 F. Conclusions .55  - iv - 3 The Distribution System ..................................... 58 A. The Changing Role of the State in Distribution .58 B. The Efficiency of the Present Distribution System .63 Evolution of the Materials Distribution System .63 The System Today ........................... 67 The Efficiency of the Present Materials Distribution System ... 70 C. Parlel Changes in Agriculture. 75 Agrcultual Wholesale Markets .75 D. Transpoitation, Telecommunications and Services .76 The Raflroad System .78 Truck Transportation .78 E. Summay and Implications. 31 Annex 3.1 A Note on Producer Goods Distnbution Systems ................. 82 Efficient Distribution Systems ...................... 82 Altermative Cbannel Structures ...................... 82 Chamel Functions ............................. 83 The Evolution of Distnbution Channels for Producer's Goods . . 84 Some Comments on Distributor Efficiency .... .......... 86 'Best Practice' Tools and Techniques to Minimize Costs ...... 87 4 New Forms of Markes ...................................... 89 A. China's Distinctive Pattern of Development of Commodity Exchanges . 90 B. Agricultural Markets .91 C. The Metals Exchanges of Shanghai and Shenzhen .93 The Shenzhen Meta Exchange .96 The Shanghai Meta Exchange .98 D. An Assessment of Trading on China's Two Metals Exchanges. 101 The System of Trading on the Exchanges .101 The Costs of Trading on the Exchanges .104 The Nature of Trading Activity on the Exchanges .105 E. Policies and Regulations for Commodities and Futures Markets 109 The Difficulty of Reconciling Free Markets and Contimued Goverment Intervention .109 Financial Safeguards for Participants on the Exchanges 110 . Framework of Regulation for Commodity Markets in China and Oder Countries .111 F. Future Prospects for China's Commodity Exchanges ................... 114 The Pressures for the Rationalization of the Number of Chinse Commodity Exchanges .................... 114 The Likely Development of Trading on the Exchanges .... ... 115 G. Implications for Government Action ............................. 117 Annex 4.1 Commodity Market Trading: A Zero-Sum Game ................. 119  S Market Regaon . ........................................ 121 A. Regulation in a Market Economy .121 B. Competition and a Competitive Enviromnent .122 Market Structure: Firm Size and Industrial Concentration 123 Potental Changes in Market Structure: Mergers .125 Potential Changes in Market Structure: Enterprise Groups 127 Market Conduct Issues .134 Legal Provisions on Competition .134 C. The Entry of New Firms .136 The Role and Functions of the SAIC .136 Other Agencies Concerned with Entry .139 D. Other Regulations Affecting Market Structre .140 Consumer Protection Related Rules: Advertizing and Fraudulent Practices .140 Protection to Producers: Tridemarks, Patent and Copyright ... 142 E. Conclusions .144 6 Mbarkets ad Government: Future Perspectives ................... 146 A. General Themes - A Synthesis .146 B. Policy, Regulation and Administration .149 Price and Quantity Controls .149 Internal Trade .149 Factor Mobifity. 10 Market Reguation .152 C. Physical Constraints and the Management of Distribution .154 Distribution Practices and Distribution Facilities ..154 Road Transportation ..155 Commodities and Futures Markets .155 D. The Future Role of the Govermment .156 References ......................................... 158  - vi - Tables in Text Table 1.1 Trends in the Branch Composition of China's Industrial Output .... ...... 13 Table Al. 1 Comparison of Average Coefficients of Structural Difference .... ....... 19 Table 2.1 Ratios of Market to State Prices for Main Materials ................. 23 Table 2.2 Plan and Market Prices for Selected Materials (1985-1991) .... ........ 24 Table 2.3 Coefficient of Regional Variation of Retail Prices of Major Commodities .... 25 Table 2.4 Coefficients of Variation of Materials Prices by Province (1990-1992) ..... 25 Table 2.5 China and Other Regional Trading Areas: Interregional Trade .... ....... 31 Table 2.6 Interprovincial and Foreign Investment in Selected Provinces .... ....... 41 Table 2.7 Mean and Coefficient of Variation of Effective Tax Rates of 20 Provinces (1986-1990) .... ..... 43 Table 3.1 Composition of Total Retail Sales Value by Ownership (1960-1991) ....... 61 Table 3.2 Number and Share of Domestic Trade Units by Ownership and Region (1985-1991) . 61 Table 3.3 Retail Trade Services in China and Other Countries.63 Table 3.4 China and Other Countries: Employment in Trade and Transport .... ..... 77 Table 5.1 Industrial Concentration Ratios for Selected Industries ............... 124 Table 5.2 Size Distribution of Industry by Alternative Indices (1991) ............. 125 Figues in Text Figure 1.1 Reduction in Scope of Price Controls ........................... 2 Figure 1.2 External and Domestic Trade Shares ........................... 3 Figure 1.3 Coefficients of Structural Difference ........................... 15 Figure 2.1 Free Market Prices Relative to State List Prices ........ ............ 23 Figure 2.2 Domestic and Foreign Trade Ratios (1980-1992) .................... 30 Figure 3.1 Material Supply by Government Contact ........................ 59 Figure 3.2 Marketization of Agriculture ................................ 60 Annex Tables Annex I Table Al. la European Community: Coefficients of Structural Difference of Number of Firms, 1987 .................................... 168 Annex I Table Al. lb United States: Coefficients of Structural Difference of Number of Firms, 1987 .................................... 169 Annex I Table AI. lc China: Coefficients of Structural Difference of Number of Firms, 1991 ............................................ 170 Annex I Table AI.2a European Community: Coefficients of Structural Difference of Number of Employees, 1987 ................................. 171 Annex I Table AI.2b United States: Coefficients of Structural Difference of Number of Employees, 1987 ................................. 172 Annex I Table Al.2c China: Coefficients of Structural Difference of Number of Employees, 1991 .................... ... 173 Annex I table AI.3a European Ccommunity: Coefficients of Structural Difference of Output Value, 1987 ....................................... 174  - vii - Annex I Table Al.3b United States: Coefficients of Structural Difference of Output Value, 1987 . ..175 Annex I Table Al.3c China: Ciefflcients of StructUral Difference of Output Va;ue, 1991 ..................t . . . ... . 176 Annex I Table Al.4a EC, US and China: Coefficient of Variation of Average Employees Per Firm (Nos) ............. .. .............. 177 Annex I Table Al.4b EC, US and China: Coefficient of Variation of Average Output Per Firm (US$ million) ........... .. .............. 178 Appendx Tables Appendix Table Al.l Per Capita National Income by Province (1983-1991) .... ..... 179 Appernix Table A1.2 Per capita Investment in Fixed Assets by Provinces (1983-1991) 180 Appendix Table A1.3 Per Capita Gross Value of Industrial Output by Province (excluding village enterprises) (1985-1991) .................. 181 Appendix Table A1.4 Per Capita Gross Value of Industrial Output by Province (includiDg village enterprises) (1985-199i) .................. 182 Appendix Table A1.5 Number and Gross Output Value of Industrial Enterpises by Ownership (1985-1991) .................................... 183 Appendix Table A1.6 Number of Enterprises, Gross Output Value (GOV), and Number of Employees (1991) ................................ 184 Appendix Table Al.7a Average Gross Output Value (GOV) Per Enterprise by Province and Industry (1990) (Y million) ............. . ............ 187 Appendix Table A1.7b Average Gross Output Value (GOV) Per Enterprise by Province and Industry (1991) (Y million) ......................... 188 Appendix Table Al.8a Average Number of Employees per Enterprise by Province: 1990 189 Appendix Table A1.8b Average Number of Employees per Enterprise by Province (1991) 190 Appendix Table A2.1 Price Controls: Reduction in Scope (1978-1991) ...... ...... 191 Appendix Table A2.2 Free Market Price Indices of Consumer Goods ....... ...... 192 Appendix Table A2.3 Free Market Prices Relative to State List Prices (1983-1991) .... 193 Appendix Table A2.4 Planned and Market Prices of Main Materials (Y/ton) ........ 194 Appendix Table A2.5 Planned and Market Prices of Main Materials (1989-1991) ..... 195 Appendix Table A2.6 Retail Prices of major Commodities in 29 Provincial Capitals (1986) ................................ 197 Appendix Table A2.7 Retail Prices of Major Commodities in 29 Provincial Capitals (1989) ....... ........... ................ 198 Appendix Table A2.8 Retail Prices of Major Commodities in 29 Provincial Capitals (1991) ................ ....... 199 Appendix Table A2.9 Average Price of Materials by Province (ecember 1990) ....... 200 Appendix Table A2. 10 Average ?,dce of Materials by Province (December 1991) ...... 201 Appendix Table A2. 11 Average Price of Materials by Province (June 1992) . .202 Appendix Table A2.12 Imports of Commodities from Other Provinces (1985-1992) ......203 Appendix Table A2.13 Exports of Commodities to Other Provinces (1985-1992) ...... 204 Appendix Table A2.14 Total Domestic Sales within Province (1985-1992) .......... 205 Appendix Tablc A2.15 Ratio of Interprovincial Exports to Total Domestic Sales (1985-1992) .............. .. ............... 206  - viii - Appendix Table A2.16 Ratio of Inter-provinical Imports to Total Domestic Sales (1985-1992) .............. .. ............... 207 Appendix Table A2.17 Ratio of Inter-provinical Trade to Total Domestic Sales (1985-1992) ............. .. ............... 208 Appendix Table A2.18 Inter-provinical and Foreign Trade (RMB Y billion and %) .... 209 Appendix Table A2.19 China and Other Regional Trading Areas: Interregional Trade ... 210 Appendix Table A2.20 lnterprovincial and Fo.-eign Investment in Selected Provinces .... 211 Appendix Table A2.21 Effective Tax Rates by Province (1986) ................. 213 Appendix Table A2.22 Effec*ive Tax Rates by Province (1987) ................. 214 Appendix Table A2.23 Effective Tax Rates by Province (1988) ................. 215 Appendix Table A2.24 Effective T-x Rates by Province (1989) ................ 216 Appendix Table A2.25 Effective Tax Rates by Province (1990) ................ 217 Appendix Table A3.1 Supply by Government Contacts (1981-1991) ............. 218 Appendix Table A3.2 Production of Main Products (1981-1991) ........ ........ 219 Appendix Table A3.3 Distribution of Retail Sales in Quantity and Value ........... 220 Appendix Taole A3.4 Total Value of Retail Sales by Ownership (1960-1991) ........ 221 Appendix Table A3.5 Composition of Total Retail Sales by Ownership (1960-1991) .... 222 Appendix Table A3.6 Number of Domestic Trade Units by Ownership and Region (1985-1991) ............. .. .............. 223 Appendix Table A3.7 Composition of Dumestic Trade Units by Ownership and Region (1985-1991) ............. .. .............. 224 Appendix Table A3.8 Staff and Outlets of Materials Circulation System (1985-1991) ... 225 Appendix Table A3.9 Number of Units and Persomel in Domestic Trade by Ownership (1985-1991) .................. .................. 226 Appendix Table A3.10 Sales of Machinery and Electrical Trading Companies under MME (1991) .................... .................... 227 Appendix Table A3.11 Sales of Metal Materials Trading Companies under MME (1991) 228 Appendix Table A3.12 Sales of Fuel Trading Companies under MME (1991) .... .... 229 Appendix Table A3.13 Sales of Comprehensive Trading Center ulder MME (1991) .... 230 Appendix Table A3.14 Purchase, Sales and Inventory of CommercW Units (1962-1991) 231 Appendix Table A3.15 Coal Industry: Inventory and Working Capital Requiremes in Sample .............................................. 232 Appendix Table A3.16 Cement Industry: Inventory and Working Capital Requirements in Sample ..... ....................... 233 Appendix Table A3.17 Steel Industry: Inventory an . 'orldng Capital Requiemens in Sample .............................................. 234 Appendix Table A3.18 Length of Transportation Routes by Province (1983-1991) .... 235 Appendix Table A3.19 Per Capita Length of Transportation Routes by Province (1983-1991) .................... .................. 236 Appendix Table A3.20 Average Shiping Distance of Freight (1962-1991) .......... 237 Appendix Table A4.1 China's Foreign Trade in Non-Ferrous Metals ... ......... 238 Appendix Table A4.2 Trading Volume on the Shenzhen Metal Exchange ........... 239 Appendix Table A4.3 Trading Volume on the Shanghai Metal Exchange .... ....... 240 Appendix Table A5. la Size Distribution of Industry by Number of Employees and Number of Firms (1991) ............................ 241  - lx- Appendix Table AS.lb Size Distribution of Industry by Number of Employees and Persons Employed (1991) ..... 242 Appendix Table AS. lc Size Distribution of Industry by Number of Employees and Gross Output Value (1991) .243 Appendix Table A5.2a Size Distribution of Industry by Gross Value of Industri Output and Number of Firms (1991) .244 Appendix Table AS.2b Size Distribution of Industry by Gross Value of Industrial Output and Number of Employees (1992) .245 Appendix Table A5.2c Size Distribution of Industry by Gross Value of Industrial Output and Output Value (1992) ........................... 246  CONTRIBUTORS This report and its annexes are based on the findings of a preparatory visit to China in November 1992, followed by a full-fledged investigative study during March 1993 in China, jointly undertaken by the World Bank, the Ministry of Materials and Equipment, and the State Administration of Industry and Commerce, Government of China. In addition to discussions in Beijing, the team visited Shenyang (Liaoning Province), Shanghai Municipality, Suzhou, Wuxi (Jiangsu Province) and Shenzhen (Guangdong Province). Excellent support was provided at each location visited by the local departments of the Ministry of Materials as well as the State Administration of Industry and Commerce. The World Bank team consisted of Anjali Kuniar (team manager and principal author of this report), Wang Yuan (task coordinator from the Beijing Office of the World Bank), Mark Dutz (competition policy), James Fry (commodities and futures markets), Lawrence Wortzel (distribution systems) and Jun Ma (capital mobility, data base). Jun Ma also provided able research assistance in Washington and Cathy Song helped with document preparation. The Chinese team consisted of Wu Baozhong (task leader from the Ministry of Materials and Equipment), Zhao Jie, Wang Erliog, Li Chenghuai, Qi Xiaojie and Shi Chunling and Xu Su (MME). Wang Baotong from the SAIC also accompanied the team on its field visits. Background papers for this study were prepared by a team led by Tao Fei of the Chinese Academy of Social Scienc, s; by the Ministry of Materials and by the Development Research Council. The team extends its gratitude and appreciation to all the officials from the various govermment agencies, distribution companies and enterprises with whom it met.  Executive Summary A. An Overview i. China's commitment to the creation of a market economy received new emphasis in the recent 8th National People's Congress of March 1993. The congress ratified the decision taken at the 14th Party Congress of October 1992, to develop a 'socialist market economy', shifting decisively away from central planning. The Constitution of 1982 was amended to emphasize this shift. ii. The development of the internal market was fostered by a series of mechanisms intended to reduce the scope of state intervention: (1) Progressive price decontrol was first introduced through three categories of prices (planned, guidance and market prices) and the gradual movement of goods from more reglated to less regulated categories. The 'dual track' pricing, introduced in 1985, permitted output above certain target levels to be sold on the free market. The proportion of goods in total domestic retail trade subject to planned prices fell dramatically between 1978 and 1991, In favor of 'guidance prices' and free market prices. Goods subject to planned prices have fallen considerably further, with recent announcements in early 1993 of the relaxation of controls on prices of grain and edible oils. (2) The allocation of goods moved progressively out of the mandatory plan. In 1980, 90 percent of industrial goods and 837 production materials were allocated under the plan system. By 1993, the proportion of industrial goods under the plan had declined to less than 10 percent and the number of production materials in this category was reduced to 11. At the same time, consumer goods administered by the Ministry of Commerce declined in number from 274 in 1978 to 14 in 1993. (3) Distribution systems and chamcis gradually expanded. Formerly, the system of unified purchase and sale of consumer manufactures, and the unified purchase of farm products, by designated government agencies, accounted for virtually all sales. Sales may now be made to private purchasing agencies or directly to consumers. New 'comprehensive' and 'specialized' cistribution agencies have sprung up. Sales undertaken by government agencies have also diversified in form and function, and state-owned distribution agencies are providing new forms of services. (4) Sophisticated forms of commodities markets, for many agricultural products and Industrial raw materials have been established. Today there are 21 centrally sponsored  - xii - commodities exchanges in China, many of which are equipped with advanced computer technology and newly constructed modern trading facilities. (5) In conjunction with these policy and real side adjustments, the government has drawn up a major program of legislative change for establishing a framework for a market economy. iii. Over the last decade, China has made remarkable strides towards the establishment of a market economy. But the progress achieved so far has been uneven. This report evaluates the extent to which China, through the adoption of the measures described above, has been able to establish well- functioning markets. Well-functioning markets imply markets which transmit accurate signals to economic agents in terms of production decisions and factor allocation. The report distinguishes between the regional or spatial aspect of market functioning, and the movement from plan to market. Foliowing a policy evaluation, the report analyzes the new systems for allocating and distributing goods that have evolved in the aftermath of planning. The report also discusses present regulation of markets In the changing environment. B. Main Flndings iv. There are large potential benefits in achieving well-functioning and regionally integiated internal markets and other countries have achieved greater market integration through systematic and deliberate policies (Chapter 1, para 1.21 to 1.30). The report examines China's present Industrial structure and demonstrates that the composition of output has remained remarkably staic despite shifts In the ownership of industrial output (para 1.33). The cross-section structure of industi output by region shows that each major industrial group is located in virually all provinces. Firm size is also remarkably similar across provinces. V. To assess the extent to which China could gain from greater integration of its domestic market, the report compares China and other large regional markets. Subject to the caveats that apply to international comparisons with the EC and the US, the findings suggest that regional differences in China appear relatively small, and there is little evidence of industrial specialization or a well-integrated structure (para 1.37 and Annex 1.1). Relative to other countries, China Is far from realizing the benefits of its potentially large internal market. As a consequence of its relatively 'cellular'economic structure, many benefits, such as scale economies in plant size and the spreading of overheads in management, technology and learning, communications and infrastructure, associated with the development of industrial 'clusters', have yet to be exploited. vi. To promote regional trade and specialization, mechanisms for the redistribution of benefits among the various regions are needed. Today with the marked relative decline in the proportion of total revenue accruing to the central government, the scope for such redistributive mechanisms is limited. Options for such mechanisms are discussed (Chapter 1, para 1.27 and Chapter 6, para 6.21). vii. Using a series of measures of price behavior, an analysis shows that there has bee a significant convergence between plan and market prices (Chapter 2, parn 2.8 to 2.10). Recent price  - xiii - reforms in early 1993 have consolidated and extended the progress achieved with the dual track system. This shows that China has achieved notable success in replacing the allocative mechanisms of the planning regime with allocation through the market. The reduction in the proportion of goods allocated through the plan, as well as the increase in the proportion of goods subject to market prices, has been remarkable. viii. Progress is less evident in the regional integration of China's markets. Despite the rapid decline In the number and level of price controls, there are still persistent regional price differentials among both producer and consumer goods (para 2.12 to 2.16). Price convergence across regions has been slower and more erratic than convergence between plan and market prices, for specific products. Some divergence in regional prices may have emerged as a consequence of the lifting of price controls and the reflection of real costs of transport in prices. But eventual price convergence (with transport cost adjusted differentials) would still be expected. The present differentials suggest spatial segmentation of the internal market. ix. An analysis of domestic Interprovincial trade In goods indicates that the share of trade flows across provinces, relative to total retail trade, have declined in many provinces, and on aggregate for the country as a whole (para 2.17 to 2.29). These declines have occurred at th3 same time as the shares of external trade, and inflows of external investment, have increased In most provinces. From 1985 to 1992, overseas exports and imports grew at 17 and 10 percent per year, respectively. While domestic interprovincial trade also rose in absolute terms, its rate of growth at 4.8 percent per year was low relative to foreign trade and also lower than the 9 percent annual rate of growth of total retail sales. The findings suggest that individual provinces are tending to behave like independent countries, with an increase in external (overseas) trade and a relative decline in trade flows with each other. x. A part of the relative decline in internal trade could be ascribed to the reduction in the forced movement of goods under planning. Another explanation is that the partial deregulation of the output and selling price of some goods led to incentives to evade public procurement, over 1985 to 1988, in the period of the interprovincial 'trade wars'. Provincial authorities responded with the erection of export embargoes. With further relaxations in price and quantity controls, as well as the decline in the short-lived demand boom, export embargoes became less significant. xi. The downward trend in interprovincial trade, continuing untl the present, cannot be explained only by these considerations and requires other explanations. Some relative reduction may be due to an increase in intraprovincial production as well as consumption, due to the rapid growth in township and village enterprises. Problems of numerous fees and fines, extracd on the road, legal as well as illegal are also an explanation. The absence of overarching regulations on iteprovincial trade implies that decisions which may limit trade made at the provincial, or lower levels, cannot be easily overtned. Difficulties of transportation by road as well as by rail also hinder the domestic flow of goods. Transport facilities have not grown as fast as output. Mimisterial and jurisdictional barriers have aggravated spatial segmentation. Difficulties encountered in interprovincial payments and settlement mechanisms have also segmented the internal market. xii. Cross-provinical investment flows have declined in relative terms (compared to the share of foreign investments, and relative to provincial GDP) over 1985 to 1992 (para 2.54 to 2.60). The fiscal system, and the incentives and authority given to provincial and local governments to raise revenues, provide partial explanations. The separation of profits and taxes was accompanied by the introduction of profit retention, as well as an increase in local authorities' taxation powers. It is therefore to the advantage of local governments to retain enterprises within their jurisdictions. InAtivs for  - xiv - Interprovincial investment are also confused by the large number of special investment zones, with nmny authorized or unauthorized tax concessions. xiii. Some progress is observed in labor mobility in terms of increased flexibility in the hiring and dismissal of labor in state enterprises, and in determining wages and bonuses. There is less progress in the regional mobility of labor, despite the recent relaxation of urban grain rationing In several locations (para 2.74 to 2.88). xiv. Foreign exchange had been constrained in its mobility across regions, as regional differentials in swap markets indicated. Recent changes, introduced on January 1, 1994, indicate considerable imporvement in the flexibility of access to foreign exchange, as well as simpliflcation of the trade and exchange control regime. How the new system will operate in practice can only be determined after it has been in place for some months. In conclusion, there has been considerable progress in the substitution of planned allocation by the price mechanism. Yet, markets for both goods and factors of production still show signs of regional fragmentation. xv. The withdrawal of the state from allocation and pricing decisions was not accompanied by a parallel withdrawal of the state from distribution (Chapter 3, para 3.7 to 3.12). The share of the state sector (excluding collectives) in distribution, as measured by both the value of retail trade and the number of distribution units increased in absolute terms over the last decade. While there was a relative decline in the state's share over the early years of the reform (1978 to 1985), there was little perceptible change from 1985 to 1991. xvi. Yet, in aggregate, retail trade grew and the level of retail trade services available now put China above the former Soviet Union, though still below Western Europe (Table 3.3). Innovative changes have also occurred in the distribution system, in response to other changes in market mechanisms. They illustrate that the state sector has been able to respond to competitive stimuli and that changes in operation are being effected despite relatively gradual changes in ownership. The combined requirements of capital-intensive infrastructure and the need to build information networks across large regions and many entities may make it more difficult for the non-state sector to enter the business of distribution, relative to production. xvii. While the evolution of new forms of distribution in China has been in the right direction, there is scope for better management of distribution functions of existing warehouse facilities, improved inventory management, delivery scheduling and the development of backchannels for the recycling of used materials (Annex 3.1). xviii. In terms of the organization of the distribution of producer goods, some enterprises under the leadership of material and equipment bureaus and their sponsor, the former Ministry of Materials and Equipment (now a part of the Ministry of Internal Trade) are involved in a wide range of activities, including industry, real estate and construction. This diversification has been in part a response to poor profitability from their main task of distribution, due to price controls and allocative obligations. The twelveenterprise structure of many materials bureaux results from the takeover of the marketng and distriltion functions of some production bureaus, with agreements to maintain their structures intact. This 12-enterprise structure has developed variations in some areas and firther flexbility is encouraged to adapt to local industrial needs.  - xv - xix. Some of the warehouses owned by tha materials bureaus are old, with inadequate protection against the elements, leading to spoilage and damage in storage. The location of the new facilities at the sites of existing storage centers is not optimal. Many warehouses today are located in urban areas where land is scarce and expensive in terms of its opportunity cost. The present level of mechanization of materials handling and computerization of order placement and inventory management is very limited. Due to a variety of causes, which may Include internal management and administration as well as market conditions, the financial condition of some materials bureaus is reported to be precarious and should be analyzed. xx. Difficulties caused by trade barriers and distribution problems are compounded by real bottlenecks in transport (para 3.51 to 3.65). The demand for 200 million tons of freight (around 10 percent of freight capacity) was estimated to be unsatisfied in 1989. China's rate of investment in transport, at around 1.3 percent of GNP, compares unfavorably with other developing country ratios, of 2 to 3.8 percent of GNP (para 3.56). Producer goods depend largely on the railroad system, that suffered from underinvestment due to limited revenues resulting from low passenger and freight tariffs. Recent successive raises in tariffs are expected to improve the profitability of the system. The assignment of freight quotas to specific producers or users also distorted the prices of commodities requiring rail freight. xxi. On road transportation, the regulation and administration of the trucking business is an issue of concern. Although the entry of new operators of trucking services has grown easier, and pricing has become more flexible since 1983, there is still overlap in the functions of the multiple agencies whose permits are required for licensing and registration (the local Transportation Bureaux as well as the Public Security Office). There are also constraints on the time period and permitted uses of 'own account' trucks. Deregulation of trucking tariffs has taken the form of 'decentralized regulation', with the transfer of the authority for setting tariffs to the to local Departments of Communications. Consequently, there are now wide regional variations in tariffs. xxii. The development of trucking operations is constrained by the lack of freight forwarding and consolidation centers and the limited development of intermodal transportation systems. Such systems require the development of containerized shipping, which China is now beginning to explore. xxiii. A remarkable number of commodities exchanges have been established in the last two to three years, in grain, non-ferrous metals, petrochemicals, and agricultural commodities such as rubber and sugar (Chapter 4). A new framework of supervision for the new exchanges was announced, on Nov. 4, 1993. The registration of exchanges remains the responsibility of the State Administration of Industry and Commerce, but the responsibility for their supervision has been assigned to the State Council Securities Commission. Day to day administration of such supervision will be entrusted to the China Security Supervision and Administation Committee. After scrutiny by this body, all exchanges will be re-registered with the SAIC. There have been wide differences in the operating rules of the various exchanges. Some regulations (concerning margin deposits and fees) have been at inappropriate levels. Essential elements of commodities market regulations (such as Pidelity funds) did not exist. It is hoped that under the new framework these difficulties will be resolved. xxiv. Continued intervention in activities related to the exchange of commodities, such as setting price ceilings or floors (as in the case of the Zhengzhou grain center), warehousing (through the provision of differential subsidies, in the metals trade) raises the risk of either undermining the price uncertainty on which such exchanges depend, or raising the pressure to continually increase government subsidies,  - xvi - as subsidies are transferred through arbitrage to all market participants. The recent operation of the commodity exchanges emphasizes the possibility of 'proxy markets' arising in cases where continued government intervention persists. xxv. The most striking example provided here of the effects of controls in one market on the rest of the economy is the case of foreign exchange speculation through trade on the metals exchanges. If exporters and importers do not have free access to foreign currencies, and there are markets which deal in forward and futures contracts for internationally tradable commodities, these markets will reflect expected movements in the foreign exchange rate. Hedging or speculative transactions in foreign exchange become part of the raison-detre of such exchanges. The large and growing volume of trade on the exchanges suggests that the foreign exchange market is more constrained today than apparent, and price signals are consequently distorted (para 4.44 to 4.49). xxvi. A key issue which China must confront in its experiments with new market forms, and speciflcally in the area of establishing commodities markets, is that the present large numbers of such exchanges will probably diminish over time due to a number of factors; the improvement in internal communications, closer integration with the world economy and consequently closer links with exchanges outside the country. Speculative activity will fall as the 'zero-sum' nature of such trade is better understood. The establishment of independent markets, especially in foreign exchange, will hasten this process. There is a likelihood of waste in the establishment of several new exchanges, especially in view of the presently preferred capital-iatensive methods . f screen-trading which is an expensive option to adopt in the initial stages of an exchange. xxvii. There is room to improve the efficiency and reduce the cost of trading practices (para 4.33 to 4.40). The metals Exchange at Shanghai is a fully computerized screen based system, where the existence of a trading floor is redundant. The Shenzhen exchange is a combination of an 'open outcry' system, with a large central screen recording bids and buys. In both cases, a simple open outcry ring dealing system may have been preferable on cost grounds. The computerized information entry requirements slow the trading process and will become a hindrance as the pace of trading accelerates. It also impedes the growth of trade by 'market makers', trading on their own account and providing essential liquidity to the system. While cultural reticence may be a factor against the adoption of 'open outcry', its cost advantages for a newly-established should also be considered. In the future, once exchanges are well-established, they could evolve towards more expensive screen-based trading. xxviii. China is aware of the need to safeguard competition and develop regulations for competitive markets. A law on competition was approved in September 1993, and a new law on consumer protection has also been adopted. Laws to safeguard market competition through the protection .f patents and trademarks were approved earlier. The problem of monopoly in China is not pervasive, unlike many other transforming socialist countries. Consequently, the emphasis should be on market 'conduct' issues, such as the the control of unfair trading practices rather than market 'structure' issues, such as enterprise size, or mergers and acquisitions. China is today experimenting with the fostering of links between enterprises and the formation of enterprise groups and some of the experiments are likely to increase operational efficiency, and facilitate interregional investments (5.13 to 5.27). xxix. Procedures for establishing new enterprises are still onerous (para 5.35 to 5.46). Many different agencies' permits are required and a large discretionary role is given to some agencies, such as the State Administration for Industry and Commerce (SAIC). Ihe role of the SAIC has expanded enormously over the last few years and it may be undertaking the work entrusted to several different  - xvii - agencies in market economies (including licensing new establishments, safeguarding competition and registering 'kew commodity exchanges). xxx. A large agenda for legal reform is now under preparation as part of the Five-year plan for economic legislation. Many differen. agencies will tackle different aspects of reform, and the process could be slow, especially In view of the need for drafting assistance required by some of the agencies concerned. The World Bank has offered assistance to the Chinese government in this process of legal reform through an Economic Law Reform Project which is currently under preparation. C. Recommendattons xxxi. Key recommendations to help China accelerate its movement towards the adoption of well-functioning internal markets and an integrated domestic economy are presented below. These are grouped under four broad heads: (1) increased market integration through trade, price and factor mobility; (2) enhanced efficiency in distribution; (3) better functioning of new markets; and (4) a more appropriate regulatory framework. Market Integration xxxii. China's authorities should ift residual controls on prices. So far, they have emphasized the prices, or allocation, oa goods. They must now achieve further progress with the decontrol of the prices of both critical consumer goods and producer goods still subject to the Plan and then move towards price and quantity restraints on services and on factors of production. xxxiii. Concerning regional trade policies and the Integration of regional markets: (1) China must establish a general framework of legislation on interregional trade and prohibit trade barriers, such as internal 'export' embargoes or 'import' restraints; (2) The myriad fees and fines levied on interstate (and intercounty) trade must be harmonized across provinces. A nationwide standardized list of genuine charges should be prepared. The transparency of the procedure followed in each local jurisdiction can be improved through the collection and periodic publication of schedules of tariffs, taxes and other charges, at a provincial or national level; (3) Authorities should standardize the collection agencies for fees and publish details of persons or agencies responsible for collection; and (4) Once a list of genuine fees is established, authorities must stop the collection of illegal charges. xxxiv. In the context of capital mobility and interprovincial investments, the government should: (1) Condnue and extend the separation of profits and taxes;  - xviii - (2) Reduce the Incentives to provincial or lower level authorities to restrict the transfer of enterprises to other locations through the stricter enforcement of the rule of tax accrual to the home province. Establish an appropriate monitoring system for this; and (3) Stop the legal and illegal circumventions of the interstate income tax regulation resulting from the establishment of special 'zones'. While many illicit zones have receinly been removed, the 200-odd which have been permitted to remain are still a non-negligible number. xxxv. To ensure the equitable distribution of the, benefits of the gaias from increased internal trade and factor mobility, the Government should consider the establishment of an appropriate redistributive or compensation mechanism. Alternative mechanisms incluee the European Community's Structural Funds, or the fund suggested in the Bank's recent Budgetary Expenditure study (see Chapter 6). xxxvi. Attention should be turned towards regulations which permit an increase in the regional mobility of labor. One important reason for restricting labor mobility in the past was urban grain rationing. Some rations have been lifted in early 1993, and many price controls on consumer essentials such as grain and edible oils. This is an appropriate moment to begin to lift restraints on labor mobility. xxxvii. In the context of the recently unified exchange rate, care should be taken to ensure free access to foreign exchange by exporters and importers through the banking system. Besides the wider implications for efficiency this should increase foreign exchange mobility and also permit the new commodities markets to fulfil their primary function. DMbutton Syste xxxviii. While the evolution of new forms of distribution in China have been in the right direction, there are still shortfalls compared to best practice in market economies. A detailed study of current distribution practices should be undertaken, to investigate the scope for better management of distnrbution functions of existing warehouse facilities, through (i) the reduction of partly-loaded truck shipments; (ii) the reduction oe +he number of times goods are handled or moved; (iii) improved inventory management through more reliable shipping from producers and timely information from users; (iv) better physical management of warehouse space by arranging goods on a computerized customer order in the order in which they will be picked up from warehouse shelves; (v) the introduction of 'cross docking' practices to permit vehicles bringing in supplies to be transferred directly to delivery vehicles to purchasers, and (vi) the development of backcbannels for the recycling of used materials. xxxix. Concerning the range of operations of the former MME and the organization of materials bureaux, China should: (1) Accord greater flexibility to the MME in their primary activities, in terms of the procurement, pricing and distribution of the goods they carry, through the accelerated lifting of price controls and allocation obligations on these activities; (2) Discourage the branching out of materials bureaux into unrelated and speculative activities such as real estate purchase or construction;  -xix - (3) Permit the present twelve-enterprise structure to be more flexible and better adapted to the needs of local industry; and (4) Encourage value-adding activities at the materials bureaux, to provide additional quality or convenience for buyers. But research on products distributed may be better integrated with production enterprises than with distribution enterprises. xl. Actions to increase future competition through new entrants are also required. Local bureaus should be permitted and encouraged to expand into other localities, and entry into distribution by individuals and collectives could also be encouraged, for example by permitting them to lease warehouse space from government bureaus. xli. Detailed studies of the physical facilities of the distributionsystem are recommended. The costs and benefits of investing in improved facilities must be evaluated. The evaluation should examine the potential loration of any proposed new facilities, as well as the relocation of existing urban warehouses to points outside major cities. The study should also appraise the costs and benefits of the mechanization of materials handling and the computerization of order placement and inventory management. xlii. A study of the financial condition of the materials bureaus and an esdmation of the extent to which the decline in profitability of the materials bureaus is due to losses made on goods which remain under planned allocation should be undertaken. The expected improvement in profitablity at materials bureaus, with recent reductions in the number of goods under planned allocation or controlled prices, should then be calculated. The examination of the profitability of the materials distribution system should also include an evaluation of cash-flow and inventory management, and should be launched as an exercise which combines marketing as well as financial expertise. Since the last major round of price decontrols has just been concluded, this is an appropriate time to begin such an undertaking. xliii. Detailed recommendations on transport are available in other reports. This report points to some key issues affecting distributional efficiency. Regarding railways, the government should: (1) Undertake successive increases in railway tariffs, to their long run marginal cost levels, to improve profitability and ensure that decisions on industrial location are based on the right parameters; and (2) Phase out the assignment of freight quotas to specific producers or users, to avoid distortions in the prices of commodities requiring rail freight. xliv. On the regulation and administration of the trucidng business, China should: (1) Remove the overlap in some of the functions of the multiple agencies whose permits are required for licensing and registration (the local Transportation Bureaux as well as the Public Security Office); (2) Gradually remove constraints on the time period, and permitted uses, of 'own account' trucks;  -xx - (3) Deregulate altogether the 'decentralized regulation', of trucking tariffs (which has led to the transfer of the authority for setting tariffs to the to local Departments of Communications, and consequent wide regional variations in tariffs); (4) Develop freight forwarding and cousolidation centers to encourage 'own account' truckers by serving as collection points for goods shipped in less-thaa-truckload quantities; ar4 (5) Further promote the development of containerized shipping to facilitiate intermodal transportation systems. New Marets xlv. A first concern in this area is completion of the overal framework of supervision for the new exchanges, to be adopted by the new CFMC. The new legislation should take into consideration alternative approaches to the regulation of commodities exchanges, presented in the report (pp 109). Second, once the umbrella legislation is in place, the task of reconciling the differences in operating rules of different exchanges must be undertaken. Areas of the present legislation which require attention are: the nature of the supervisory Board, the regulations on participation, on transaction fees, and margin deposits. The establishment of provisions for a Fidelity Fund (for protection against default by brokers) is also recommended. Third, the role of the SAIC, as the body best suited to handle the registration of new exchanges, should be reevaluated. The SAIC is already considerably overextended and this is a task requiring specialized knowledge. In this context, the regulations, recendy adopted by the SAIC, for traders and brokers on the exchanges, may restrict the number of participants on the new exchanges, and should therefore be reviewed. It is more desirable to have a smaller munber of exchanges, but with a relatively large number of participants on each, than vice versa. Fourth, the likelihood of considerable waste in the establishment of several new exchanges, especially in view of the presently preferred capital- intensive methods of trading, must be recognized and more exchanges should only be established if shown to be sustainable in the medium term. xlvi. In terms of the physical organization of the new exchanges, the following improvements can be pointed out. First, the adoption of a simple open outcry ring dealing system should be considered, as an alternative to the present computerized system, not only in all new exchanges, but also in the existing ones, ast the time when the next increase in computer requirements is reviewed. Objections to 'open outcry' based on their vulnerability to fraud, are exaggerated. However if this a major consideration, the 'Japanese Auction System' could be introduced, in which there is a single price for all buying and selling orders for a given trading session. xlvii. Meanwhile, trading costs can be reduced with the utilization of the facilities at a given trading center by more than one exchange. Since most exchanges at present do not trade every day of the week, or all hours of the day, this should be feasible. Ma*et Regukaion xlviii. FMrst, there is little evidence of monopoly, in the sense of industrial structure, in China. The regulatory emphasis should therefore be on market conduct issues. Care must be exercised to not snuff out early experiments with enterprise groups, with unduly restrictive regulations on mergers.  -xxi - xlix. Second, entry for new enterprises should be simplified. The administration of the process of entry and exit may sometimes be as important as the law. Third, the functions of the SAIC and other agencies should be redefined to make them more transparent and reduce the discretionary element present today in the granting of approvals. Fourth, some of the functions of the SAIC (such as the monitoring of unfair practices, monitoring cases of fraud in labelling and trademarks, and taking care of enterprise entry requirements), should be delegated to more specialized agencies in the future. Finally, it should be noted th.at a proliferation of new laws, sometimes conflicting in scope, or in terms of agencies concerned, could be counterproductive. Care must also be taken to counter any tendencies to permit the interests of the agencies drafting the laws to dominate the new draft legislation.  1 Market Segmentation and Market Development A. Introduction 1.1 China's commitment to the creation of a market economy, which has been the central plank of its program of economic reform, received new emphasis in the 8th National People's Congress of March 1993. The congress ratified the decision, already taken at the 14th Party Congress of October 1992, to develop a 'socialist market economy', shifting decisively away from central planning. The Constitution of 1982 was amended to emphasize this shift of policy towards the development of 'socialism with Chinese characteristics'. These decisions reflect the culmination of a series of policy shifts which began in December 1978, when the Third Plenum of the 11th Party Congress announced for the first time that planning and markets could be compatible. Over the subsequent period, futher policy pronouncements steadily moved China towards the goal of an increase in the role of its markets and a decline in central planning.' 1.2 Shifts in administrative responsibility had been introduced in parallel to the changes in policy direction. In 1982, internal distribution functions for consumer goods were consolidated under the Ministry of Commerce, which merged the Ministry of Grains and the National Trading Corporation with the former Ministry of Commerce. In 1988, the Ministry of Materials was established, by a decision of the State Council to gradually abolish the material supply and marketing organizations of individual ministries, and consolidate the supply and marketing responsibility of producer goods at the national level though enterprises under the new Ministry. Finally, in 1993, at the 8th National People's Congress, it was decided that the erstwhile Ministries of Commerce and Materials would be merged in a single new Ministry of Internal Trade. 1.3 The development of the internal market was fostered by a series of mechanisms intended to reduce the scope of state intervention. A first key element of the strategy was progressive price decontrol, through the introduction of three categories of prices, planned prices, guidance prices and market prices and the gradual movement of goods from more regulated to less regulated categories, together with 'dual track' pricing, introduced in 1985, which permitted output above certain target levels I Following the success of agncultural maiket reforms after 1979, the 12th Congress of the Party aimed to use nadcet regulation as a supplement to planning, and in October 1984 it called for a further reduction in the scope of madatory planning and its replacement by 'guidance planning'. The 13th Congress of 1987 adopted the goal of 'letting the state regulate tL3 market, and letting the market guide the enterprises'. The evolution of the politics of market reform is taced in White (1993).  -2- to be sold on the free market.2 The proportion of goods in total domestic retail trade subject to planned prices fell dramatically between 1978 and 1991 (Figure 1.1), in favor of 'guidance prices' and free market prices. Goods subject to planned prices have fallen considerably aurther, with recent announcements in early 1993 of the relaxation of controls on prices of grain and edible oils. Figure 1.1 Ieduot1on In Scope of Price controls (Peroentage)(1978-1991) L1 t1 t993 1 Iliad Ples 1 Gulded Priew UmI Fe" Pdie 1.4 Second, the allocation of goods was progressively moved out of the mandatory plan. In 1980, 90 percent of industrial goods, and 837 production materials were allocated under the plan system. By early 1993, the proportion of industrial goods under the plan had declined to 12 percent and the number of production materials in this category has been reduced to 11. At the same time, consumer goods whose planned allocation was administered by the Ministry of Commerce declined in number from 274 in 1978 to 14 in 1993. Third, a diversification of distribution systems and channels was gradually permitted. Formerly, the system of unified purchase and sale of consumer manufactures, as well as the unified purchase of farm products, by designated government agencies, accounted for virtually all sales.3 Sales may now be made to private purchasing agencies, or directly to consumers. A variety of new forms of markets are evolving as a consequence, including sophisticated commodity exchanges and comprehensive as well as specialized distribution centers. 2 Explored furtr in Chapter 2. Descriptions of the progress of price reform in China may be traced through Byrd (1987), Wu and Zhao (1987) and World Bank (1990a&b). Sectodal details are given in World Bank (1992) 'China: The Achievements and Challenges of Price Reform', Albouy (1991) and a companrtive pepective is offered in RIjaran (1991). 3 The Unified Purchase system dated from 1951, wben it was introduced with an Implementing Decision of the State Council. Manufachtued consumer goods were classified under three categories, according to whether they were deemed to be essential goods, items of mass demand, or others. The purchase and sale of goods in the first two categories were handled by the central government, while goods in the third category were handled by local governments. Agrcultural goods were similarly grouped and goods in the first two categories were subject to 'monopoly purchase' and 'designated purchase', respectively, at statedetermined prices. Goods in the third category were subject to purchase at negotiated prices.  - 3 - 1.5 At the same time as these measures to improve the functioning of the internal market were being introduced, China also adopted an 'open door' policy towards foreign trade and investment. It Is clear that China has made rapid strides in the development of its external trade. In recent years, from 1985 to 1992, exports and imports grew at 17 and 10 percent per year, respectively. While domestic interprovincial trade also rose in absolute terms, its rate of growth at 4.8 percent per year was low relative to foreign trade, and also lower than the 9 percent annual rate of growth of total retail sales (Figure 1.2). As a consequence, while the share of external trade in GDP increased, the share of interprovincial trade in domestic retail sales declined. Figure 1.2 External and Domestic Trade Shares GBX 7~~~~~~~~ox. 40o% . t% 50% 307o .. 1- . 640% *- - ZoSa *-** - 11- 111|1-- -1 . 3 80% . - _ lox. I 1985 1988 1990 1991 1992 1985 1988 1990 1991 1992 i hternal Trade / GDP I Dro= Trade/ReLSalee fomwe Appendix Table P.10 nd WM Bank hti 1.6 Together with the finding of the relative decline in domestic trade, there are reports of difficulties encountered in the processes of internal trade, both in terms of the difficulties of establishing new forms of markets, as well as obstacles created by authorities in some provinces, which restrict the inflow or outflow of goods and factors in their provinces. These difficulties are compounded by real bottlenecks in transport, storage and distribution. It has recently been estimated that the demand for around 200 million tons of freight, or around 10 percent of freight capacity, remained unsatisfied in 1989. China's rate of investment in transport has averaged around 1.3 percent of GNP, while other developing nations' investments in transport ranged from 2 to 3.8 percent of GNP.4 1.7 The limited extent to which internal trade exists has sometimes been attributed to the uniquely 'cellular' structure of the economy.' Though geographically vast, it has been pointed out that attempts at achieving the local self-sufficiency emphasized in the Maoist era led to a duplication of industrial pattern by province. The inefficient location of industry was compounded by dispersal resulting from the 'Third Front' policy, of moving industrial enterprises towards the interior. In later years, (as pointed out today by some government officials), with increasing dencentralization, local government officials sometimes established 'repetitive and non-economic industries with a view to increasing local 4 World Bank (1992). Report No. 10592-CHA. 5 Commented on by Donnithome (1972), and later by Lyons (1987). Recent evidence, particularly in the provinces around Shanghad, has been described by W. Huang (1992).  4- fiscal revenues, or local employment, or even to "chase achievements" during their official careers. In 1987, 80 factories in 21 provinces produced refrigerators, over a hundred factories in 26 provinces produced televisions and 300 factories in 28 provinces could produce washing machines. The pattern was reinforced by the nature of the planning mechanism and the decentralization of investment decisions in the early 1980s at the provincial level. As a consequence, industrial plant is frequently undersized. One reason why provincial and local authorities have sometimes limited the entry of goods from other provinces is to attempt to shelter these small and relatively inefficient enterprises. This protection results ultimately in higher prices for consumers and inefficient production. While there are now some signs of change, impediments to regional trade flows still exist in a variety of forms. A major potential economic advantage, the large internal market, is diminished as a consequence. Factors Affecting Internal Markets 1.8 As the preceding paragraphs suggest, there is a wide range of factors which determine market structure and affect the functioning of markets, beginning, first, with a broad group of government policies. Most important among these are decisions regarding resource allocation and resource distribution systems, and price determination systems. Decisions to remove goods from the system of centrally-planned procurement, allocation and distribution implied by the unified purchase and sales systems represent major moves towards the creation of markets. The relaxation or removal of price controls, which permits prices to be determined by the forces of market demand and supply, is also a critical element of market creating policies. 1.9 Another key factor in the creation of efficient markets is the spatial integration of markets within an economy. The geographical size of China's internal market offers huge potential benefits from such integration, in terms of increased efficiency in industrial structure as well as in the deployment of factors and pricing of goods. The policies affecting the realization of market integration are those which relate to the mobility of goods and factors of production. The extent to which goods, or factors of production such as labor and capital, are permitted to move freely within the country depends not only on the establishment of distribution systems, but also on both national and local level policy decisions to facilitate, or at least allow, their movement. In international trade, such constraints on trade flows in goods take the form of tariff or non-tariff barriers. In internal trade, tariff barriers in the form of codified specific or ad valorem levies on goods entering or leaving provinces are rare, within a country.6 In the case of China, there are no such formal tariffs, but there many accounts of ad hoc charges, fees and tolls on goods entering or leaving provinces, and in economic terms their equivalence to tariffs may be established. Moreover the uncertainties created by the ad hoc nature of some of these charges and the difficulties they add to interstate transactions constitute a form of non-tariff barrier to trade. Additional non-tariff barriers take the form of policies such as procurement guidelines, at the levels of provincial or lower level govermments, which may restrict imports or exports. 1.10 Both central and lower level government policies also affect factor mobility. The mobility of capital refers to investment flows as well as credit flows, across provincial boundaries. Capital mobility is essential for efficient resource allocation in a market economy, if investment is to flow into its most productive uses, and in the most geographicaliy suitable areas. Labor mobility includes the I In India, however, there is an interstate 'octroi', which takes the form of an ad valorem sales tax on goods crossing state boundaries. bItersfrte sales tax registrion procedures are also cumbersome and act as a de facto constraint on intemal trade.  ability of both skilled and unskilled labor to seek jobs in alternative occupations and locations, also permitting industries to have access to the labor skills they require. Policies affecting the development and functioning of markets for capital and labor are therefore integral elements of the creation of an efficient internal market. 1.1' ~In additional to these policies, the functioning of the internal market will increasingly be affected by the regulations of the government which monitor market behavior to safeguard competition and guard against the abuse of market power. The issues alluded to here lead to the question of the future role of the government in the support of the market economy. As the government retracts from its close involvement in market administration, its role in a more liberal market requires definition. While the government may no longer be setting prices, there may be a need for monitoring price setting in some contexts, for example, if there are possibilities of monopoly or oligopoly. This requires the creation of a legal framework which permits this to be undertaken, as well as the setting up, or einforcement, of appropriate agencies to perform these functions. The reduction in the role of state planning also requires the proper functioning of contractual mechanisms, as well as the enactment and enforcement of mechanisms to protect consumers, for example against fraudulent trade or false advertising. 1.12 Finally, in parallel to these policies and regulations, the physical framework for transport and communication that permits the flow of goods and factors across the country will also critically determine how well the market functions. At present China does not have sufficient capacity in its ransportation system to sustain its high rates of growth, and transportation is a particular impediment to the development of an internal market, leading to production stoppages due to lack of inputs, the holding of excessive inventory, and the spoilage of perishable goods, awaiting shipment. Objectives of this Report 1.13 The everall objective of this report Is to evaluate the extent to which China, in its process of transition towards a market economy, has really been able to establish well-functioning and efficient markets which transmit accurate signals to economic agents in terms of production decisions and factor allocation, and permit the efficient exchange and distribution of goods. To this end, the report examines the present efficiency of markets and evaluates policies which affect market formation. Both the regional or spatial aspect of market functioning, and the 'vertical' issue, of the movement from plan to market, are exaniined. Following a policy evaluation, the report analyzes 'real' aspects of market formation, in terms of the new systems for allocating and distributing goods, which have evolved in the aftermath of the diminished role of planning. The present framework of regulation for the new markets is also examined to evaluate its adequacy in the changing enviromnent. 1.14 In the following section, the report begins by pointing out the potential benefits of well- functioning and regionally integrated internal markets and shows how greater market integration has been realized in other countries. In this context, the report examines China's present industrial structure and shows that there is little evidence, so far, of a well-integrated structure, and that, relative to other countries, China appears to be below its potential. 1 .1S Next, the report aims to analyze and evaluate policy measures which affect the functioning of the internal market (Chapter 2), including, first, policies relating to the price mechanism, and second, policies direcdy affecting the iterregional flows of goods and factors of production. The report shows that, despite some success in the integration of plan and market pricing, regional integration, in terms  -6- of the regional price convergence, has met with less success. Moreover, regional flow of goods, as well as interregional investments and capital flows, appear to have declined, at least relative to the growth of total retail sales, or provincial GDP. Issues relating to regional mobility of labor are also examined, particularly in terms of recent developments, which suggest that there has been some progress in this direction, although further gains may be realized.' 1.16 Third, on the real side, the report evaluates changes in the distribution system and points out its present botdenecks (Chapter 3) It shows that the role of the state remains surprisingly large in terms of distribution, despite Its withdrawal from planned allocation. However the state distribution mechanisms themselves have adapted to the new market environment While the evolution of new forms of distribution in China has been in the right direction, there a&e still constraints and limitations, compared to best practice in market economies, and areas in which Improvements may be achieved are pointed out. Constraints to distribution caused by transportation difficulties are also examined. 1.17 One striking development in Chinaes evolution towards a market economy are its ambitious recent experiments at setting up new forms of markets, in particular, the commodities exchanges, some of which engage in not only spot, but also forward and futures transactions. A remarkable number of these new markets has been established in the last two to three years, notably in grain, non-ferrous metals, petrochemicals, and agricultural commodities such as rubber and sugar. The present report focuses particularly on the two non-ferrous metals exchanges as examples (Chapter 4). The report points out reasons why these markets are in many cases not functioning as intended. Areas where the efficiency and regulation of these markets could be strengthened are discussed. The report also provides a demonstration of the links between markets for commodities and the market for services and foreign exchange. One of the difficulties faced by China, in its present situation of partly regulated and pardy liberated markets is that 'proxy markets' are beginning to evolve, where prices in liberated markets sometimes subsume the effects of price or quantity constraints in more controlled markets. Another difficulty is the continued govermment intervention in different areas of price setting. 1.18 Finally, turning to market regulation, the report aims to provide a first assessment of the elements of the legal framework which are in place already, and to point out areas where extensions to this would be required (Chapter 5). It also examines the institutions charged with the enforcement of the present system and evaluates their effectiveness, suggesting areas where reinforcement may be necessary. In the concluding chapter, the report pulls these different strands together to map out a feasible route for the integration of the internal market, in terms of appropriate policy and regulatory instruments as well as an adequate physical infrastructure. The report will discuss the specific 'real" and 'policy' variables affecing the mobility of goods and factors of production and will also describe the broader areas in the legal and regulatory framework that require attention if internal competition is to be promoted. 7 Condrable attention has already been paid to this issue in a number of works, and therefore the tr_ant here is largely a summary of existing wor Evidence on the extent of labor mobility is _ummarized in World Bank (IM) Report No. 10266-CHA, and links between poverty levels and labor mobility are discussed in World Bank (1992 October). Issues concerning the floating population of urban labt and migrants are discussed in Banister (1989); Jefferson and Rawski (1992); Rutkowskd (1991); Solinger (1992 and 1992). New measures to enhance labor mobility are deAiled in Ody (1991).  -7- B. The Potential Benefits of Internal Free Markets 1.19 The benefits of market determined prices and distribution systems are now well recognized in China. The case for allowing prices to be determined by demand and supply rests upon first, the long-run allocative efficiency that this will lead to, as resources flow towards their best uses, based upon price signals which reflect relative scarcities and needs; second, on the elimination of rent- seeking and parallel markets that arise, if prices are pegged at levels which do not reflect their equilibrium values; third, a reduction in artificial losses (profits) in certain economic activities where prices are set at levels below (above) their equilibrium values, and in addition, a reduction in direct or indirect subsidies that may be paid to loss-making economic agents, if these losses are due to policy constrained prices. It is also accepted that greater flexibility in distribution systems which gives greater flexibility to producers and consumers in procurement channels can reduce costs, cut inventory requirements and shorten delivery periods. 1.20 Economic gains from regional integration and its links to market efficiency are less well understood and they are therefore the focus of this section. Regional economic integration, in its broadest sense, refers to the absence of economic discrimination and restrictions among economic agents of a region." The process of integration requires the gradual elimination of economic frontiers and trade restricting instruments between territories within a region so that the mobility of goods, services and factors is not constrained. This process of 'integration from below', can be reinforced by 'integration from above', or the active promotion of economic cooperation between territories which may be encouraged through appropriate policies or institutions.9 Forms of Regional Integration 1.21 The core of most economic literature on regional integration refers to theories of customs unions. As a national unit, however, China is already a customs union, in the sense that it has a common external tariff. The aim in the Chinese context is to go beyond the creation of a customs union, to the formation of a common market. The creation of a common market does not necessarily automatically follow, within a customs union, as the example of Europe well illustrates. The customs union of the EEC was formed in 1957. However it was not till 1986 that the more ambitious goal of a 'market without frontiers' was adopted, together with the wider goal of economic union in other areas. An economic union, such as the EC aims to be, progresses beyond a customs union to monetary union and interlinkages in internal (for example fiscal) economic policies. In China today, there is an anomalous situation where major elements of economic union including a single currency and a common external tariff are combined with a lack of some basic features of a free trade area, such as the free movement of goods and factors. 8 In this chapter, thb analysis of regional integration is conducted at the level of intra-provincial trade flow statistics. It would be interesting and valuable to examine intra-provincial trade flows as well, particularly in the larger provinces, to see whether similar patterns emerge. Lack of data have prevented this from being included in the analysis. 4 Tinbergen (1965), discussed in the Chinese context in W. Huang (1992). Huang also refers to integration from above and below as 'positive' and 'negative' regional itegraion, and discusses distnctions between customs unions atnd common markets, based on Balassa (1961).  -8 - 1.22 Attempts at the regional Integration of markets elsewhere have taken many forms with varying degrees of Implied integration. A free trade area, for example, such as the NAFTA, does not require the free movement of factors of production (abor and capital) or a common external tariff, unlike a customs union. Free trade areas may also be created for single commodities, or single sectors of activity, and combinations of partial common markets and coordinated investment plans are also possible. Recognizing these advantages, there have been many attempts world wide at regional trade integration, among both developed and developing countries.10 New Moves Tords Regional lntegraton In Developing Countries: Central Amerka Recognizing the potentil inpact of the NAIPA for trade Salvadores private airline, TACO, has bought shares in five between the US, Canada and Mexico, the six countries of other regional arlines since 1989 to face north American Centrla America have recently launched new attempt at oompedtion. Banco Uno, a Guatemalan bank, has recently creating free markets among themselves, and discussed an begun to open branches in Honduras. 'integration protocol' for economic union, in August 19. The proposed protocol sets out ambitious goals including Four of these countries, Guatemala, El Salvador, Nicaagua monetary union and a single currency, but sets out no and Honduas have already begun to dismantle the baniers timetables, so far, for their achievement. A two-speed or to movement of goods, labor and money across their multi-speed process may be adopted to accommodat borders. Trade within Cental America has almost doubled individual countries. While Costa Rica has joined the other (to $1.8 bilion) rlative to its 1986 low point. By setting up countries in cutting extenal tariffs, it is more hesitant about a low common extenal tariff, the group is also opening up the idea of a single market, given its relatively more stable to the rest of the world, unlike the previous attempt at a economy and lower current rates of unemployment. It may common market, set up in the 1960s. The four are now therefore opt out of some of these provisions for the negotiating free trade agremen with Mexico, Columbia preent. Panama is similarly hesitant about the common and Venezuela. etemal tariff. The importance of compromise and the need Business interest in the integration proposal is evident. El to accommodate individual requirements is weU illustrated. Sourc. Whm Econois. July 17 1993, p.63. ITe Case for Regional Integration 1.23 The case for freer trade within a region rests upon a series of static and dynamic gains, to be achieved from production according to comparative advantage, increased competition, the benefits of scale economies, and the diffusion of technical knowledge. Traditional theories of comparative advantage point out that production costs and selling prices for different products are likely to differ between locations, due to differences in factor endowments (natural resources, skilled and unskilled labor, and capital), technical methods of production and regional differences in preferences and tastes." Due to these differences in production costs and selling prices at different locations, there will be an overall economic gain to the region if locations are encouraged to engage in 'division of labor' and specialize in the production of goods and services for which they are best suited. 10 Different forms of regional integration and their implications are described in Hufbauer and Schott (1992). Among developed countries the EC and recendy the proposed NAFTA are examples of regional integration. Among developing countries, examples may be found in the ASEAN nations of south east Asia and among north (Maghreb) and West (CFA franc zone) African countres. A recent summary for developing counties is available in Langhammer and Hiemenz (1991). hTe classic Heckscher-Ohlin-Samuelson model of international trade.  9- 1.24 The benefits of achieving scale economies in production are important in many capital intensive industries where cost-savings may be effected though the better utilization of machinery with longer production runs and fuller utilization of existing capacity. Joint management and the coordinated use of joint resources also contribute to this. Mosc production processes face indivisibilities at some stages, for example, large-scale handling equipment, regional infrastructure, transportation and storage costs. Scale economies are of particular significance in the group of manufactures referred to as 'process industries' (for example, cement or fertilizers) which deal mostly with the conversion of bulk industrial raw materials. In these industries, the principle of non-linearity arises due to the fact that equipment cost is a function of surface areas, whereas capacity is related to volume. In such industries, engineers estimate coefficients of the proportional increase in cost, per unit increase in volume, and the resulting coefficients are well below 1, at around 0.6 according to some estimates.'2 1.25 Greater regional integration also permits an increase in the effective competition for all industries producing in that area. An increase in the number of firms puts pressure on each individual unit to cut costs and improve technology. Over time, there will also be a tendency towards regional price convergence, as well as a reduction in the overall number of firms, as the least cost-effective producers are forced to lower costs, or leave the market. For example, in Italy, there were 50 washing machine producers in 1960, and only 13 in 1974, as competition with other European producers increased. The Italian industry's exports to France, Germany and the UK, which by then accounted for 30 percent of its output, lowered unit costs by 8 percent." Another benefit of competition is greater product diversification between producers, as different units specialize in different varieties of products. 1.26 Economic geographers also point out that there is a tendency for 'clusters' of production to develop at certain locations, and that sometimes, given a critical mass of enterprises, growth in a given region will tend to accelerate. Links between such clusters an-d regional growth have long been recognized by development economists.'4 There is now a growing recognition of the interrelation between the factors cited above, and its impact on industrial structure and regional development. The importance of scale economies, combined with transport costs, imply that many national economies develop 'cores' of manufacturing activities, combined with outlying agricultural peripheries.'5 The 12 Balassa (1961). Economic work relating plant size to cost efficiency, by industry, has calculated the 'MEPS' or minimum economic plant size by industry for a number of industries. Examples cited, in terms of minimum annual volumes of production, are 10,000 tons of soap, between 1 and 3 million tons for steel, 160,000 units for bicycles, 90,000 units for tractors, 200,000 tons for cement, 1 million units for automobiles, and 800,000 units a year for refrigerators. See HMSO 1975, as cited in Huang (1992); Scherer and Ross (1990), as cited in Wu (1990). 3 Similar examples are cited for the European car and truck industries. The number of automobile producers fell in Germany, Britain and France, between 1955 and 1970. Meanwhile the lowest-cost truck producer, Daimler-Benz of Germany, raised output by 7.5 percent through its increased exports to a single country, France. Owen (1983), W. Huang (1992). 14 Hoover (1948) discussed the economics of agglomerations in the context of the US. Myrdal (1957) discussed the 'circular causation' of development and Hirschman (1958) discussed backward linkages in the context of developing economies. Is See particularly Krugman (199la,b&c). Murphy, St;leifer and Vishny (1989a&b) also discuss the importance of scale economies, market size and market structure.  - 10- demand for manufactures arises not only from consumers, but also from other geographically proximate manufacturing industries. The importance of such clusters in the presence of 'growth enabling factors', such as foreign knowledge, learning, labor turnover and the diffusion of technical information is also being pointed out, both in the general context and in the specific case of its application to some of the faster-growing areas of China."' 1.27 Progressing towards a common market, however, requires the drawing up of a large agenda of measures, to address both physical and technical issues impeding integration. Some of these issues are multisectoral (such as border checkposts and 'customs' formalities, including delays imposed on road haulage, differences in product standards or technical regutations) while others must be examined at the level of individual subsectors (for example, variations in charges for telecommunications or other services). An illustration of the process of moving towards a 'market without frontiers' Is provided by the European Community, which demonstrates that progress may be spread over long periods of time, and must be meticulously mapped out. 1.28 Regional integration which permits the free movement of not only goods but also factors of production may however have associated costs, for specific regions, in some circumstances. While the arguments in favor of integration demonstrate that there are possibilities for improved total economic welfare, the distribution of these gains among regional economies is also a consideration. One consequence of the clusters and increased polarization that may occur with greater opportunities for specialization is that, in the absence of appropriate distribution mechanisms for the total gains, some regions may be worse off with integration. The possibilities for greater polarization increase with greater factor mobility. While this is the implicit argument behind many forms of regional protection, it should be recognized that there Is a potential for greater total gains, and also, that the existence of a credible redistribution mechanism during the process of integration is critical for its acceptability and success. In the case of China, the decline in the central government's budgetary expenditure as a share of GNP from 31 percent in 1978 to 20 percent in 1991 (and a parallel decline in revenue shares from 31 to 17 percent) reduces the redistributive capacity of the center. The concerns that this may justifiably arouse in the context of promoting regional integration have to be taken into account. 1.29 The economic case for regional free trade blocs also raises the question of the extent to which such a bloc creates trade, or diverts trade away from areas outside the bloc."' Even for the participants in the free trade area, the effects of tariff revenue losses from diverted trade may sometimes outweigh the beneficial effects of price gains. Whether this occurs in any situation is empirical and will depend on the relative attractiveness of domestic and external prices (including the effects of domestic and external tariffs or their equivalents and any premia that may be attached to export privileges) which in turn depend on the relative demand and supply conditions in these markets. It remains, however, that the likelihood of internal gain increases if current internal obstacles to trade are high. Moreover, the lower the external tariffs, the less the likelihood of trade diversion. 16 Jacobs (1969), Romer (1986) and Porter (1989), as cited in Wang and Mody (1993) in the context of explanations for rapidly growing areas in China. 17 de Melo, et. al (1992), in an extension of the classic analysis by Viner (1950). What is also pointed out (based on Kemp and Wan 1976) is that it is always possible to design a welfare improving free trade area.  - 11- The Process of Creating a Common Market The Example of the EC The Process of Integration and indirect tax ates, which made some locations more The process of integration in the European Communuty attracdve for investment than others. These have been has taken seal steps. Bitay only stoal integration reduced through (i) the gadual harmonizadon of indirect tax was attempted, in the form of a European Coal and Steel rates, (u) the adoption of rules such as the imposition of taxes Community, set up in 1951 with a limited duration of 50 by country of origin only (that is, the place of production, years. In 1957 the principle of a Common Extemal rather thn 'ownership' of the entetprise) and (iii) the setting Tariff was extended to al sectors, and the EEC, set up up of a 'clearinghouse' to divide tax receipts as appropriate under the Treaty of Rome, was of unlimited duration. between member countries. From 1962, a Common Agricultural Policy was also adopted. But while taiffs on intra-community trade had Gains From Integration been eliminated, many restictions ramained which limited The first phase of the establishment of the EC led to an the operation of the Community as a single market. increase in the share of exports between member countries The 1985 policy paper of the European Commission, from 34 percent in 1958 to 52.4 percent of total EC exports which paved the way for completing the internal market, by 1983. Import rose in paralle from 34 percent to 50.5 attempted to identify all existing bariers to the 'four percent. Gains to bo achieved from the Single Market freedoms', the free movement of goods, services, capital agreement of 1986, by 1992, were assessed at between 4.3 to and people. Later, competition policy, consumer 6.4 percent of EC GDP, or some $270 billion, by one protection, and the mutual compatibility of network estimate (Ceccini 1988). The boost to capital stock, and gains systems was added to this list of elements essential for the from scale economies, have been estimated to add a further smooth working of the internal market With the adoption 1.2 to 2.6 percent to the estimated GDP gains (Baldwin 1989). of the Single European Act shortly thereafter, 279 specific legislative proposals were identified to create a Distribution Issues and the Structural Funds unified market. Severd additional proposals have since How has the EC handled the issue of the distribution of the been added. gains from the single market? It was recognized that some Barriers were identified in three categories, physical, regions would have structural deficits in their balances of technical and fiscaL Fronter formaLities and the payments with other regions in the prooess of growth, and associated administrative costs for business and publio also that these regions would benefit from jointly provided administration were esdmated to amount to 1.8 percent of aid, through a series of 'stcural funds'. The largest of the value of goods traded in the EC (Emerson 1988), or these is the 'Regional Development Fund', which empowers around 9 billion ECU. Barriers due to public the Community to finance half the cost of unemployment pay procurement resticons as well as resictons to entry, and retraining for workers made redundant because of the especially in service industries, were cstimated to amount establishment of the Common Market. The Fund also helped to another 20 billion ECU, leading to projected cost and finane Community programs, and national programs of price reductions of 10-20 percent in some industries community interest. Since 1985, the Regional Fund's (energy generation, transport, office equipment, financial resources have been allocated on the basis of ranges, with services) where government purchases are important By upper and lower limits fixed for each member state. The December 1992, frontier formalities were reduced other principal Structural Funds are the Social Fund (to through the introduction of a 'sine administrative promote the geographic and occupational mobility of labor document' and modifications in statistical trade-recording. within the Community) and the Agricultural Fund (for poor Improved tra ency and new regulations for public farmers and rumal areas), and in the Maastricht proposals, a procurement have been introduced. In tansport services, new 'Cohesion Fund' has been suggested. Eligible regions there are proposals for the introduction of the rights of are classified by the objective they fulfil. operators to move freight outside their member states. The total budget of the Funds amounts to around 1.5 Bilateral quotas on road transport are to be abolshed and percent of combined GDP. With the adoption of the Single air traffic routes to be permitted greater flexibility. European Act, the principle of a doubling of the structural Technical barriers due to differences in product funds was adopted, in February 1989. The funds constitute a standards and licensing requirements have been reduced significantly larger amount in some poorer countries, such as through the principal of mutual recognition, so that the Portugal and Greece, where they have been estmated to reach setting of unique common standards is not essential. 5 percent of GDP. Fiscal barriers arose through differences in value-added Sources: European Commission D 11 and DO m, Euopean Commision (1985, 1992a,b&c), Emerson et. al. (1988), Ceccini (1988), Hufbauer (ed.) (1990), Plnder (1991), Hualng (1992), Swami (ed.) (1992), Buips (1993)  - 12 - 1.30 In China, the rapid rise in external trade, together with the relative fall in internal trade flows implies that trade diversion cannot be entirely ruled out. Trade expansion with the external market may well have been easier, for some provinces, than internal market penetration. However, recent moves in China to lower external tariffs make this less likely to occur. There may also have been dynamic secondary effects of external trade in some areas, which may have led to increased domestic trade as well, for example, the establishment of backward links with domestic suppliers, or increased sales to other provinces to achieve scale economies required to keep unit costs low. Estimating the real effect of this is difficult and the present report will only point out the relevant factors to be taken into account, and their behavior so far, based on available evidence. C. Market Structure in China 1.31 It is necessary to examine the evidence of market fragmentation in China, and see how this 'cellular' character affects overall industrial structure. The extent to which market fragmentation may affect China's growth potential as a consequence must be evaluated, and this in turn depends on how China today compares, in this respect, with other large economies. 1.32 There is evidence which suggests that China has enjoyed some success in terms of reducing interprovincial income inequalities. An analysis of regional distribution of per capita income, and shifts in this over time, indicates a decline in per capita income variation.' Between 1983 and 1991, the coefficient of variation in regional income declined steadily from 0.77 to 0.59. There has been a similar decline in regional coefficients of variation in different measures of per capita industrial output (from 1.4 to 1.1, or 1.24 to 1.03,) and a somewhat more erratic decline in regional variations in per capita investment (0.84 to 0.75)."9 However, as explained above, greater income equality or inequality need not be associated with the structure of output. In the long run in China, the relative structural homogeneity in output may limit increases in total income for all provinces taken together. 1.33 Turning next to industrial structure and the structure of output, it is noticeable that, in China as a whole, there have been remarkable shifts in the ownership of industrial output. The proportion of gross output value accounted for by the state sector declined from 76 percent in 1980 to 65 percent in 1985, and further to 53 percent by 1990. Both the number of firms and the output contribution of collective, individual, private and other enterprises (such as joint ventures), which make up the non-state sector, have grown steadily during the last decade. Despite this, the structure of I However, there is also evidence that points to increasng urban-rural income differentials over the past decade. (Khan, et. al., 1992, presents carefilly adjusted data from published statistics as well as a survey). 9 Measured as the ratio of the standard deviation to the mean. The GINI coefficient of dispersion give similar results. For per capita income, these declined over the same period, from 0.300 to 0.264 (Appendix Table Al. 1). There is a similar clear decline in the value of the GINI coefficients for per capita industdal output (0.5 or 0.47 to 0.43, using altemative measures, as shown in Appendix Tables A1.3 to A1.4) with a less marked decline in the GINI coefficient for per capita investment (0.36 to 0.348; Appendix Table A1.2).  - 13 - industrial output over this period has remained remarkably static.21 Looking at the structure of output, using a 15 branch classification of industry, remarkable stability over tme is suggested (Table 1.1). Tle share of light industries, for example (industries 9-14), their share in output was 33.3 percent in 1980 and 32.8 in 1990. (More significant change had occurred earlier, from 1970, when the share of this group was 25.5 percent, to 1980).21 It can also be shown that this is not due to offsetting changes in the composition of state and non-state output, or urban and rural output. The relative composition of each of these groups has also remained virtually unchanged. This is in spite of other considerable policy shifts which occurred over this decade, in terms of the move from plan to market allocation and pricing, ownership changes in Industry, and extenal trade expansion. Table 1.1 Trends in the Branch Composition of China's Industrial Output/a (1970-1990) (percent) 19701b 1980 1981 1990 M Bautg 10.3 8.6 8.8 73 Electuicity 3.5 3.8 3.8 3.0 cod 2.6 2.3 3.0 2.1 Perolen 4.8 5.1 S5. 3.8 Chemical 18.5 12.5 11.4 12.7 Mac111MY 30.0 25.5 20.9 28.9 Buud b mates 2.9 3.6 3.8 4.3 Fatedtproducts 1.7 1.7 2.0 1.3 Food proces4s 9.2 11A 133 10.5 Texie 15.0 14.7 16.5 14.0 Apparel 0.0 2.7 2.8 2.8 Leshr oods 0.0 1.0 1.1 1.2 Paper&publlsbi 1.3 1.3 1.3 1.3 Cukl & caftpgaods 0.0 2.2 2.4 3.0 Other 0.0 ,.4 3.3 3.8 Total 100.0 100.0/b 100.0 100.0 Is ExcudinS vflago leve firms. lb Adjusted to t account of addlng-up inconsency. Source: Rawsld (1993) 1.34 Looking at the cross-section structure of industrial output by region, another striking finding is that each major industrial group is located in virtually all provinces. Looking at eight principal groups of industries (coal mining, tobacco, textiles, chemicals, building materials, machinery, and electronics and telecommunication), we find that these are represented in all provinces (Appendix Tables Al.6 to Al.8). TMe variation across provinces, in terms of the numbers of firms or total employment a Appendix Table Al.5 and Rawskd (1993). 21 It has been shown in greater detail (Solinger, 1991) that the proportion of the gross value of industrial output in light industry rose noticeably in 1980 and 1981, suggesfing that the early policy of 'readjustment' of 1979 to 1982 did make a difference to industrial composition, albeit for a limited period. The actual numbers depend on the level of aggregation and definitions used for 'light' and 'heagvy' industry.  - 14- in each sector is low, compared to what might be expected, in view of the considerable diversity of the provinces in terms of size and resource endowments. For five out of these eight sectors, the coefficients of variation for these measures are below I in 1991O In terms of gross output value, the coefficients of variation are below 1 in six sectors in both 1990 and 1991, and the values for 1991 are lower than for 1990. 'he most pronounced similarity is for the average mnmber of persons employed per enterprise, where the coefficients of variation are less than 0.5 for 5 sectors and below 0.8 for the remaining three. Ilis suggests that firm size is also remarkably similar across provinces. 1.35 The significance of this structural similarity across provinces, especially in conjunction with a fairly static industrial structure over time, would suggest, in terms of the discussion of the orevious section, that China so far has not benefited from the opportunities for regional specializadon that its large iernal market would permit. To assess the extent ,- which China may potentially gain from this, a comparison of China and other large regional markets is undertaken here. The two comparators chosen are the European Community, and the United States. The selection of the US is obvious, as another large, federal nation state. Ihe presence of 'manufacturing belts', and sometimes highly concentrated industries in a few specific towns, is notable. The choice of the EC is due to the fact that it is increasingly approximating a single market, in the same sense as the US. Although the regions of the EC are individual countries, with huge differences between north and south, differences in size and also a high degree of linguistic and culturl diversity, advantage has been taken of relative regional specializatimn. Thus most manufictures are located in countries such as Britain and Germany, many agricultural products are grown mostly in Portugal and Spain, and France and Italy dominate the internal EC clothing industry. 1.36 The analysis measures the difference in the shares of individual industries between each pair of regions within the three countries (e, for each pair of countries in the EC, and each group of provinces in China or states in the US), and then constructs an average of these differences for each of the three countries considered. The higher the value of this measure, the greater the relative regional differences in industriat structure, and the bigher the degree of local specialization. Three different indices of industrial structure have been used; the shares of individual industries in output, employment and numbers of firms, in each region. Details of the analysis are provided in Annex 1.1. As shown in the Figure 1.3, regional differences in China are relatively low, suggesting that there is little industrial specialization or regional industrial concentration. The degree of differentiation is much higher in both the EC and the US, particularly in terms of the first two measures S" 22 The coefficient of varation is the standard deviation of a distribution divided by its mean. Using coefficients of variation to measure dispersion enables 'normalized' comparisons of the dispersion of distributions, in tuations where where may be widely diffenng ranges and mean values. 2 As explained in Annex 1, the reason for fte less pronounced difference in terms of numbers of firms is tdat this variable may be afrected by systematic variations in firm size, across the three countries or country groups. This is one of the caveats concerning the interpretation of results of cross-country o ons. Admittedly, the use of the EC and the US as compartors is far ftom ideal, since these countries are at a more advanced level of indusraliation, and moreover have not undergone the process of transition from a planned to mret economy. However, data on better comparators are not available at present.  - 1S- Figure 1.3 Coefficients of Structural Difference Chia, USA and EC 0.91";v.IM Sburaw S" Auae i.37 To summaize the observations of this chapter, it is noted first of all that China has made many moves towards the creation of a market economy over the last decade. There have been pronounced reductions in the degree of central control over resource allocation and pricing. At the same time, there has been a remarkable opening up of the economy towards the exterior, with a rapid growth in foreign trade. Yet, there are some disturbing imbalances in this movement towards a market economy. First of all, industri structure has remained remarkably constant over time, and moreover, the regional differences in industri structure are very low relative to other counties or communities of comparable size. This indicates that China has taken relatively little advantage of the opportunities for regional specialization according to comparative advantage, and the potential available to it in this direction may be large. The additional finding that internal trade flows have been declining in relative terms reinforces the urgency of exploring means towards market integration, as part of the movement towards the establishment of a market economy.  - 16- ANNEX 1.1 Calculation of Regional Structural Difference CoeffldentsP 1. Methodology 1. The underlying assumption is that the integration of a market can permit, and will encourage, greater regional specialization. If constraints to internal trade or factor mobility exist, regions are less likely to specialize and industrial structures across regions will tend to be more similar. 2. If the regions within a country have identical industrial structures, the shares of different subsectors of industry in the total for each region will be the same. These shares can be measured in terms of variables such as the numbers of firms in a given subsector, the numbers of persons employed in that subsector, or its share in output value. 3. If y, represents the share (On terms of number of firms, number of persons employed, output value) of subsector i in region j, and yD represents the share of subsector i In region k, then the shares of subsector i in regions j and k may be defined as: dij = ,& and dik nY+ , i = 1,2, ...,n, j, kg = 1,2, ... m Yij Y1- k 4. Tnen the difference in the shares of all subsectors i between regions j and k may be defined as: n Djk= Z Idij -dikl 0 s Djk s 2 2=1 5. Note that the number of subsectors i in each region j and k must be equal, to permit the comparison. The upper limit of D , will be 2, because if the two regions have no industries in common, each pair of values will be counited twice. The lower limit of D,k will be 0, because if the structures of the two regions are identical, each difference will be zero. For an easier understanding of the coefficient, this can be normalized, giving us Djk = Djk/2 o s Djk s 1 ........l (1) 21 This section draws upon and extends the methodology used in Krugman (1991b), 'Geography and Trade'. MIT Press, Cambridge, Massachusetts.  - 17- 6. The greater the strucural difference between these two regions, across all industries, the closer the value of this measure is to 1. If a country had three regions, we can estimate the values of this coefficient for each pair of regions within the country, and the resulting array would be a matrix of elements, such as: Jl i2 i3 i El.D 2 3 j, k = 1, 2, ... ,m ~~k 0 7. By extension, an index of the 'overall structural difference', or degree of regional specialization, of all the regions of a country may be estimated as an averaged value of the elements of this matrix. Therefore, for any country with m regions, we can define: m m D-ks1 D'1 8. D, by analogy with the above, has a lower limit of zero. The upper limit of D is determined by m, the number of regions, which is the upper limit of j and k. The limts of the measure are m a O D s (m-j) 9. For example, if m is 3, the upper limit of the value is 3, as the matrix above shows (provided the elements below the diagonal are not counted). Dividing by this upper limit, we have a 'normalized' value of D, which varies between zero and 1. Thus, .6 D o D 1 ....... (2) m )-1 (m-j) 10. The advantage of this measure is that it provides a summary of the overall degree of specialization of a country, and permits comparisons to be made with other countries. For such comparisons to be valid, the number of regional groupings in each of the countries considered must also be the same.  - 1