Chinese industrial reform : accomplishments, prospects, and implications

RESEARCH PAPER SERIES ENTERPRISE BEHAVIOR AND ECONOMIC REFORMS: A COMPARATIVE STUDY IN CENTRAL AND EASTERN EUROPE AND INDUSTRIAL REFORM AND PRODUCTIVITY IN CHINESE ENTERPRISES RESEARCH PROJECTS OF THE WORLD BANK CHINA NUMBER CH-RPS #29 JANUARY 1994 CINESE INDUSTRIAL REFORM: ACCOMPLISHMENTS, PROSPECTS, AND IMPLICATIONS* by Thomas G. Rawski Department of Economics University of Pittsburgh Forthcoming in American Economic Review, May 1994 Support from the Henry Luce Foundation, the John Simon Guggenheim Memorial Foundation, and the University of Pittsburgh's University Center for International Studies is gratefully acknowledged. Transition Economics Division Policy Research Department World Bank Washington, D.C. CONTENTS ACKNOWLEDGEMENT ........................................... i I. ACHIEVEMENTS OF CHINA'S INDUSTRIAL REFORM, 1978-1993 ............. 1 II. THE DYNAMICS OF CHINESE INDUSTRIAL REFORM .................... 2 Ill. CAN PARTIAL REFORM CONTINUE? ..............................4 IV. LESSONS FROM CHINA'S INDUSTRIAL REFORM EXPERIENCE ............... 5 TABLE 1 INDUSTRIAL GROWTH AND STRUCTURE .............................. 7 R EFERENCES ............................................................. 8 . ACKNOWLEDGEMENT The research projects on "Enterprise Behavior and Economic Reforms: A Comparative Study in Central and Eastern Europe", and "Industrial Reforms and Productivity in Chinese Enterprises" are research initiatives of the Transition Economics Division (PRDTE) of the World Bank's Policy Research Department and managed by I.J. Singh, Lead Economist. These projects are being undertaken in collaboration with the following institutions: for the project in China, The Institute of Economics of the Chinese Academy of Social Sciences (IE of CASS), The Research Center for Rural Development of the State Council (RCRD), and The Economic Systems Reform Institute (ESRI), all in Beijing; and for the projects in Central and Eastern Europe The London Business School (LBS); RMforme et Ouvertures des Syst6mes Economiques (post) Socialistes (ROSES) at the University of Paris; Centro de Estudos Aplicados da Universidade Cat6lica Portuguesa (UCP) in Lisbon; The Czech Management Center (CMC) at teldkovice, Czech Republic; The Research Institute of Industrial Economics of the Janus Pannonius University, Pe6s (RIIE) in Budapest, Hungary; and the Department of Economics at the University of L6di, in Poland. The research projects are supported with funds generously provided by: The World Bank Research Committee; The Japanese Grant Facility; The Portuguese Ministry of Industry and Energy; The Ministry of Research and Space; The Ministry of Industry and Foreign Trade, and General Office of Planning in France; and the United States Agency for International Development. The Research Paper Series disseminates preliminary findings of work in progress and promotes the exchange of ideas among researchers and others interested in the area. The papers contain the views, conclusions, and interpretations of the author(s) and should not be attributed to the World Bank, its Board of Directors, its management or any of its member countries, or the sponsoring institutions or their affiliated agencies. Due to the informality of this series and to make the publication available with the least possible delay, the papers have not been fully edited, and the World Bank accepts no responsibility for errors. The authors welcome any comments and suggestions. Request for permission to quote their contents should be addressed directly to the author(s). For additional copies, please contact the Transition Economics Division, room N-l 1-065, World Bank, 1818 H Street, N.W., Washington, D.C. 20043, telephone (202) 473-1442, fax (202) 522-1151 or 522-1152. This series would not be possible without the invaluable secretarial assistance of Emily Khine. i Participants in a recent conference asked "why China has grown so fast when conditions thought to be necessary for growth. . . were absent" (Olivier Blanchard and Stanley Fischer 1993, p. 4). Nowhere is this dissonance greater than in China's industrial sector, which has recorded big gains in output, employment, and exports in the absence of privatization, effective bankruptcy legislation, and other policy innovations widely seen as prerequisites for successful reform. This essay reviews the accomplishments of Chinese industry since the start of reform in 1978, focusing on the internal dynamics of the development process, considers the future of partial reform, and discusses the implications of China's industrial reform experience. I. ACIDEvEMENTs OF CHINA'S INDUSTRIAL REFORM, 1978-1993 Table 1 summarizes official measures of real output growth. These figures probably overstate actual performance, but the reality of rapid and sustained growth is beyond dispute. Although real output in the state-owned sector doubled during the 1980s, growth in the state sector lagged behind the national average. The output share of state firms plunged from 78 percent in 1978 to less than half in the 1990s. Collective firms raised their share from 22 to 38 percent during the same period. Table 1 also shows the public sector's continuing domination of industrial activity. Although some authors maintain that collectives operate under circumstances that "mimic conditions of private ownership" (Inderjit Singh, Dilip Ratha, and Geng Xiao 1993), this exaggerates the independence of collective firms. Local governments own and control most collectives. They remain deeply involved in the appointment of managers and in strategic management decisions. Government involvement has increased with the economic importance -of collectives, leading some Chinese economists to describe collective industry as the "second state sector." Industry has broken a long-standing pattern of "extensive" output growth arising from applying larger quantities of labor, capital, and materials to the production process. Studies of state-owned industry show total factor productivity rising at an annual rate of about 2.5 percent during 1980-88 (Gary Jefferson and Inderjit Singh, 1993); this trend seems to have continued after 1988. Figures for collective industry indicate faster productivity growth, but some of the difference may arise from measurement error. China's booming exports of manufactured goods, which surged from US$9 billion to $68 billion between 1980 and 1992 (Yearbook 1993, p. 634) show that reform has pushed industry beyond its earlier preoccupation with tonnage and plan requirements to a new focus on quality, variety, and customer service. Information on innovation points in the same direction: state firms, long accustomed to dealing with captive buyers, now find themselves scrambling to develop new products and improve old ones. 1 2 Chinese Industrial Reform: Accomplishments, Prospects, and Implications The improved performance of Chinese industry is the result of increased competition and growing financial pressures that have accompanied a gradual and still incomplete shift from plan to market. In industry, the shift from plan to market began with commodities and has begun to penetrate the allocation of land, labor, and capital. The share of industrial products sold through markets surpassed 50 percent in the late 1980s and now exceeds 80 percent. Mandatory plans now control less than ten percent of industrial output. Few firms remain immune from competition. Concentration ratios are low and declining, competition from manufactures imports has expanded, and barriers to domestic trade are increasingly porous. Skeptics (e.g. Jeffrey Sachs, 1993) point to lacunae in the reforms and emphasize that central and local governments continue to provide direct and indirect subsidies to loss-making firms. But these circumstances have not prevented the emergence of a large gap between the incomes and opportunities available to managers and workers of profitable and unsuccessful firms. Sample data reveal strong correlations between profits, retained earnings, and employee bonuses (Thomas Rawski, 1994; Gary Jefferson and Thomas Rawski, forthcoming). Loss-making collectives are frequently closed down and their workers dismissed. Workers at unprofitable state firms are rarely dismissed (although this has begun to change), but they are not immune from financial penalties, which may include low or zero bonuses, furlough with partial salary, payment in kind, or removal of free health care. Growing awareness that China's partial reform has generated favorable outcomes leads to three important questions. What are the dynamics of reform in Chinese industry? Can China's industrial boom continue without privatization and other initiatives aimed at deepening the reform process? What can Chinese experience teach us about socialist transition and, more generally, about the nature of market systems? II. THE DYNAMICS OF CHINESE INDUSTIAL REFORM China's leaders initiated economic reform because they were dissatisfied with their nation's economic performance. They wanted China to match the achievements of its East Asian neighbors. Neither the architects of Chinese policy nor independent researchers anticipated the outcome of partial reforms. There was no clear strategy and no planned sequence of reform measures. Policy-makers responded to a succession of problems and opportunities with ad hoc improvisation. Only in the 1990s did China's policy elites settle on a decentralized market economy as the desired outcome of economic reform. China's reforms consist mainly of enabling measures that remove barriers to enterprise initiative. The first reforms introduced around 1980 allowed enterprises to retain a share of their profit. A bonus system sought to harness workers' latent energies. Chinese Industrial Reform: Accomplishments, Prospects, and Implications 3 Enterprises were allowed some latitude in procuring inputs and in producing and selling goods outside the plan. There was also a rapid expansion of foreign trade and investment. A second tranche of reforms implemented in the mid-1980s focused on two components. A growing number of firms were allowed to replace plan targets with "responsibility contracts" that allowed them to retain any surplus after fulfilling specific production and financial obligations. At the same time, China's government initiated a "two-track" or "dual price" system under which commodities produced outside the plan could be exchanged in markets with prices determined largely by uncontrolled forces of supply and demand. These reforms fall far short of the sweeping changes that many economists have recommended to governments of former socialist states in Europe and Asia. Yet they produced enough competitive and financial pressure to stimulate massive beneficial change. The ingredients for competitive industrial product markets existed in latent form within China's pre-reform economy. Deregulation - even the partial deregulation of the 1980s sufficed to unleash vigorous competition in a broad range of product markets. Competitive pressures arose from four sources. Rural industry developed widely in the decades prior to reform, but was largely confined to fabricating local materials into goods for local buyers (Dwight Perkins et al, 1977). Entrepreneurial leaders in hundreds of counties and thousands of production brigades were poised to take advantage of deregulation by bursting into markets that they had coveted for years. China's southern provinces, excluded from large-scale industrial investment during three decades of central planning, took advantage of the new "open door policy" to promote industrial growth with the aid of capital, skill, and commercial contacts from overseas Chinese, most of whom trace their ancestry to the southern coastal provinces. Defense conversion brought strong new entrants into a number of civilian industries. Finally, China's long-standing policy of building "complete sets" of state-owned industries in most provinces provided a ready-made source of competition. Competition erodes earnings. In China, the 1980s brought dramatic reductions in industrial profits. The dominance of the public sector made governments the chief victim. Tax and profit deliveries from industry, which provided 83 percent of fiscal revenue in 1980, lagged far behind the growth of output. The ratio of industrial revenue to total industrial output tumbled from 18 percent to 5 percent between 1980 and 1991 (Yearbook 1993, pp. 215, 217, 412). Widespread tax evasion exacerbated the fiscal consequences of falling profits. Government's declining share of economic output is a key link in the dynamics of reform. Lacking funds to provide all firms with "soft budget constraints," the central officials repeatedly faced an unwelcome choice between escalation of fiscal deficits and forcing state enterprises to seek sustenance from market activities rather than from the state. 4 Chinese Industrial Reform: Accomplishments, Prospects, and Implications Central officials frequently, although not always, selected the latter option. Provincial and local governments, whose share of revenues rose at the expense of the center, also restricted subsidies. Again, competition provides an explanation. Provincial and local governments compete fiercely for foreign and domestic investment. With virtually no access to credit markets, local governments fear that large subsidy payments will cripple their competitive strength by delaying vital infrastructure projects. This is a capsule account of developments more fully described by Barry Naughton (1994) and others. In essence, institutional changes arising from partial reform created a virtuous circle in which the growing intensity of competition not only rewarded winners and punished losers, but, by crippling the growth of fiscal revenues, diminished the ability of the state to protect losers from the consequences of high costs, poor quality, inattention to customer requirements, and other long-standing habits carried over from the planned economy. State enterprises, stung by competition and only partially compensated for falling profits or financial losses, pressed for further relaxation of the state's regulatory web and sought relief from costly social obligations which their collective rivals had largely avoided. These pleas brought fresh increments of deregulation, stronger competition, additional erosion of profits, slower growth of government revenues, and so on. III. CAN PARTIAL REFORm CONTINUE? Partial reform has produced fifteen years of strong growth and stimulated massive shifts from plan to market, from rent-seeking to profit-seeking, and from innovation-by-direction to decentralized technical change. These advances leave important issues unresolved. Widespread financial losses among state and collective enterprises raise questions about the viability of public ownership. The framework of commercial law remains weak. Bankruptcy, although widely discussed, is rarely imposed on urban enterprises. The reform of markets for factors of production lags far behind the growth of commodity markets. Although large-scale transfer of labor to the underdeveloped service sector may relieve state industry of redundant workers, the emergence of urban labor markets awaits the reform of housing, pensions, medical insurance, and unemployment compensation. Capital markets pose equally thorny issues. The partially reformed banking system continues to accumulate unrepayable loans. With the economy facing these difficulties (and many others), can the partial, ad hoc policy stance of the 1980s maintain industry's forward momentum in the 1990s? This perspective, however, neglects the powerful impact of reform experience on the range of choices that elites perceive as legitimate policy options. Advocates of sweeping reform have expressed the fear that gradualism may permit conservatives to mobilize against reform. In China, events have moved in the opposite direction. The 1990s have seen the emergence of a broad consensus favoring a market economy in which the state's role is limited to macro Chinese Industrial Reform: Accomplishments, Prospects, and Implications 5 control, Western-style regulation, and determination of broad economic strategies. This vision, which stood far outside the boundaries of legitimate discussion throughout the 1980s, has received the formal endorsement of China's Communist Party. Neither party nor government flinched from supporting a surge of market-oriented measures in 1992 and 1993; another salvo of reform measures awaits implementation in 1994. IV. LESSONS FROM CHINA'S INDUSTRIAL REFORM EXPERIENCE? In the past 15 years, China has moved rapidly in the direction of transforming a largely planned economy into a market system. Economists are preoccupied with market phenomena. But the reform experience of China and other transitional economies shows that a penchant for excessive abstraction often leads economists to overlook essential features of actual market systems. China's experience with the creation of market systems offers a fertile source of observation that can help to fill the gaps in our understanding of market phenomena. One obvious lesson is that partial, gradual reform of public-sector industry can produce substantial results. Early privatization of industry may be useful in some circumstances, but it is not essential to the reform enterprise. Even if China's current industrial system, in which most resources remain in the public sector, quickly gives way to something much closer to the current economic set-up in Japan or Taiwan, Chinese industry has already achieved fifteen years of substantial growth, export success, and technical advance under institutional arrangements deemed unworkable by many -economists. China's success with gradualism does not mean that other ex-socialist nations should rush to embrace Chinese policies. Even this brief discussion reveals the crucial role of specific initial conditions - the prior growth of rural industry, the dispersion of large-scale manufacturing facilities, and the availability of knowledge and resources from overseas Chinese - in propelling a virtuous circle of institutional change, market competition, and financial pressures. The superiority of China's recent economic performance over that of Russia, other former Soviet republics, and the nations of Eastern Europe does not mean that Chinese-style policies would have enabled these states to do better. In these transitional economies, as in China, initial conditions strongly affect policy outcomes. This suggests that government officials might beneficially imitate Chinese skepticism toward the recommendations of globe-trotting consultants untutored in local economic structures and institutions. Administrative capacity offers a crucial and widely neglected example. China's stable and relatively effective bureaucracy finds it difficult to cope with multiple reforms; some Chinese economists fear that the impending reform push of 1994 may overtax the state's management capacity. Dudley Seers' observation that scarce administrative talent "cannot be deployed on all fronts at the same time" (1962, p. 331) 6 Chinese Industrial Reform: Accomplishments, Prospects, and Implications should alert us to a possible trade-off between quantity and quality in the reform process. Beyond its implications for socialist transition, China's reform experience also points to areas for fresh research in economic theory. The "dual-track" pricing system of the mid-1980s, which partitioned supplies of virtually all industrial goods into plan and market components, with the latter free to circulate through commercial channels, provides a good example. Is it possible that such a system can generate a Pareto-efficient distribution of resources? Can the plan system be viewed as giant array of lump-sum taxes and subsidies? Does a semi-market system in which 30, 50, or 70 percent of commodity sales are transacted at market prices provide the same amount of signal information as a pure market economy? More generally, the experience of socialist transition may help economists to formulate an operational definition of a market system. No one hesitates to identify the United States economy as a "market system" even though it is heavily regulated and riddled with distortions. The degree of regulation and distortion in the "market economies" of Japan, Korea, Taiwan, and Singapore is, if anything, even greater. As the fulcrum of China's economy moves farther away from state ownership and control, when does the term "market economy" apply? The issue of terminology is perhaps trivial. But the deeper issue of what sort of institutional arrangements are conducive to rapid growth of output, incomes, and technological capabilities cuts to the core of economics. Chinese Industrial Reform: Accomplishments, Prospects, and Implications 7 TABLE 1 INDUSTRIAL GROWTH AND STRUCTURE Type of 1992 Annual Firm Output Real Growth Share 1980-1991 State 48.4% 7.8% Collective 38.2 18.6 Private 6.7 140.6 Other 6.6 43.5 Total 100.0 12.8 Sources: Industry 1992, pp. 34, 36; Survey 1993, p. 70 8 Chinese Industrial Reform: Accomplishments, Prospects, and Implications REFERENCES Blanchard, Olivier Jean, and Fischer, Stanley. NBER Macroeconomics Annual, 1993. Cambridge: MIT Press, 1993. Industry. Zhongguo gongye jingli tongii nianjian 1992 [Statistical Yearbook of China's Industrial Economy 1992]. Beijing: Zhongguo tongji chubanshe, 1992. Jefferson, Gary H. and Rawski, Thomas G. "Enterprise Reform in Chinese Industry." Journal of Economic Perspectives, forthcoming. 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