Report No. 19361-CHA Rural China Transition and Development May 28, 1999 Rural Development and Natural Resources Unit East Asia and Pacific Region Document of the World Bank CURRENCY EQUIVALENTS (As of January 1999) Currency Name = Renminbi Currency Unit = Yuan (Y) Y 1.00 = $0.12 $1.00 = Y 8.3 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System I ha= 15 mu Vice President Jean-Michel Severino, EAP Country Director Yukon Huang, EACCF Sector Manager Geoffrey Fox, EASRD Task Team Leader Albert Nyberg, EASRD CONTENTS Preface ............................................v Acknowledgments ............................................ vi Abbreviations and Acronyms ............................................ vii Executive summary ............................................ ix Part I. The Rural Sector Challenge .............................................1 1. A Vision for the Rural Sector ............................................1l Part II. An Enabling Environment for Rural Development ............................................. 6 2. Rural Income and Macroeconomic Linkages .6 A. Domestic Macroeconomic Dimensions .6 B. The International Market. 2 3. Rural Public Finance. 5 4. Rural Credit and Finance .22 5 . The Development of Markets .33 6. International Trade and Foreign Capital Flows. 4 1 A. Trade .41 B. Capital and Technology Flows ............................. 49 Part HI. Managing Rural Development ............................. 57 7. Cultivated Land .57 8. Water Resources .63 9. Technical Change and Technology Transfer .73 A. Agricultural Research .73 B. Extension. 81 10. Rural Industry .85 II. Poverty Reduction .92 12. Natural Resource Management and the Rural Environment .100 Annex: Policy and Action Matrix ......................... 111 Bibliography ......................... 117 - ii- TABLES IN TEXT Table 2.1: Resource Flows from Agricultural and Rural Sectors to Nonagricultural and Urban Sectors .....................................................................7 Table 3.1: Township Finance in China, 1986-93 .................................................................... 19 Table 4.1: Percent of Households Engaged in Different Activities that Finance Activity with Loans and Average Loan Amount, by Activity ........................................................ 23 Table 4.2: Deposits, Loans, and Assets of China's Financial Institutions, 1996 ........................... 23 Table 5.1: Cost of Carryover Stocks .................................................................... 37 Table 6.1: China's Agricultural Trade Balance, 1992-97 .............................................................. 43 Table 6.2: Grain Price, Production, and Supply Volatility (1990-97) ........................................... 47 Table 6.3: Agricultural Subsector Distribution of Contracted FDI Inflows (1994-96) ................. 52 Table 6.4: Financial Indicators of Agriculturally Related Foreign-Financed Enterprises, 1995 ... 53 Table 6.5: Distribution of Foreign-Financed Enterprises in Agriculturally Related Manufacturing, by Factor Intensity, 1995 ................................................................ 53 Table 6.6: ODA Allocations by Subsector .................................................................... 54 Table 8.1: Water Balance and Estimated Water Requirements, 1993, 2000, and 2010 ................ 63 Table 8.2: Average Grain Output and Revenue per Cubic Meter of Irrigation Water .................. 69 Table 9.1: Agricultural Research Budgets and Research Intensity, 1986-96 ................................. 75 Table 9.2: Agricultural Extension Expenditures in China, 1986-95 .............................................. 81 Table 10.1: TVE Employment, by Ownership ..................................................... ............... 85 Table 12.1: Indicators of Rural Environment and Natural Resource Conservation .................... 100 Table 12.2: National Investment in Environmental Protection, 1991-95 .................................... 102 Table 12.3: Reforestation in China (1980-93) .................................................................... 106 FIGURES IN TEXT Figure 1.1: Gross Value of Agricultural Output ..................................................................... 2 Figure 1.2: Rural Income by Source .....................................................................4 Figure 2.1: Rural-Urban Per Capita Income Ratios .................................................................... 11 Figure 3.1: China: National and Subnational Shares of Revenues and Expenditures ................... 15 Figure 3.2: Rural-Urban Per Capita Income Ratios .................................................................... 17 Figure 3.3: Investment to Wage Spending Ratio, Shaanxi, 1983-92 ............................................. 18 Figure 5.1: Free Market Sales Index of Agricultural Products ...................................................... 33 Figure 6.1: Major Commodity Groups as a Proportion of Agricultural Trade .............................. 44 Figure 6.2: Domestic and International Grain Price Volatility ...................................................... 46 Figure 6.3: Actual Capital Flows .................................................................... 49 Figure 6.4: FDI Inflow as a Percent of Gross Fixed Capital Formation, 1991-95 ......................... 50 Figure 8.1: Water Regions and Irrigation Zones .................................................................... 65 Figure 8.2: Proportion of Investments in Water Conservancy, by Type ....................................... 65 Figure 10.1: Percent of TVE Output Value, by Ownership Type .................................................. 86 Figure 10.2: Managerial Contract Evolution in TVEs, Sample Data, 1984-93 ............................. 86 Figure 10.3: Bank Borrowing as a Percent of TVE Output Value ................................................. 89 Figure 11.1: Rural Absolute Poor .................................................................... 93 Figure 11.2: Real Investment in Poor Areas Poverty Reduction Program .................................... 93 - i- BOXES IN TEXT Box 9.1: India Growth Accounting Analysis .............................................. 77 Box 9.2: Agricultural Research Considerations .............................................. 79 Box 10.1: Types of TVE Ownership and Control in Rural Industry ............................................. 87 Box 10.2: TVE Credit Constraints .............................................. 89 Box 1 1.1: Microfinance in Yilong County .............................................. 94 Box 11.2: India: Government Spending, Growth, and Poverty .............................................. 96 Preface v PREFACE The primary purpose of this report is to identify and consolidate information on crucial issues that impact on rural development in China. The report, prepared with the assistance of Chinese and non-Chinese scholars and analysts, assesses strategic options from the perspective of efficiency, equitable development and growth. The authors acknowledge that many reforms in the macroeconomic environment and in other sectors are ongoing and that additional reforms are planned; many of these go beyond the scope of this report. We recognize that concurrent macroeconomic policy and institutional reforms across all key sectors would be unmanageable and destabilizing; therefore, priorities consistent with Government's gradualist reform approach need to be established. Such economy- wide reform priorities and individual reform sequencing are the responsibility of Government, giving due consideration to social stability issues (food security, employment, etc.) that temporarily override economic efficiency criteria, and require "second-best" reform solutions during the transition. The report is presented in the spirit of assisting government officials and World Bank staff to prioritize policy and institutional reforms and public investment decisions in the rural sector. Also, it is hoped the report will support the Government in defining rural reform priorities and programs for the Tenth Five-Year Plan. As priorities are established, the World Bank is ready to work with government officials to move beyond strategy and help design and prepare the tactical approaches to implement priority rural subsector reforms. vi Acknowledgments ACKNOWLEDGMENTS The scope of this report was determined in discussions with the Director and staff of the Institute of Rural Development, Chinese Academy of Social Sciences during a visit to Beijing in April 1998. The report was written by Albert Nyberg (East Asia and Pacific Region, Rural Development and Natural Resources Sector Unit) and Scott Rozelle (Consultant) based on inputs and working papers from many individuals. Major inputs were provided by Huang Jikun (Center for Chinese Agricultural Policy, Chinese Academy of Agricultural Science), Du Zhixiong and Li Zhou (Institute of Rural Development, Chinese Academy of Social Science), Wen Tiejun (Research Center for Rural Economics, Ministry of Agriculture), Christine Wong and Albert Keidel (East Asia and Pacific Region, China Resident Mission), John Weatherhogg (FAO), Loren Brandt, Albert Park, Chen Chunlai, Colin Carter, Andrew Walder, Gary Kutcher, and Madeleine Varkay (Consultants). Inputs and discussions with Abraham Brandenburg, Alan Piazza, Richard Scobey, and Juergen Voegele (East Asia and Pacific Region, Rural Development and Natural Resources Sector Unit) also contributed to the development of ideas and conclusions. The report benefits from discussions with staff of various international organizations (International Food Policy Research Institute and Asian Development Bank), international nongovernmental organizations (Ford Foundation), and bilateral agencies (Economic Research Service, United States Department of Agriculture). The report includes ideas generated during discussions and interviews with numerous Chinese and international scholars, particularly those associated with Chinese research institutions. Also, it cites the findings and conclusions contained in a wide selection of literature. The authors worked closely with counterparts from the Rural Development Institute, Chinese Academy of Social Science, and particular thanks are due Professors Chen Ji-yuan (Director), Zhang Xiaoshan, (Deputy Director), and Associate Professor Du Zhixiong for their insights, discussions, and assistance. Also, particular thanks are due Dr. HuangJikun, Director of the Center for Chinese Agricultural Policy, Chinese Academy of Agricultural Science, and his colleagues who provided significant staff time and effort in preparing working papers as well as reading and commenting on various portions of the report. Abbreviations and Acronyms vii ABBREVIATIONS AND ACRONYMS ABC Agricultural Bank of China ADBC Agricultural Development Bank of China bcm Billion cubic meters CAAS Chinese Academy of Agricultural Science CASS Chinese Academy of Social Science CCAP Center for Chinese Agricultural Policy DDT Dichloro-diphenyl-trichloro-ethane EPBs Environmental Protection Bureaus FAO Food and Agriculture Organization FDI Foreign Direct Investment FFW Food for Work HRS Household Responsibility System GDP Gross Domestic Product GVAO Gross Value of Agricultural Output HRS Household Responsibility System IFPRI International Food Policy Research Institute IOU I Owe You IPM Integrated Pest Management IPR Intellectual Property Right IRD Institute of Rural Development LGPR Leading Group for Poverty Reduction MFIs Microfinance Institutions MOA Ministry of Agriculture MWR The Ministry of Water Resources NEPA National Environmental Protection Agency (now SEPA-State Environmental Protection Agency) NGO Nongovernmental Organization ODA Overseas Development Assistance PBC People's Bank of China PPP Purchasing Power Parity R&D Research and Development RCCs Rural Credit Cooperatives RCFs Rural Credit Foundations RFIs Rural Finance Institutions SMEs Small and Medium Enterprises SOE State-Owned Enterprise SPC State Planning Commission (now SDPC-State Development Planning Commission) TFP Total Factor Productivity TVEs Township and Village Enterprises VAT Value-Added Tax WUA Water User Association WTO World Trade Organization Executive Summary ix EXECUTIVE SUMMARY 1. In its two decades of reform, China has achieved remarkable agricultural and rural- industrial growth, impressively reduced poverty, and reversed some of the environmental and natural resource degradation. The population growth rate also continues to decline. Since 1978 aggregate gross domestic product (GDP) has grown at an average annual rate of 10 percent; agricultural GDP, at 5.2 percent; and rural industrial output, at 31 percent. The number of residents living in absolute poverty has declined by 210 million, to about 6 percent of the rural population. However, these trends have slowed noticeably in recent years and China's rural sector stillfaces considerable challenge in achieving further development. 2. Rural reforms have been gradual, deliberate, and largely effective as the rural sector has increasingly moved away from a planned economy-despite several remaining remnants of the planning legacy and continuing market interventions by government. However, the productivity gains from transition policies are largely exhausted. Sustaining rural income growth will require a carefully crafted effort for several reasons: Many of the conditions that facilitated earlier growth no longer prevail. In addition, China's rural products, input, labor, and land markets, while improving, are still in their infancy. Finally, China still needs to foster several critical institutions, such as an effective fiscal system, a more efficient rural financial system, a workable land tenure arrangement, and a revamped trade and investment environment for agriculture. 3. Increasing rural standards of living, eliminating poverty, and reversing the divergence in rural and urban income levels will require a delicate balance of productivity-enhancing investments and bold policy measures to remove the constraints that are preventing the emergence of institutions that fully incorporate market principles. In the long run, the government should divest itself of industrial and other commercial activities and focus investments on public services, research and extension, and infrastructure. Policy should focus more on developing government's regulatory role and less on direct market intervention. Our ultimate vision of China's rural economy is one in which economic administrators focus on promoting policies, creating institutions, and targeting public investments that improve resource allocation and comparative advantage, enhance productivity, and facilitate more efficient markets. In this vision, economic administrators intervene only where markets are inefficient or have the potential to positively affect national welfare, such as alleviating poverty and redistributing wealth, controlling environmental pollution, and improving management of natural resources. Rural Fiscal Policy's Undermining of Sectoral Growth 4. An inefficient rural fiscal system is one of the most important problems hampering rural development. Decentralization has led to a self-sufficient rural fiscal structure that, coupled with a development legacy oriented toward the urban-industrial sector, has hardened budget constraints and distorted rural investments toward developing potentially taxable local industry at the expense of rural-agricultural infrastructure and development investments that are long term and growth oriented. Over the two decades of reform, national tax revenues have declined to about 12 percent of GDP-a portion that is among the world's lowest. The 1993 fiscal reform and adoption of a value-added tax increased central control over revenues and stemmed the declining trend in collections in both rich and poor regions. However, revenue reallocations are still urban x Executive Summary biased, regressive, and ineffective in redistributing resources. Thus, the equalization of taxation, redistribution, and expenditure for public goods has declined, particularly in the poorest regions. Furthermore, net rural-to-urban fiscal outflows have increased and now exceed Y 100 billion annually, starving the rural sector of investment and operating resources. The massive movement of funds out of the rural economy indicates its importance in the national economy and emphasizes the necessity of keeping it healthy. 5. General (untied) fiscal transfers to townships and villages have declined by two-thirds, in real terms, over the past decade. Thus in the environment of reduced subventions and in the absence of taxing authority, local governments have imposed unofficial, nontax levies and fees on rural producers and consumers and rely on other creative mechanisms to finance governance, social obligations, and unfunded central government mandates. Since the most easily tapped source of off-budget revenues are derived from miscellaneous fees assessed on rural enterprises, poor areas that lack such enterprises are further disadvantaged. Off-budget collections are not officially sanctioned, are not transparent, frequently are regressive, are inconsistently levied, distort investment allocations, and have occasionally caused rural dissention. Because of the urgent needfor additional resources, the government should consider converting some of these fees and levies into transparent components of the tax system. 6. Inadequate budgets for rural social service and advisory institutions (for example, nature and forest preserves, agricultural research and extension, schools, and rural clinics) frequently result in the diversion of staff and financial resources from their primary mission to commercial activities to supplement budgets. Infrastructure investment funds are often redirected to potential tax-producing enterprises or diverted to meet salaries and other recurrent costs. Also, to generate revenue some protective agencies resort to exploiting the resources they are charged with protecting. 7. Further fiscal reform is imperative to enable China to maintain rural infrastructure and services, sustain long-run growth, and reduce poverty. Further assessment of the consequences of such a highly decentralized economy is needed, along with options for additional revenue sources and expenditure reduction. A radical option would be to transfer the basic unit of fiscal responsibility from townships to counties (except perhaps for the most industrialized towns with surplus budgets). This would reduce administrative staff, a move that would significantly reduce costs, as wages are the primary expenditure at the township level. Reducing numbers of "grass roots" staff, however, may hinder policy implementation. Local government consolidation and reform should be high on the policy agenda. Rural Incomes, Off-Farm Employment, and Township and Village Enterprises 8. Recent increases in agricultural income have resulted, in part, from increased farmgate commodity prices. This option has been fully exploited as domestic prices are near international price equivalents-unless government decides to embark on a costly farmer subsidy program and ignore the commitments made in the yet unfinished World Trade Organization accession negotiations. Other options for improving agricultural income growth include (a) increasing factor productivity; (b) diversifying production into labor-intensive, higher-value commodities; and (c) investing in transport and other marketing infrastructure to reduce marketing costs and enable farmers to increase their share of consumer expenditures. Factors affecting these alternatives are reviewed in this report and in other recent World Bank publications. 9. The transformation of China into a more affluent, modem industrial economy depends on sharply increasing incomes and shifting a large part of the population out of agriculture. Executive Summary xi Obtaining off-farm employment has been the surest route to improving incomes. In the past, rural and urban institutions restricted the movement of labor off the farm. The recent explosion of off- farm work proves that many of these barriers have been removed. (Nearly 140 million of China's 450 million rural labor force work in nonfarm jobs.) However, obstacles still prevent farm families from moving to locations that promise them higher returns, particularly features of the urban economy, such as strict prohibitions to job access, urban resident permits, and restricted access to urban services. Rural barriers are less restrictive, although debate continues regarding how land tenure arrangements, quotas, and other institutions affect household decisions to seek employment or residence outside of agriculture. China should make every effort to eliminate the barriers to the movement of labor off the farm. 10. Typically, off-farm employment is associated with rural-urban migration, but in China's case township and village enterprise (TVE) employment and rural-rural migration also is an option. Millions of rural workers have migrated to urban jobs in the past decade, but for the next decade such migration may become a less viable option, as restructuring of state-owned enterprises (SOEs) and rationalization of employment has begun. A surplus of unemployed urban-industrial workers will have priority for deployment in any newly created urban jobs, making agricultural labor's search for nonrural employment in cities more difficult. Off-farm migration to rural industries could play an important job-creation role. Rural industry provides the fastest-growing subsector of the off-farm labor market. Continued out-migration would permit those remaining in the agricultural sector to combine additional land, water, and capital with their labor and improve income. Improvement in the land/labor ratio will be a crucial element in increasing future income within agriculture, particularly if water development and conservation schemes and credit-institution reform increase water and capital availability.Given the inevitable conflict that will arise between laid-off urban workers and city-bound rural migrants, China should promote policies that encourage the efficient expansion of rural industries. 11. Consolidating Past Gains from Rural Enterprises. The contribution of TVEs to China's rapid economic growth during the reform period has been extraordinary. TVEs contribute 40 percent of the national gross industrial output and employ about 130 million workers- representing the major employer of rural nonfarm labor. Unfortunately, output and employment growth are decelerating, access to credit has been curtailed, and severe debt problems are appearing. However, ownership and management are evolving from collective and cooperative to private ownership in response to the changing economic environment. By 1997, 90 percent of TVEs were privately owned and accounted for more than half of TVE employment. Also, the management structure of those firms that remain collectively owned is rapidly shifting away from fixed-wage management contracts to more responsive profit-sharing and fixed-lease arrangements. 12. The initial conditions that favored the rapid development of rural industries no longer prevail; product competition has increased, production has become more efficient, and competitive pressures have eliminated the large profits of earlier years. However, the inland provinces have a few advantages that tend to offset the disadvantage of being distant from major, high-income markets along the coast, including lower-cost labor and often better access to agricultural raw materials. Some coastal TVEs have sought to relocate inland to take advantage of these benefits. However, an attempt by the less developed regions to emulate the policies and institutions of an era that no longer exists would be counterproductive. Local governments in inland and other disadvantaged areas should promote, but not subsidize, small-scale family enterprises that target local niche markets and enterprises that can exploit local comparative advantage, or aid firms that emphasize agriculture and related sideline production more than xii Executive Summary industry. Officials promoting rural industry inland should also seek to elicit the management and capital inputs of those who have successfully developed enterprises in other areas. 13. The financial needs of TVEs are not well met by the financial markets, which is a serious constraint. Rural financial reforms have curtailed formal credit, and as credit becomes restrictive, TVEs are among the first to lose access. A portion of the credit problem is due to uncertain creditworthiness of the TVEs. However, this is paradoxical, as TVEs are the most dynamic segment of the industrial sector. Given their importance in the national economy, China must find a way to increase their access to credit. Explicit financing (for onlending or loan guarantees) for small and medium enterprises channeled through existing financial institutions is an option. However, a training program to improve financial management and operational skills of both the lending institution and borrowing enterprise should accompany, or be a component of, a financing program. 14. Reforming Rural Credit. The financial sector has reformed more slowly than some other sectors, and the government maintains strong controls. Several financial institutions have developed to serve the rural sector, but most lending is to rural enterprises and to state agencies to procure grain and cotton (policy lending). The Rural Credit Foundation system, the smallest and newest quasi-state credit institution, is the only institutional credit source that lends primarily to agricultural households. Informal credit among villagers, both with and without interest, is an important component of agricultural production credit. 15. A definitive separation of policy and commercial lending is clearly needed. China should fully understand that policy lending to state agencies for mandatory procurement of grains- particularly that which goes into grain procurement, strategic reserves or buffer stocks-will incur losses. Concentrating policy lending in a single institution would permit better monitoring of costs, subsidy requirements, and impacts. 16. China must decontrol interest rates if rural credit institutions are to adequately serve the sector. Rural financial institutions (RFIs) focus primarily on lending, but they could improve service to the rural community by creating new savings deposit instruments that provide attractive combinations of return and liquidity. Such instruments, combined with improved rural markets, may persuade farmers to hold increased savings in the form of deposits and less in the form of grain. Regulation must be prudent to ensure stability and safeguard deposits while avoiding excessive restrictions. 17. Rural credit is constrained, in part, by the lack of technical and financial skills of RFI staff, which limits their ability to evaluate alternative projects and monitor loans appropriately. China should develop institutions that support RFIs in improving their capacity to screen loans, enforce repayment, improve the use of loan histories and credit ratings, develop and standardize accounting and reporting procedures, evaluate assets and collateral, and develop resale markets for collateral. Also, China should create a diversity of RFIs to compete and specialize in meeting the needs of different demand characteristics-which might range from full-service banking to specialized banks for rural industry to microfinance institutions. Productivity-Enhancing Policies and Investments 18. Research and Extension: A Means for Raising Total Factor Productivity. Historically, the agricultural sector has been well served by the public research system. By creating new technologies and crop varieties and improving agronomic practices, the research system raised total factor productivity in agriculture, expanded production frontiers, reduced long-terrn production costs, and improved rural incomes. Growth accounting analyses indicate Executive Summary xiii that crop growth over the past decade was overwhelmingly attributable to research investments. Unfortunately, agricultural research investments have declined in real terms and research expenditures as a proportion of agricultural GDP have fallen below the average of developing countries, creating concern for long-term agricultural growth. Without access to new efficient production technologies, China's farmers will be disadvantaged in competitive international markets. 19. Government has several options: (a) increase public investments in agricultural research and technology transfer to develop a continuing stream of applicable modem agricultural technology for agriculture,. (b) encourage domestic private sector investment in new agricultural technology, (c) provide incentives for foreign entrepreneurs to develop and produce new technologies for the domestic market, and (d) encourage the import of technology developed elsewhere through minimal import constraints and tariffs. The most efficient process is likely to be a combination of these activities; some government-financed research is necessary to ensure priority issues and public goods are addressed . This especially true where research benefits are long term or cannot be readily captured and would not be undertaken by the private sector (such as research on subsistence commodities for resource-poor areas and natural resource management). 20. A large quantity of fiscal resources continue to be directed into the grain subsector. These resources consist primarily of storage facilities, stocks, and monetary subsidies-all of which absorb finances but have no investment multiplier effect on growth. Redirecting some of these resources to agricultural research would have a better impact on long-term growth. However, pending fiscal restructuring, several actions could improve the efficiency of the existing research funds, increase research financing, and increased access to nongovemment research results. To ensure the most important research issues are addressed, the government should make the competitive grants-awarding process fully transparent and widely publicized and ensure broad scientific representation on judging panels and access for younger, recently trained scientists. To increase research financing, the government could impose cesses on agricultural commodities that are processed (such as cotton, tobacco, and tea) or on transit points where a cess can be administratively collected, such as an export port. After enforcing of intellectual property right (IPR) protection and licensing become better established, commercial activities of research institutes should be discontinued. However, in the shorter term, implementing a matching grant program to provide funds equal to an institute's commercial earnings, rather than automatic funding reductions, could strengthen the research program. China cooperates with several of the International Agricultural Research Centers. Increasing its interaction with these institutions and with additional centers that focus on livestock and crops in arid and semiarid zones could improve China's access to agricultural technologies suited to poverty areas. 21. Extension services suffer from substantial financial problems, staffing shortages, and staff skill deficiency. Funding shortages have driven away many field staff. Those remaining in- post require increased training to upgrade their existing skills and acquire new skills related to production of nontraditional commodities, and new methods of understanding and addressing marketing issues. Given the small scale of its farms, China must revitalize its public extension system. Some activities of the public extension service could be assumed by the private sector if commercial companies were permitted greater participation in domestic marketing. Such activities would include introducing new seed varieties, managing pests, applyingagrochemicals (includingfertilizer), and controlling the quality of commodities. 22. Foreign Direct Investment in Agriculture. China has been enormously successful in attracting foreign direct investment (FDI)-primarily in labor-intensive manufacturing-which xiv Executive Summary has been an important source of new job creation. However, only about 4 percent of actual FDI inflows during the 1 990s was for agricultural and agriculturally related manufacturing investments. FDI in technology-intensive agroindustries (seed, agrochemicals, veterinary pharmaceuticals, and agricultural machinery) have important modernization potential and could supplement or substitute for research that is currently being carried out by China's own, already- stressed research system. Given the potential contribution to sectoral growth, the government might actively seek foreign investment in technology-intensive industries as well as capital- intensive industries, such as fertilizer, which is in short supply domestically. 23. Although the government has enacted IPR legislation, legal protection is perceived to be poor and China's large potential market for new input technology has not attracted significant private investments. Consequently, technology developed by transnational corporations and made available for Chinese farmers primarily comprises inputs that are very difficult to replicate, thus the property rights are technically protected. If transnational corporations are to provide and promote proprietary technology, China must show that it will resolutely enforce its recently enacted IPR legislation. In addition, officials of transnational corporations have indicated that the weak regulatory environment, opaque foreign investment policy, and fragmented wholesaling and retailing networks inhibits investment in technology and capital-intensive industries.Incentives need to be crafted to stimulate investment and resolve the various marketing and distribution constraints. Resource Development and Production Inputs 24. Water: The Major Constraint to Future Agricultural Productivity. China has abundant labor but other resource inputs are in short supply. Water is agriculture's most limiting agricultural resource, particularly in northern China-and the government has identified several hundred water development projects to assist in alleviating this constraint. Despite massive investments in water development and conservation over the reform period, water available for irrigation in 1993 was marginally less than that of 1980. Given the unmet water requirements in some sectors and the higher availability of water in other sectors, large investments in developing new resources and in improving distribution and use efficiency are needed if supplies to agriculture are to be maintained. The most probable source of new supplies are water transfers from the more water-abundant south, as both surface and groundwater resources are fully or overexploited in most northern locations. China should initiate work on one or more of the south- north transfer routes as early as possible, as completion will be costly and time consuming. 25. While water transfers from the south will help shortages in the north in the near term, they will not increase long-term water supplies in the north, as the transfer volumes will likely be less than current overabstraction of groundwater in the North China plain. Investing in projects for improving irrigation efficiency is equally important. These would include improving delivery efficiency through rehabilitating systems and lining canals (or building pipelines), and improving on-farm efficiency through implementing advanced application techniques and new water-saving technologies. Achieving the targeted delivery efficiency of 78 percent would deliver an additional 100 billion cubic meters of water to farmers' fields-increasing production and farmers' income enormously. 26. Applying financial resource constraints means that farmers will be required to shoulder the costs of managing, operating, and maintaining lateral canals. Some successful pilot programs in transforming irrigation management agencies into self-financing entities have developed and should be replicated as rapidly as institutional managers can be trained. However, farmers have little incentive to conserve water and alter their cropping patterns if water costs are low or Executive Summary xv unrelated to the amount used. Therefore, to ensure water conservation and efficient on-farm water use, we encourage rapid implementation of full-cost volumetric water charges. China must begin to address ways to begin to implement water pricing schemes. 27. In southern China, controlling the flow of abundant water is the greater issue. Flood control is an integral component of an investment program, and China should clearly direct additional attention to watershed management. 28. Land Resources and Land Use Rights. Nearly every farm household in China is endowed with land. By law, land ownership rests with the village (or collective), which contracts or otherwise allocates the use of the land to households. The central government recently extended legal tenure security on contracted land from 15 to 30 years, but village leaders frequently do not follow these policy directives. The dynamics of household and village demographics and other policy pressures often induce local authorities to reallocate land before contract expiration. Although significant long-term gains to productivity would likely be associated with better tenure, several analyses have demonstrated that China's land tenure system has only a marginal impact on agricultural production. However, the absence of secure tenure rights does prevent farmers from using land as collateral and limits their access to formal credit markets. 29. Formal land-rental markets are infrequently found in China. Informal arrangements allow households to transfer short-term use rights to others for a fee-including tax and quota liabilities-although the proportion of land rented is very small. Farmers find renting out their land increasingly difficult as increasing numbers of rural residents migrate or otherwise obtain nonagricultural employment, leading to inefficiencies in land utilization. Finding a mechanism to permit the remaining full-time farmers to access additional farm land, and thus improve incomes by raising the land/labor ratio, is imperative. 30. Despite the benefits that farmers would receive if land were privatized or if land rights were more secure, a number of household surveys have determined that most farmers prefer collective ownership and periodic land adjustments based on demographic dynamics. Therefore, an abrupt change in land property rights, such as privatization, would have significant social costs and be ill advised. Given the importance of land in China's rural society, continuing experiments in the land market and tenure to carefully assess impacts on security, income, equality, investments and efficiency are crucial. Improving Resource Use and Allocation Efficiency 31. External Agricultural Trade. Agricultural trade increased about 50 percent over the past decade-somewhat less than overall trade-and the agricultural trade balance has been positive in all but one of those years. Although the trade data series are short, they imply that the composition of agricultural exports increasingly reflects a production and trade pattern consistent with comparative advantage-exports of labor-intensive horticulture products and imports of land-intensive cereals have both risen. 32. In the interest of stabilization, state trading companies continue to monopolize much of China's agricultural trade. But several factors combine to deny achieving the stabilization goal. State trading companies respond slowly to changing trade conditions, implement trade quotas planned far in advance of harvest (by the time the trade occurs it may be unrelated to prevailing supply conditions), and in the absence of competitive efficiencies destabilize, rather than stabilize, supplies and prices. Prices in some of China's grain markets have been more volatile xvi Executive Summary than international prices and grain imports/exports have exacerbated domestic supply fluctuations over the past decade. 33. A liberal, open, and competitive grain market-including state and nonstate enterprises operating under the same constraints, incentives, and commercial standards-would facilitate more rapid trade responses to grain surpluses (including surplus stocks) and shortages, and be more stabilizing than the current market . More open trade would require removing trade quotas and replacing the two-tier grain tariff regime (I to 3 percent for within quota and more than 100 percent for above quota) with a single tariff rate that would provide farmers with downside price protection and protect consumers from exorbitant price increases. 34. If China maintained tariffs at the binding rates that it has offered in its World Trade Organization (WTO) negotiations, grain and oilseed prices for domestic producers and consumers could be maintained at about 60 percent above world prices. While such bindings are low by international standards, they would prevent China from adopting the extreme protectionist policy of its East Asian neighbors, and prices could be kept at a level that would significantly benefit grain and oilseed producers. If China's objectives focused more on consumer welfare, it would lower the tariff rate, making production of these crops less attractive and directing productive resources into alternative high-value crops. This would improve the long-run welfare of both producers and consumers. To the extent that rural poverty groups are not self-sufficient in food staples, a high import-tariff regime would increase their food costs, but liberalized trading rules would hurt those who specialize in grain production, a part of the rural population that is still relatively poor. 35. Reevaluating Food Security. Some national objectives will require compromise if other objectives are to be effectively addressed. This particularly applies to 95 percent cereal self- sufficiency and maintaining large buffer stocks, which compromise poverty reduction and efficiency objectives and exert a substantial drain on the national and provincial treasuries. Evaluating national food security from a financial perspective and placing greater reliance on domestic and international markets would address both efficiency and food-security objectives. Savings resulting from decreasing grain storage could be redirected to assist those groups most affected by trade liberalization. Growth and income also might be increased by discontinuing grain quotas and permitting farmers to select their own production combination on the basis of their resource availability and prices. 36. From a financial perspective, China is food secure because its foreign exchange reserves and balance of trade are highly favorable. International grain prices are expected to continue their long-term decline, although short-term volatility is likely. International grain reserves exceed 100 million tons, and the major grain-exporting countries could rapidly produce and export much larger volumes if a steady growth in export demand were anticipated. China also has the infrastructure and bureaucratic expertise to run an effective buffer-stock system as part of its domestic marketing strategy. This system could also be used in conjunction with imports to buffer domestic prices. Liberalizing international cereal and oilseed trading would be an efficient option for managing trade and supporting the objective of 95-percent grain self-sufficiency. 37. Domestic Marketing: Room for More Improvement. Marketing and pricing policy reforms have led to unprecedented market development over the past decade. Most food commodities are now sold at market prices, and statistical analyses indicate domestic grain markets are well integrated and increasingly competitive and efficient. The rise of a private trading class has resulted in between 25 to 35 percent of China's grain procurement going through private channels. Executive Summary xvii 38. Despite the rapid emergence of China's markets, problem areas remain, including continued intervention by government grain agencies, incomplete separation of policy and market functions, the continuance of producer quotas, and the high expense involved with a large and costly grain reserve. The marketing channels of the grain bureau continue to incur losses, extend overdue loans, and require large subsidies-inefficiencies that result in part from the conflict of their operating commercially while implementing policy directives. Grain stocks have continued to rise and require expensive maintenance from the fiscal and financial system. An appropriately budgeted government agency should be responsible for maintaining grain reserves or buffer stocks, knowing that it will incur losses directly related to their size. Therefore, China should carefully evaluate the need for reserve stocks from the perspective of minimizing requirements. India and Indonesia employ buffer stocks to stabilize grain prices, albeit at significant cost, but procure only 20 to 25 percent of the marketed grain. 39. If the proposed grain reforms of 1998 had been successfully implemented, the government would have met its complex set of policy objectives of improved efficiency, protection of farmer income, and reduction in government's fiscal burden. However, policy implementation departed from the design and will likely fall short of meeting the core objectives. Recent measures adopted in mid-1998 are reminiscent of those of the 1980s, which were costly and relatively unsuccessful. These measures include remonopolizing farmgate procurement at government-determined prices, prohibiting the grain bureau enterprises from selling grain at prices below the government-determined procurement prices, and clearly separating commercial and policy functions and central and local government responsibilities in price stabilization and buffer stock management. Implementation of the new policies will likely lead to substantial grain overprocurement-stressing financial and physical storage capacity. 40. Although the marketing of fruit, vegetable, and livestock products was liberalized more than a decade ago and has grown rapidly, several policy and institutional constraints impede marketing efficiency. Standardizing national quarantine and phytosanitary inspection procedures and shipping documents applicable to all interprovincial commodity transport would improve marketing efficiency and farmers' incomes. Commodity transporters meeting national standards should be able to transit all provinces unhindered upon presentation of certified documents at provincial border checkpoints and payment of officially sanctioned transit fees (based on weight, number of axles, or other objective criteria). 41. Producer marketing associations are institutions designed to improve farmers' bargaining power with respect to downstream purchasers. A few farmer organizations have developed in rural China, but these focus primarily on production rather than marketing. The government could assist their development by establishing a positive legal and regulatory framework for their existence and obligations. The lack of prohibiting legislation is insufficient to encourage them to develop. Also, farners need technical, managerial, and training assistance to develop the expertise required to establish such an organization and to develop associated market intelligence units. Without marketing organizations, farmers are unlikely to be able to exploit market niches and meet supply deficits that may exist in scattered markets. 42. The government could assist market development by making market information comprehensive and by consolidating the information system under the auspices of a single agency. To ensure adequate information was provided to the central market information agency, China could make licensing of wholesale markets conditional on timely submission of market information. xviii Executive Summary Poverty Alleviation 43. In the early years of reform, rapid growth was associated with rapid reductions in poverty-which was achieved, in part, by labor migration to the coastal areas, where growth and job creation were occurring most rapidly. The 50 million residents still living below the national poverty line are believed to live in areas that are remote, less accessible, and very resource poor- limiting potential for increasing agricultural production. The large wage-rate differentials between poor rural areas and prosperous urban (and rural) areas provide powerful migration incentives and means to overcome poverty. To alleviate poverty, these areas will need nonagricultural employment and improved linkages with the rest of the economy. Education, which makes individuals more marketable in the labor force, also contributes to poverty alleviation. 44. Effective poverty alleviation requires getting well-designed programs to those who need it. Properly targeting poor households rather than just poor counties is crucial-subcounty administrative units need to the considered. Targeting in some provinces has improved in recent years, but targeting in some other provinces has been less effective. Designing and implementing poverty reduction programs on the basis of detailed consultations with local leaders and planned participants is particularly important. Community participation has been an integral element in designing the World Bank-supported poverty reduction projects, which also involve concentrated resources and intensive monitoring. Food-for-work projects apparently have been quite successful, in part because the funds bypass the fiscal system and in part because the projects are narrowly defined, easily monitored, and focus on high-return investments. Investments in agriculture, rural enterprises, roads, and other rural infrastructure have increased the productivity and income of the poor. However, resource constraints in many poor areas limit efficient infrastructure investments. Investments that do not have reasonably favorable rates of return should be reconsidered unless poverty alleviation considerations are compelling. 45. While economic growth is clearly associated with poverty reduction, programs for reducing poverty have had mixed success in increasing growth. If poverty programs are to contribute to long-term growth, they must be based on efficiency criteria and add to investment stock. The subsidized credit program for poverty alleviation generally has not reached the poor, achieves low repayment rates, and should be replaced with programs that place funds into the hands of rural households. In some areas, "grassroots" microfinance programs that are able to reduce the transaction costs involved in evaluating projects, issuing loans, and monitoring repayment by using peer monitoring and group lending have succeeded in alleviating poverty. Such programs must be carefully designed, staffed, and implemented, and their impacts must be carefully evaluated. Also, it is important that credit policies be sufficiently flexible, particularly regarding interest rates, that the programs can be sustained. Natural Resources and the Rural Environment 46. Natural resource degradation and pollution of the rural environment are a serious concern. Anecdotes, quantitative assessments of small circumscribed areas, glaring visual impacts of erosion and pollution, and the 1998 Yangtze River flood create an impression of very severe degradation. However, little nationwide quantitative assessment of the extent and severity of natural resource and environmental problems has been conducted. The natural resource base suffered from widespread deforestation and pasture conversion to cultivated land, leading to serious erosion problems during the 1950s and 1960s-situations that were reversed in the 1980s and 1990s. The evidence on environmental degradation is ambiguous; statistical data indicate that forest cover is increasing and sediment traps along the Yellow River have reduced sediment Executive Summary xix concentrations by 25 percent in the lower reaches. However, many rivers are polluted along lengthy stretches, coastal wetlands continue to be drained, and desertification is said to be increasing. 47. Also, interpretations of the impact of environmental degradation on growth conflict. Various estimates of the cost of environmental degradation range from zero to 15 percent of GDP, but the highest estimates are based on gross assumptions that are not credible. One of the more comprehensive studies on the impact of environmental pollution and ecological degradation estimated the cost at 7 percent of GDP. However, the cost of degradation reduction and prevention has not been analyzed. Better information is needed to determine what prevention and reduction measures would be economically efficient. Also, minimal effort has been made to determine the proportion of degradation that is occurring naturally. A thorough quantitative assessment of the impact on growth of natural resource degradation and environmental pollution and the costs and benefits of preventive and remedial actions is essential to support an effective natural resource policy. 48. Several factors contribute or lead to environmental degradation. The legal framework to conserve natural resources and protect the environment exists; however, the fiscal system often provides insufficient financial resources for environmental protection services to properly perform their jobs. Consequently, agencies responsible for conservation and protection are often encouraged to use natural resource assets to generate revenue for wages and other recurrent expenses. Such income-generating activities may exploit the resource and contribute to further degradation. The fiscal resources for environmental protection, maintaining biodiversity, and sustainable management of long-term natural resources must come from the public treasury. 49. Poverty is an important contributor to environmental degradation. The present, rather than the future, is the concern of the very poor. Consequently, denuding hillsides to cultivate subsistence crops and deforestation to meet immediate fuelwood needs have led to erosion and natural resource degradation. Various projects have found that improving erosion control through increasing vegetative cover and improving cultivation techniques are economically efficient and should be replicated. Similarly, expanding the forest resources to support continued growth in construction and agroprocessing has been an economically efficient investment. Chapter 1. A Vision for the Rural Sector I PART I. THE RURAL SECTOR CHALLENGE 1. A VISION FOR THE RURAL SECTOR 1.1 Since the founding of the People's Republic, the leaders of China have been preoccupied with one overarching goal; the modernization of the nation. Our vision for the early part of the 21St century perceives the rural economy as an integral part of this modernization effort, with equitable increases in income, and the elimination of poverty, achieved in large part by transferring rural labor to the urban-industrial economy-all accomplished in an environmentally sustainable manner. We envision an enormous government effort in transforming its role into an investor for public services and goods and fostering a market environment-enabling individual farm and nonfarm producers, consumers, and traders to make more efficient decisions and improve their welfare. 1.2 In pursuit of this vision, two issues remain central to the government's rural development objectives: food security and poverty alleviation. China has made remarkable progress in meeting these goals; the economy, including the rural sector, has grown at phenomenal rates during the reform period. The growth of food supplies has exceeded the growth of domestic demand and China exports horticultural, livestock, other agricultural, and aquacultural products. The growth of rural industry has been an important element of recent growth as the rural economy continues to diversify. Increased productivity and income growth have reduced the massive pre-reform poverty problem, improved the standard of living of most residents, and launched the structural transformation of China from a traditional rural to a modern society. 1.3 However, growth will be difficult to sustain and many challenges face those responsible for China's modernization. The economic base is considerably greater than it was two decades ago, the easy sources of growth have been tapped, and several underlying conditions have changed. Further expansion and intensification of China's cultivated land base will be difficult and input levels for agriculture are already high. Development of additional water resources will require massive investments. Future growth will increasingly rely on technology, capital, increased cropping intensity, and production shifts to higher-value commodities. The early rapid growth of township and village enterprises (TVEs) and the expansion of jobs they created were possible because of large, unfulfilled domestic demand-a situation that exists much less today. Past growth also relied partially on new export markets and foreign direct investment inflows. Increased global competition will make further expansion of export markets more difficult. Objectives and Structure of this Report 1.4 The objective of this report is to identify and develop strategy options that will assist policymakers and donors to prioritize investment decisions, policy and institutional reform efforts, and continue to guide China's progress toward modernization. This volume presents our vision of the growth and development of rural China in the 21St century. To this end, we systematically review the institutions, state of China's resource base, and the policies that transformed the rural economy in the following chapters. We explore the macrolinkages with the 2 Chapter 1. A Visionfor the Rural Sector rural sector and impacts of industrial and external sector interactions on rural incomes (Chapter 2). We examine the state of China's rural fiscal and financial service systems, and try to assess how further reform and performance can be enhanced (Chapters 3 and 4). We search for options in which government can assist producers manage their resources more efficiently by improving domestic markets and international trade (Chapters 5 and 6); and encouraging new productivity- enhancing investments in land, water, and new agricultural technology (Chapters 7 to 9). Further attention is focused on efforts required to revitalize township and village enterprises (Chapter 1O), poverty alleviation (Chapter 11) and environmental and natural resource protection (Chapter 12). 1.5 We briefly review recent rural economic and income growth and achievements, examine the sources of growth, delineate a number of challenges still facing China's rural sector leaders, and recount some of the basic strategies that leaders have at their disposal to address them. We discusses the State's roles and options in establishing an enabling environment to maintain the growth momentum into the next century, including governance, regulatory framework and market interventions, investments in rural infrastructure and public services. Some weaknesses in the rural fiscal and financial policies and institutions are exposed that, unless resolved, could seriously undermine future growth. Public interventions in domestic marketing and international trade are then discussed, followed by a review of investments in rural infrastructure and public services. Finally, the necessity to reduce poverty while maintaining growth is emphasized, as is the importance of sustainable growth through natural resource and environmental protection and pollution control. 1.6 Although this vision statement addresses problems across the rural economic spectrum, several important topics have been excluded. The problems of village governance, barriers to the emergence of rural producer and marketing organizations, the development of agricultural input markets (such as seeds, fertilizer, pesticides, and custom services), and rural infrastructure are not examined Their exclusion does not mean they are unimportant but that time and budget constraints precluded a more comprehensive assessment of the sector. Some recently completed and impending World Bank studies address some of these issues. Post-Reform Growth and Achievements 1.7 Historically, agriculture has been the primary contributor Figure 1.1: Gross Value of to rural growth, but the Agricultural Output exceptional growth of the output Ine (1985= value of TVEs (averaged 24 percent, 1985-95) has made them the major factor since 0 1987. By 1995 the output value - - ----- _ _-- _ ---- - ---------- - of TVEs was more than that of agriculture. Total agricultural 3000 . _ -- -- ----------- output grew at an annual rate of 0 - - - - -- - 4.2 percent between 1985 and 1997. Growth in the major 70- ------------ agricultural components is illustrated in Figure 1.1. Crops -------- cm - continue to contribute well over --00-0-_--- ---- % half of the output value despite rapid growth in livestock and 900 ,sN 198o 1971 *9 O 191 192 003 1994 1995 199I 937 Chapter 1. A Vision for the Rural Sector 3 fisheries. Livestock contributes about 30 percent of the output value; fisheries, less than 10 percent; and forestry, about 3 percent. Recent analyses by Zhong (1998) concluded that China's agricultural databases tend to overstate production, particularly livestock statistics; thus these growth rates may well be upwardly biased. Notwithstanding adjustments that will follow the evaluation of the recent agricultural census data, the statistics will likely confirm exceptionally high agricultural growth. 1.8 Rapid economic growth and active poverty alleviation activities lifted more than 210 million from poverty and reduced the number to around 50 million in 1997-about 6 percent of the rural population.. The explosion of rural industrial growth and off farm employment has been an important element of China's overall rapid economic growth, rapid increase in rural incomes, and poverty reduction. TVEs expanded rapidly during the reform era, contributing more than 40 percent of China's industrial output. Rural enterprises also were an important source of job creation. More than 135 million people found off-farm jobs by the mid-1990s--contributing to the 63 percent increase in real per capita incomes between the mid-1980 and mid-1990s. 1.9 Rural reforms have been gradual and methodical and often based on policy experiments These experimental options are limited to specific geographical locations to ensure that actual and theoretical results are sufficiently consistent to proceed with wider implementation. If the experiment is judged unsuccessful, it is discontinued; however, if it meets a declared objective, the policy is promoted nationwide. This format is perceived to have been successful and will likely remain the norm for future rural reforms. Thus reforms in areas of major importance (e.g., land) will proceed slowly until sufficient experiments indicate the selected policy will meet a complex of objectives. Experimental approaches to policy reform may be costly in efficiency terms and should be discouraged in the longer term; but "Big Bang" reforms practiced in some other transition economies, are unlikely to be practiced in the near term in China. Sources of Past Growth 1.10 A significant part of output and productivity has come from improved incentives for households, TVE owners and managers, and local government officials. Replacing communal responsibility with the household responsibility system (HRS) contributed 30 to 60 percent of the growth of agricultural output during the early reform years. Improved incentives for managers of rural industry and the rise of private rural firms made the sector one of the most dynamic elements of China's economy. However, institutional reforms provide one-time, incentives. 1.11 Investments in agricultural technology, rural infrastructure, and social welfare also have increased productivity in the rural economy. Over the entire reform period increased productivity from investments in agricultural research and extension system exceeded productivity increases generated by HRS. Improvements in irrigation and water control also continued to help expand yield frontiers, especially in North China. These are the types of investments that will increase resource allocation efficiency in the long run. 1.12 Increased domestic market integration and linkages have further improved efficiency in the rural economy. The rise of markets has increased specialization and resource allocation efficiency. Domestic resources use patterns are increasingly more consistent with regional comparative advantage. Markets for most agricultural commodities, farm inputs, and labor have increased income earning opportunities for many rural households and have contributed to the decline in poverty. 4 Chapter 1. A Vision for the Rural Sector Persistent Challenges 1.13 While past growth and development achievements have been impressive, future growth will be more challenging as much of the potential gains from transition have been achieved. An unnecessarily large component of the agricultural economy remains focused on cultivating relatively low-valued cereals, due in large part to the policy environment. Food-security goals remain an important element in policy-making. Grain fundamentalism, the provision of relatively inexpensive and stable supplies of grain for the urban population, still prevails in the form of quotas, marketing regulations, direct and indirect subsidies (albeit reduced from previous levels), and by social pressure from local officials. Such policies obligate farmers to ignore market developments and cultivate lower profitability crops such as grain and cotton. The emphasis on grain production also has resulted in the conversion of some fragile ecosystems-wetlands, forests, and pastures-into cultivated lands, contributing to biodiversity losses and soil erosion. 1.14 The structure of rural income earnings has evolved slowly. Wage labor as a Figure 1.2: Rural Income bv Source proportion of net income has increased to (constant 1995) only 25 percent despite the extraordinary 2000 growth in TVEs (Figure 1.2). Household 1806 income from nonagricultural activities, such 160 as trading, construction, and transport, also increased but is often not an option for many . households and individuals, particularly in e inland provinces. Although the importance of 1000 agriculture continues to decline, it still 8 v_ provided 58 percent of rural household 60 00% income in 1997. But income inequality has 400 increased rapidly and income gaps between 200 rich and poor, urban and rural, and coastal O __ l .I - - and inland are growing. Relatively equitable 1s 1990 1995 1996 income distributions prevailed in the late 1970s, but by the mid-1990s income M HousersIdAispcuitudn e Wae Labor distribution in China was among the world's most inequitable. Income growth rates in rural areas are less than half the level of urban residents. 1.15 Decentralization generally has been a growth stimulus, but it has also created fiscal problems and retarded potential growth as the rural tax base is exceptionally limited. The fiscal crisis is an overriding problem facing the rural sector. The rural economy has neither viable fiscal nor financial institutions. Declining real investment for virtually all agricultural and rural infrastructure, and declining recurrent expenditures for services and activities, bodes ill for future growth. Mandated expenditures absorb a large and increasing portion of the budget, leaving little for activities such as technology development and transfer. Many public-service institutions and staff are encouraged to undertake commercial activities to supplement budgetary resources 1.16 Increased support of agricultural research, water control and management, rural infrastructure and social services is needed. But the agricultural research and extension system is weak and deteriorating, and restrictions on importing high technology from international sources for agriculture inhibit farmers' access to better agricultural practices. New production technologies and many services could be developed and provided by the private sector-domestic and international-but weak enforcement of existing intellectual property rights and poor wholesale and retail channels discourage interest and investment by such firms. Chapter 1. A Vision for the Rural Sector 5 1.17 Poverty and environmental degradation remain serious problems. Millions of people remain in poverty pockets in resource-poor rural areas-particularly in the southwest and northwest mountainous uplands. Poor regions, characterized by poor physical and human capital, receive lower levels of investment in basic services and infrastructure. Poverty disproportionately affects minority groups and is an important cause of natural-resource degradation. Future Vision: Meeting the Challenges and Modernizing Rural China 1.18 China's miracle growth is aptly titled and with good governance China should continue on a sustained growth path. This positive vision of the rural economy will require numerous policy initiatives and institutional reforms, accompanied by an enabling macroeconomic environment that treats rural-urban, agriculture-industry-service, and government-private sectors as equally important and mutually supporting partners. China will approach modernity when these sectors are integrated, self-reinforcing partners. Each sector would have equal access to efficiency-priced resources, ensuring no cross-sector subsidization except for targeted subsidies to poverty groups. 1.19 As part of the policy and institutional reform, the government would not only balance agricultural-rural with other sectors but identify and separate the roles and activities that it will retain as public goods and services and those it will permit nongovernment entities to undertake without intervention. Government also would embrace the private sector as an integral component of the development process and encourage it to become the new engine of growth. New jobs for productively absorbing the underemployed, redundant labor from government downsizing, state-owned enterprise (SOE) restructuring, and new labor-force entrants must come from nonagricultural and nongovemment sectors. 1.20 Government reconsideration and reexamination of several policies-including those related to domestic production and marketing, external trade, and 95-percent grain self- sufficiency-with the objective of consistency and efficiency would likely alter policies enabling farmers to produce, and merchants to trade, more labor-intensive and higher-value commodities. Reforming the domestic-market and international-trade structures to make them more market responsive would have mixed impacts, and the impacts of specific reforms should be carefully assessed before being implemented. A reconsideration of national fiscal policies would include identifying methods and procedures to generate more tax revenue from the rural sector and to allocate more resources to poverty areas and to subprovincial jurisdictions, and to either discontinue off-budget revenues and expenditures or incorporate them into the budget. Financial policies would be reexamined to ensure that financial flows were driven by financial incentives- not by administrative decisions to support or subsidize state-owned industry-and assist in leveling the playing field. The rural-agricultural sector would have equal access to credit, although conditions of lending may well differ to cover various risks and higher administrative costs of smaller rural loans. 1.21 Agricultural income would be increased by ensuring farmers had access to more nonlabor resources (land and water, credit, capital, and technology) to permit them to move toward more optimum input and output combinations, including higher-value livestock, aquatic, and horticultural products. However, land is a unique production input that performs an exceptionally important social-security role in China; thus legal changes in tenure forms would be implemented only after careful assessment. Nevertheless, a land-use market would be developed to provide a mechanism for full-time farmers to access additional land resources and optimize (or move toward optimum) inputs and improve income. 6 Chapter 2. Rural Income and Macroeconomic Linkages PART II. AN ENABLING ENVIRONMENT FOR RURAL DEVELOPMENT 2. RURAL INCOME AND MACROECONOMIC LINKAGES 2.1 The rural and urban sectors are dualistic and poorly integrated. China's rural sector has continuously transferred resources to the urban-industrial sector, including capital, wage goods (food), industrial inputs, and to a lesser extent, labor. However, constrained labor flows have contributed to the large differential in rural and urban labor productivity and income. The rural sector has also served to buffer the impact of macroeconomic shocks on the urban economy. The spread of market forces and increased reliance on competitive prices has tended to increase the flow of labor and other resources and improve integration in recent years. Unless labor movement constraints are lifted the dualistic nature will remain. A. DOMESTIC MACROECONOMIC DIMENSIONS 2.2 As China has moved from a planned to a more market-oriented economy, balanced sectoral growth and integration have become more important. The urban-industrial sector provides the demand for the rural sector's marketed surplus, and as the agricultural economy becomes an increasingly smaller component of the national economy, changes in growth rates of the industrial and service sectors strongly affect the agricultural and rural economy. 2.3 Domestic Terms of Trade. In most countries growth in the total productivity of all production factors (land, labor and capital)-total factor productivity, or TFP-has led to declining rural terms of trade-despite various price support and subsidy programs. In China, however, rising domestic demand, the phasing out of administered pricing, and the adoption of market prices improved farmer terms of trade over 1990-97, as reflected in the ratio of prices received by farmers to prices paid by farmers. Domestic commodity prices are now similar to international border-price equivalents; thus China's trade and price policy decisions will influence future trends in terms of trade. If China liberalizes its trade, domestic terms of trade should decline over the near term consistent with international expectations. If not, demand will likely rise faster than supply in the near term, meaning prices will rise unless imports are expanded. Other national policies and events not effectively captured in terms of trade calculations, such as output planning and quota procurement, enforce both implicit and explicit transfers from rural to urban sectors. In addition, national credit policies generally favor urban investors and discriminate against rural borrowers. Rural residents, on the other hand, have benefited from lower increases in consumer prices relative to urban residents over the past decade and rising opportunities to remit wages. 2.4 Resource Flows. Over the reform period direct budgetary expenditures to agricultural activities have exceeded agricultural tax receipts, but the netfiscalflow to agriculture declined during the early and mid-1990s. Fiscal expenditures include allocations for investments in irrigation, land improvement, specialty crop production bases, etc. However, a net outflow from Chapter 2. Rural Income and Macroeconomic Linkages 7 the rural economy has occurred as taxes from rural-based industries were considerably greater than the net flow to agriculture. The net annual rural-to-urban flow averaged about Y 113 billion (constant 1995) over the 1994-96 period (Table 2.1); but the official resource flow may have reversed in 1998 as above-market prices for grains directed significant resources into the agricultural sector. Table 2.1: Resource Flows from Agricultural and Rural Sectors to Nonagricultural and Urban Sectors (Y billion, constant 1995) Fiscal System Financial System Grain Total Resource Flow Agricultural to Rural to Agricultural to Rural to Marketing Agricultural to Rural to nonagricultural Urban nonagricultural Urban (implicit tax) nonagricultural Urban 1980 -38.5 -30.0 13.2 3.7 46.0 20.8 19.7 1985 -18.4 11.8 23.5 7.4 15.6 20.7 34.8 1990 -31.1 16.1 68.9 47.8 43.0 80.8 106.9 1991 -35.6 20.0 59.4 28.3 27.9 51.6 76.2 1992 -35.8 38.5 56.9 17.3 20.8 41.8 76.5 1993 -28.5 103.8 49.1 8.6 24.9 45.5 137.4 1994 -26.4 105.2 53.4 38.3 59.5 86.4 203.1 1995 -21.3 122.5 51.1 27.8 50.2 80.0 200.6 1996 -22.1 113.2 44.0 27.6 32.9 54.7 173.7 Source: Derived from China Finance Yearbooks and China Statistical Yearbooks, various years. 2.5 Regardless of the direction of official fiscal and financial resource flows, it is improbable that the "farmer's burden" has been lifted. Large amounts of off-budget funds (not included in Table 2.1) are generated in the rural sector through unofficial taxes (levied particularly on TVEs), various fees, and corvee labor levied on rural households. Farmers are legally subject to a maximum total payment (township fee, village fee, and labor-or monetary equivalent) of 5 percent of the previous year's net income. However, several county-level gurveys have concluded that a plethora of additional fees and charges are levied by provincial and subprovincial jurisdictions that increase actual tax and "tax-like" payments of rural households to 20 percent or more of their income (Wen 1998). To the extent that these resources are spent on salaries of township or village officials (and surveys indicate that many farmers perceive their village is overstaffed with officials), instead of rural infrastructure and services, such fees are a pure tax. Furthermore, if the resources are not spent in rural areas, additional outflow of rural resources may occur through unofficial channels that are not captured in the consolidated fiscal statements. 2.6 Investments in land and water resources are obviously necessary for continued sector growth, but investments in energy (electricity), transport (road, rail, waterway and port), and other infrastructure that reduces marketing costs are equally important for promoting rural-sector growth. Analysis by World Bank staff indicates that the infrastructure investment elasticity in East Asia is 1.0, implying that for every 1 percent of per capita growth, infrastructure stock needs to increase by I percent of gross domestic product (GDP). Therefore, if applicable to China, infrastructure investment will need to be 6 to 7 percent of GDP if GDP growth goals are to be achieved (World Bank, undated). 2.7 To stimulate domestic demand and develop infrastructure, the government has embarked on a three-year $1.2 trillion infrastructure investment program. A recent component was a Y 100 billion bond issue to finance investments commencing in the fourth quarter of 1998. Much of the 8 Chapter 2. Rural Income and Macroeconomic Linkages investment will focus on rural infrastructure that employs rural labor for irrigation, road, and rail construction and on rehabilitation of the rural electrical grid. 2.8 The investment program described above may be having an impact-fixed-asset investment rose 28 percent in the third quarter (year-on-year basis). However, the composition of the investment effort remains a concern as investments during the first nine months of 1998 rose by 20 and 19 percent, respectively, for SOEs and property development. Thus a real risk remains that investments may be diverted from financing public goods to SOEs, where overcapacity is already serious and returns are low. 2.9 China's financial sector, like those in other Asian economies, has not evolved in parallel with real sector performance, remains structurally weak and potentially puts rural growth and development at risk. Government intervention, in the form of policy lending, pervades the banking system; and government remains involved with SOE investment in nonpublic goods. Lardy (forthcoming) reports that, if properly accounted for, the banking system's nonperforming loans would be 30 to 40 percent of GDP. Stock and commodity futures markets remain underdeveloped and underregulated, and many have been closed or consolidated. 2.10 Analysis of data from the banking system indicates a net transfer of financial resources from agriculture to industry throughout the reform period, although such findings need to be interpreted with caution because of concerns on the coverage of the available statistics. Consolidated data on rural savings and loans exclude transactions of Rural Credit Foundations (RCFs), the smallest of the rural credit institutions, and results in a modest understatement of the financial flows. Conversely the inclusion of Agricultural Development Bank of China (ADBC) data contributes to overstating financial flows, as its lending is almost exclusively for agricultural procurement by government marketing agencies. Many deposits in the Agricultural Bank of China (ABC) are by urban residents. After making allowances for these shortcomings, it is clear that although rural industries (TVEs) absorb a portion of these transfers of agriculture to industry, a significant rural-to-urban financial flow (Y 30 billion per year in 1995 real terms) remained during the 1994-96 period. Whether the financial flows reflect the response of rational investors moving funds from low-return to high-return sectors or whether they result from distortions in the financial and fiscal system is undetermined, but the massive movement of funds out of agriculture and the rural economy highlights the importance of the sector and emphasizes the importance of keeping it healthy. 2.11 About 40 percent of the SOEs incur losses and survive on subsidies and bank overdrafts -which then become nonperforming loans of the banking system. A government priority is SOE restructuring, of which a major element is employment rationalization. This, combined with downsizing the civil and military services, will move large numbers of workers to the ranks of the unemployed. Labor reductions should improve SOE performance, but the reduced labor income will certainly erode demand and emphasizes the need for rapid growth to create new jobs for redundant labor. This overhang of unemployed urban-industrial workers will have priority for employment in newly created jobs and make it difficult for rural workers to stay and work in urban enterprises. To mitigate the impact of income losses, government has budgeted Y 1.5 billion for a new welfare program to assist laid-off, retired, and disabled workers. 2.12 Tight credit that has hampered growth and expansion of small and medium enterprises (SMEs)-which account for 60 percent of industrial output-has been relaxed. Lending by state- owned commercial banks to SMEs, including TVEs, has been increased by several billion yuan. This should bode well for expansion and employment; however, it is equally important to ensure the borrowing proposals and loans meet appropriate financial and economic efficiency criteria. Chapter 2. Rural Income and Macroeconomic Linkages 9 2.13 Labor. In general, the rural labor force acts as a buffer stock for the urban economy, providing labor under booming economic conditions and absorbing labor back from the city when job growth slows (Zhang et al., 1999). The buffering capacity provides a stabilizing influence for the overall development of the economy, but continued access of rural workers to urban jobs is a crucial element of China's modernization, providing income-earning opportunities for poor rural residents and increasing the efficiency of urban enterprises. Recent reforms in SOEs have resulted in layoffs for large numbers of urban workers and, as a consequence, many cities have enacted regulations restricting employment for rural migrants to low-quality, low-paying job categories. Such regulations and general urban investment slowdowns affects the rural migrant labor force and its families. The adverse consequences of layoffs and urban recession could be mitigated by placing the unemployed in retraining programs, instead of granting them privileged access to jobs without regard for their skill level. 2.14 Rural-Urban Migration and Employment. Natural population growth is slower in urban than in rural areas but over the past two decades China's urban population increased from 18 to 30 percent (in 1997) of total population-due partially to expanding urban boundaries and partially to rural-urban migration, which has been continuous despite restrictions on population movement. A changing complex of incentives and disincentives influences both the decision of rural residents to migrate and the characteristics of migrants. The rural-urban income differential has been a powerful stimulus to migrate (officially or unofficially) but the household registration system made it difficult for rural residents to obtain access to urban social services and obtain well-paid jobs; also, village "use it or lose it" land policies may inhibit family migration. Jobs available to migrants were primarily in traditional male-dominated construction or transportation sectors as industrial SOEs are still obliged to hire urban residents. Thus, urban-bound migrants are typically young males whose families remained in the villages to till family plots. 2.15 Market development, relaxation of labor movement and urban employment restrictions, and discontinuance of the grain coupon system in the early 1990s removed some of the migration disincentives. Meanwhile, the continuing rural-urban income gap has maintained the migration incentive. During the 1990s urban job creation and employment increased at five times the rate of rural employment and up to 100 million rural laborers and self-employed traders have migrated to cities and coastal regions (Chan 1996, Huang and Cai 1998). 2.16 Barriers to migration appear to be primarily on the urban side, implying rural-urban migration will increase as the constraints and barriers are removed. Whether such migration will result in the creation of megacities or whether new medium-size towns (an issue currently under debate by scholars and officials) will be developed as job centers remains under debate. Regardless, however, increasing pressure will be placed on urban infrastructure and services and additional urban investments will be. A strong, and open, urban sector is important for the rural economy as migration reduces the agricultural labor force and improves the ratio of nonlabor/ labor resources and income potential. 2.17 Agricultural employment reached an absolute peak of about 350 million in 1991 and then declined by 19 million by 1997-but agricultural employment as a proportion of total employment declined continuously over the reform period and now accounts for less than 50 percent of total employment. However, China is unique as a large share of industrial output is produced by rural industries that employ about 25 percent of the rural labor force. Thus, during the same period the rural industrial sector created about 38 million additional off-farm jobs. Although TVE employment suffered a decline in 1997, it is too early to determine if the employment trend has reversed as temporary declines have previously occurred. 10 Chapter 2. Rural Income and Macroeconomic Linkages 2.18 TVE growth and expansion has been impressive over the entire reform period-except during 1989-90. Despite rapid growth in rural industrial employment, output, and wages (TVE wages have grown at 18 percent annually), and the substantial direct and indirect contribution to the rural economy, rural-urban income disparities have worsened since 1985. Doubtlessly, rapid TVE expansion prevented the income ratio from being even more adverse, but it was unable to reverse the worsening trend. Jin and Qian (1998) found that TVEs did not increase average per capita rural income given the levels of nonfarm employment and/or local public goods provision. Furthermore, the local nature of rural industry also has contributed to risingintrarural inequality (Rozelle, 1994). 2.19 TVEs not only have successfully generated off-farm work opportunities for the local rural labor force, but for workers from other villages as well, creating rural-to-rural migration. Rural- to-rural migration in China is a paradox internationally-it has previously not been observed on such a large scale, and yet in China it is the fastest growing subsector of the rural labor force. The rise of private sector ownership can, in part, account for the shift in hiring nonvillage residents, since their owners are unconcerned with noneconomic criteria, such as employment priority for local workers. From the migrant's viewpoint, common backgrounds permit rural in-migrants to better integrate into the work environment. These factors, in addition to the fact that most TVEs engage in labor-intensive light industry, mean that in-migrants are more likely to be women, older, and less educated; rural-to-rural migration is one of the most important new windows of opportunities for rural residents into the economy. 2.20 An analysis of factors influencing migration found few village institutions that constrained migration (Lohmar, Zhao, and Rozelle 1999). Village "use it or lose it" land policies may inhibit family migration, but land tenure and grain delivery quotas,per se, do not influence migration. However, the ability to rent out land while maintaining nominal use rights appear to facilitate out-migration as does the existence of informal credit markets. 2.21 There are, however, several factors that facilitate out-migration. The overwhelmingly important migration determinant was a "village network." Past migration leads to future migration-fellow villagers who can be relied upon for information (and possible financial assistance), including potential job prospects, provide a chain to attract additional villagers into the migrant labor force. A similar linkage has been found for Mexican laborers working in U.S. agriculture-where it is common for contractors to solicit additional labor from the same village as previously recruited labor. Education generally improves the chances of obtaining off-farm employment-although that factor is more important for workers who live and work at home than those who engage in rural-to-rural migration. Urban in-migration continues to be severely inhibited by the household registration system and limited access to urban social services. 2.22 Rural-Urban Income Dichotomy. Inequality, among other things, is a barometer of the efficiency of an economy as well as its political stability, and the fact that during the reform era China has experienced an exceptional increase in inequality is cause for concern. Gini ratios have been above 0.40 since the early 1990s and have continued to rise. China's rural-urban income gap is large by international standards-particularly when the recent 1998 revisions to urban per capita income data are applied. In nominal terms, the rural/urban per capita income ratio declined from 0.54 in 1985 to 0.35 in 1994, then recovered by five percentage points between 1994 and 1997 (Figure 2.1). These ratios compare poorly with Vietnam where the 1997/98 rural per capita income level was 67 percent of that of urban incomes (Bales). Even when adjusting official rural and urban income data for housing costs and other poorly measured or excluded components of income, rural/urban income ratios do not improve. Further, Yang and Zhou's (1996) analysis of rural-urban income ratios, for 36 countries over the 1985-95 decade, demonstrated that urban Chapter 2. Rural Income and Macroeconomic Linkages 11 Figure 2 Rual-rbaPeCaiincomes are rarely more than twice rural Figure 2.1: Rural-Urban Per Capita incomes. The urban/rural income ratio of only 60 IncomeRatios one country (out of 22 for which 1995 data were available) exceeded that of China. Using consumption as an income proxy, China 50 - - _ . compares unfavorably with India in terms of its Constant Prce (1985) h rural/urban inequality. In 1993-94 the per capita rural/urban consumption ratios were 0.28 and 405 - -- s0.61, respectively, for China and India. Current Pnce 30 2.23 The rural/urban income ratio using constant 1985 prices, reflects the differential increases in the cost of living between rural and 20 urban areas, and illustrates a similar but slightly 1985 1987 1989 1991 1993 1995 1997 more modest decline in relative incomes. However, these data underestimate both rural and urban in-kind income. Price deflators adjust for differential price changes but not price levels. Adjusting for this differential (15 percent), imputing rent to rural incomes and adjusting urban incomes to include in-kind income for housing, education, health care, pensions and other subsidized services provides more accurate income estimates. These adjustments lowered rural incomes to 31 percent of urban incomes in 1990-substantially less than the 45 percent suggested by official data ( World Bank, 1997c). 2.24 The large rural-urban income gap points to a large differential in labor productivity and to constrained factor mobility, especially labor and capital; it also reflects the arbitrary nature in which compensation levels are set. Although only examining data through 1992, Yang and Zhou (1999) determined that the marginal productivity of labor in agriculture, TVEs, and SOEs was Y 601, Y 1,211, and Y 9,346 respectively, in 1992 . Such large productivity gaps indicate barriers to labor mobility prevent a narrowing of the differential-despite large numbers of sanctioned migration and larger numbers of "floating" population. The government attempts to control the pace of migration to ensure urban services are not overwhelmed, and in part to assure urban grain sufficiency. Other factors also constrain migration, including; lack of job information, housing, medical, education and other social services which are unavailable to rural migrants. Government policies continue to support and subsidize urban standards of living, including the absence of hard budget constraints for SOEs (protecting urban jobs), and low-cost capital for urban enterprises although housing and enterprise reforms and fiscal constraints are mitigating these benefits as urban workers now pay higher rents and contribute more to their pension and medical benefits. 2.25 Intrarural inequality has also risen rapidly during the 1980s and early 1990s, a type of inequality that may be more socially sensitive since rural residents may be more aware of the differences in standard of living between themselves and other rural counterparts (Rozelle, 1996). The World Bank (1997a) has shown that one of the largest gaps exists between coastal and inland provinces. Some of the gap may be due to factors restricting the flow of labor and other resources between rich and poor rural areas. With rising market integration, the barriers may be declining, but large initial discrepancies in resource, human capital, and locational endowments may require generations to equalize wealth levels. 2.26 It will be very difficult to improve the trends in rural/urban income ratios without improving labor efficiency and productivity through increased capital/labor and land/labor ratios in agriculture. While the former ratio can be increased by making capital more accessible, significant increases in the land/labor ratio can be achieved only by transferring labor out of 12 Chapter 2. Rural Income and Macroeconomic Linkages agriculture. During the early and mid- 1990s increasing agricultural prices contributed to increasing rural incomes, preventing further deterioration in the rural/urban income ratio but additional reliance on agricultural price policy is limited since the prices of many commodities are now above international prices. Shifting production to higher-value commodities and continued improvements in TFP will permit modest income growth in agriculture, but without additional land and capital per agricultural laborer, future per capita income growth in will be slow in agriculture. B. THE INTERNATIONAL MARKET 2.27 Internationally, exchange rate policies, grain trade quotas, and monopoly state trading influence the performance of China's rural economy and trends in rural incomes and consumption. Also the ongoing Asian financial crisis and the continuing lack of economic growth and reduced demand for imports in Japan and Korea have the potential to hinder rural growth and development. 2.28 China's agricultural export value (food and tobacco, but excluding natural fibers) is only 7 percent of total export value-considerably less than most of its neighbors; also agricultural exports are only 7 percent of agricultural GDP. Thus while $11 billion of annual agricultural exports is obviously important, it is relatively unimportant in relation to total production and to the share of total exports. The impact on agricultural imports likely will be minimal given the relatively high quota and tariff protection for agricultural commodities. Several models (e.g., IIE model described in Noland et al. 1998 and the G-Cubed model described in Stoeckel et al. 1998)1 have been developed to measure the devaluation impact of Asian-crisis countries on trade pattems. The IIE model indicates China's trade balance could decline by $12 billion-primarily through reduced exports, with 50 percent of that reduction accruing to Japanese and Korean markets. The balance of the reduced exports would be derived through third-country markets lost to competition from the devaluing Asian countries. The G-Cubed model indicates that China's import adjustments would be relatively rapid and would return to their baseline trend by 2000. However, three factors will mitigate against increased imports: (a) quota and tariff protection of agricultural commodities are relatively high; (b) with the exception of palm oil, the major agricultural imports are temperate commodities that are not produced in the devaluing countries; and (c) internationally traded agricultural commodities are internationally priced and will be largely unaffected by the devaluations. 2.29 Japan, Korea, and Hong Kong are China's principal export destinations-absorbing about 70 percent of its agricultural exports. Total exports to these destinations have declined over the past year, but the share of agricultural commodities has remained relatively constant. Thus, the recovery of the Japanese and Korean economies is crucial to maintaining and expanding China 's agricultural exports. 2.30 As the manufacturing sector is less regulated and more important in the external market than agriculture, it will likely absorb most of the market changes brought about by the Asian crisis. TVE export destinations are unspecified, but TVEs export about 40 percent of their output. Thus, TVE export demand will likely be reduced, which in turn will reduce TVE employment and rural incomes but the impact on agriculture should be marginal. Although CGE models have been developed to analyze the impacts of the Asian crisis, only the results from two of the more comprehensive models are mentioned in this report. They are (a) the model developed by Noland Liu, Robinson, and Wang (described in Noland et al. 1998), hereafter called the IIE model, and (b) the Asia Pacific G-Cubed model (described in Stoeckel et al. 1998). Chapter 2. Rural Income and Macroeconomic Linkages 13 2.31 Exchange Rate Policies. Since consolidating the two-tier exchange rate in late 1993 the nominal exchange rate has appreciated about 5 percent against the U.S. dollar (through 1997). The real effective exchange rate (trade weighted), however, appreciated by 30 percent (International Monetary Fund). To the extent that international prices influence, or establish an upper bound, for domestic prices, the impact of exchange rate appreciation has been to limit the domestic price increases. Thus, had the real effective exchange rate not appreciated, farmgate prices for grain, cotton, oilseeds, and other traded commodities could have been 30 percent higher. Instead, the appreciation benefited urban consumers. 2.32 Although prospects seem increasingly unlikely, the international community remains concerned about a currency devaluation by China and its impact both internally and externally. A devaluation would erode domestic and international public confidence, reduce foreign direct investment (FDI) inflows, and increase domestic debt but would yield relatively small gains. While China could theoretically benefit by regaining some comparative advantage in labor- intensive manufacturing previously lost to devaluing countries, actual gains would be limited- particularly if it precipitated a further round of devaluations. Actual gains would accrue in competing third markets, as bilateral trade between China and the Asian-crisis countries is relatively small. These factors, plus the large positive trade balance, appear to substantially mitigate this risk. 2.33 A devaluation would have different impacts on different components of the rural and agricultural sector. Producers of tradable commodities, both farmers and industrial TVEs, would experience increasing costs because of fertilizers, agrochemicals, and various other raw materials are imported. However, output values would increase more thereby increasing incomes for that component of the rural sector. Producers of nontraded goods, subsistence farmers, poverty groups, and urban wage earners would experience an income decline, and the number of residents living in poverty would increase. The impact models suggest that a very modest devaluation would return the real effective exchange rate to the pre-crisis level. 2.34 In contrast to many other Asian economies, China has a continental market-most domestically produced goods are domestically consumed, with modest reliance on external markets. Although exports and worldwide demand are important to domestic growth, contributing about 3 percent to recent economic growth, the health of the domestic economy is of far greater consequence. Total trade as a percent of GDP, or trade intensity, demonstrates the relative importance of external markets. In the Asian-crisis countries, trade intensity ranges from about 50 percent (Philippines) to almost 200 percent (Malaysia). China's trade intensity is 35 percent, with exports composing 20 percent of GDP. However, using purchasing power parity (PPP)-adjusted estimates of GDP reduces the trade intensity ratio to about 10 percent. 2.35 Import Restrictions. China's scarcity of land and abundance of rural labor imply that market forces will ultimately make land-intensive products expensive-if imports are restricted. Normal weather fluctuations imply that, periodically, inflation will emanate from a combination of diminished production and restrictions on imports. Economic logic suggests that low-value, land-intensive, and nonperishable products (such as grain) should be produced less and imported more, so that higher-value, labor-intensive commodities, like fresh vegetables and animal products, could be produced more efficiently, abundantly, and competitively. Nevertheless, grain imports are restricted. Possible explanations include concerns for: (a) famine, which occurred as recently as 1958-60; (b) overreliance and high cost of importing large quantities of grain (i.e., China is too large to rely on substantial imports of grain, as it would increase world prices and deprive other importing countries of supplies); and (c) managing rural-urban terms of trade (i.e., 14 Chapter 2. Rural Income and Macroeconomic Linkages transfer investable and consumable resources from rural to urban areas). Nevertheless, the impact of this restriction is suppression of the value of overall rural output and rural household incomes. 2.36 State Trading. Grain exports and imports traditionally function as balancing mechanisms to dispose of domestic surpluses or to acquire stocks to make up production deficits. However, China's external grain trade also serves political interests as grain trade targets are planned, but unpublicized, in advance of the crop year. Trade is intended to be stabilizing, but unfortunately, China's execution of trade plans has tended to exacerbate fluctuations in domestic cereal supplies (rice, wheat, and corn), and prices (Carter et al. 1997; World Bank 1997b). Conclusions and Recommendations 2.37 The rural and urban sectors are strongly linked, but full integration is impeded by various policies and institutions that fosters or hinders resource flows. The policy framework transfers fiscal resources from the rural sector; the net flow of financial resources to the urban sector may be policy directed or may represent efficient markets that transfer resources to higher return uses. Regardless, the rural sector provides a large net capital flow to the urban sector and illustrates the importance of maintaining a vibrant rural economy. Conversely, rural-urban labor flows are policy-inhibited, leading to adverse rural/urban per capita income ratios. It is improbable that long-term sustainable increases in agricultural income can be achieved without removing large numbers of agricultural labors from the sector and increasing the average land/labor ratio. 2.38 The following medium term steps to progressively transfer labor from the agricultural sector and reverse the diverging trend in rural/urban income ratios are recommended: - Remove migration constraints. This would include disassembling administrative and institutional barriers to rural laborers seeking urban employment. However, for this policy measure to be effectively implemented, the current rise in unemployment in urban labor markets must be reversed. As the State completes its labor adjustment over the medium term, it is expected that urban unemployment will decline and create a more favorable environment for removing these restrictions without social disruption. - Support policies and social services that facilitates migration. This would include support of a land use market that would permit migrants to lease their land to others yet provide a minimal amount of security if urban employment was terminated. Additional support to rural education to improve vocational skills would increase the marketability of the rural labor force and encourage migration. Removal of the constraints on urban nonresidents' access to urban social services, such education for their dependents, would also promote migration. * Encourage the creation of labor-intensive off-farm jobs. To modernize its economy China must support technology-intensive industries, which are typically capital-intensive as well. However, some industries have the option of operating in either capital- or labor-intensive modes; where this option exists the labor-intensive mode should be pursued given the large number of jobs that must be created to absorb agricultural labor, improve agricultural land/labor ratios and incomes. Chapter 3. Rural Public Finance 15 3. RURAL PUBLIC FINANCE 3.1 China needs a healthy public finance system to enable government to provide basic infrastructure and social services and an enabling environment for equitable and sustainable income growth. For the rural sector, this includes providing or facilitating investments in farmland improvements, agricultural research and development, extension services, infrastructure such as roads and communications, and social services (such as education, health, and social security). The fiscal system also sets incentives that guide the allocation of resources and influence development. 3.2 China has one of the world's most decentralized systems for providing government services. In many countries subnational governments provide day-to-day administrative and social services, but financing typically comes from the national treasury. Local governments in China, however, are largely self-financing, a trend that has increased during the reform period. China's provincial county and township governments in rural areas financed 48 percent of budgetary expenditures from local sources in 1990, but collected 66 percent of the revenues (Figure 3.1), a level much higher than in most countries. Figure 3.1: China: National and Subnational Shares of Revenues and Expenditures 1990 Revenue 1990 Expenditure Central Own Expend4tre Locally 33% Central FinacedyEpeiue On Revenue ExpedtLWr Local 34% 48_ Net Reyenue 50% Transfers Local to Localites Net 19
Groupe de la Banque mondiale · Pre-2003 Economic or Sector Report
China - Rural China : transition and development
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