China - Macroeconomic stability and industrial growth under decentralized socialism (Vol. 2 of 3) : Industrial Structure, Dynamics and Policies

Report No. 7483-CHA China: Country Economic Memorandum Macroeconomic Stability and Industrial Growth Under Decentralized Socialism (In Three Volumes) Volume II: Industrial Structure, Dynamics and Policies June 12, 1989 Country Operations Division China Department Asia Region FOR OFFICIAL USE ONLY Document of ^he World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EOUIVALFNTS The Chinese currency is called Renminbi (RMB). It is denominated in Yuan (Y). Each Yuan is 1 Yuan - 10 jiao - 100 fen Calendar 1988 June 1989 US$1.00 - Y 3.72 US$1.00 - Y 3.72 Y 1.00 - US$0.27 Y 1.00 - US$0.27 FISCAL YA January 1 - December 31 WEIGHTS AND MEASURES Metric System LIST OF ACRONYMS AIC - Administration for Industry and Commerce CASS - China Academy of Social Sciences EEC - European Economic Corporation FAW - First Auto Works FEAC - Foreign Exchange Adjustment Center FTC - Foreign Trad6 Corporations GDP - Gross Domestic Product GNP - Gross National Product GVIO - Gross Value of Industrial Output IMF - International Monetary Fund MOF - Ministry of Finance NICs - Newly Industrializing Countries PBC - People's Bank of China REER - Real Effective Exchange Rate SAEC - State Administration of Exchange Control SEZ - Special Economic Zone SNA - U.N. System of National Accounts SSB - State Statistical Bureau TICs - Trade and Investment Corporations TVE - Township, Village and Enterprise VAT - Value-added Tax  FOR OFFICAL USi ONLY TITLE : China: Macroeconomic Stability and Industrial Growth under Decentralized Socialism COUNTRY : China REGION : Asia Region SECTOR : Country Economic REPORT mYE CLASSIFICATION mmtY LANGUAGE 7483-CHA ERA Official Use 6/89 English PUBDATE : June 1989 ABSTRACT : The report is divided into two volumes. The first volume analyzes recent macroeconomic developments with special attention to the reforms that have been responsible for China's rapid growth. It also examines policies introduced during 1988-9 to dampen inflationary pressures that have resulted from high rates of expansion. The second volume looks at longer term prospects for industrial reform and development. After describing the industrial structure and the changes that have occurred in the eighties, it concentrates on (i) the dynamics of the Chinese manufacturing enterprise; (ii) the factors influencing the integration of the national market; and (iii) industrial strategies that are likely to promote competition allocative efficiency, technological progress and X-efficiency. This document has a restricted distribution and may be used by recipik ts only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY Table of Contents Page No. EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . i - xi Aims of Reform. . . . . . . . . . . . . . . . . . . . . . . . . i Emergence of Macroeconomic Instability during the Second Phase. ii Framework for Future Policy Actions . . . . . . . . . . . . . . iv Control of Inflation in the Short-run . . . . . . . . . . . . . v Long-Term Strategy. . . . . . . . . . . . . . . . . . . . . . . viii VOLUME ONE - MACROECONOMICS I. MACROECONOMIC OVERVIEW . . . . . . . . . . . . . . . . . . . . 1 Macroeconomic Overview. . . . . . . . . . . . . . . . . . . . . 1 Political Economy ot Reform .... . . . . . . . . . . . . . . 2 Growth and its Sources: 1978-88. . . . . . . . . . . . . . . . 4 Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Employment. . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Productivity. . . . . . . . . . . . . . . . . . . . . . . . . . 12 Foreign Trade.. . ..... 18 External Borrowing. . . . . . . . . . . . . . . . . . . . . . . 25 Macroeconomic Agenda and Actions. . . . . . . . . . . . . . . . 27 II. INFLATION AND ITS CONTROL THROUGH MON.ETARY AND INCOMES POLICIES 30 Reform and Inflation Dynamics .... . . . . . . . . . . . . . 30 Section A: The Pricing System and the Pattern of Inflation . . 32 Price Patterns. . . . . . . . . . . . . . . . . . . . . . . . . 33 Recent Inflation and its Cost .... . . . . . . . . . . . . . 39 Section B: Monetary Trends and Management . . . . . . . . . . 41 Monetary Policy: Short- and Medium-Term. . . . . . . . . . . . 51 Section C: Incomes Policy .... . . . . . . . . . . . . . . 56 Labor Earnings. . . . . . . . . . . . . . . . . . . . . . . . . 56 III. FISCAL STRUCTURES AND POLICY .62 Background on Fiscal Development. . . . . . . . . . . . . . . . 62 Fiscal Structures .... . . . . . ...... . . . . . . . . 64 Fiscal Reforms and Budgetary Dynamics . . . . . . . . . . . . . 69 Theory and International Practice of Fiscal Policy. . . . . . . 76 Fiscal Policy for the Transition. . . . . . . . . . . . . . .,. 80 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - IV. INVESTMENT BEHAVIOR AND DOMESTIC RESOURCE AVAILABILITY. . . . . 85 Section A: Investment. . . . . . . . . . . . . . . . . . . . . 85 Investment Pattern. . . . . . . . . . . . . . . . . . . . . . . 85 Investment Planning and Management by the Central Government. . 88 Investment Imperatives of Local Governments . . . . . . . . . . 95 Investment Control and Financing. . . . . . . . . . . . . . . . 96 Section B: Savings ...... . .. . .. . .. . . .. . . . 101 Structure and Trends. . . . . . . . . . . . . . . . . . . . . . 101 Household Saving Behavior ..... . . . . . . . . . . . . . . 103 The Stability of Savings ..... . . . . . . . . . . . . . . 109 V. INDUSTRY. AGRICULTURE AND LONGER-TERM REFORM. . . . . . . . . . 114 Section A: Industry. . . . . . . . . . . . . . . . . . . . . . 115 Section B: Agriculture ..... .. . . . . . . . .. . . . . 119 Trends during 1978-86 . . . . . . . . . . . . . . . . . . . . 119 Emerging Bottlenecks. . . . . . . . . . . . . . . . . . . . . . 121 Food Production Strategy. . . . . . . . . . . . . . . . . . . . 126 Future Policy Initiatives ..... . . . . . . . . . . . . . . 127 ANNEX A CHRONOLOGY OF ECONOMIC REFORMS, 1979-88 . . . . . . . . . 129-137 VOLUME II. - INDUSTRIAL STRUCTURE. DYNAMICS AND POLICIES EXECUTIVE SUMMARY ........................... i - ix National Market Integration. . . . . . . . . . . . . . . . . . . i Directions for Industrial Policy . . . . . . . . . . . . . . . . iii Role of Small Firms. . . . . . . . . . . . . . . . . . . . . . . v Enterprise Microeconomics. . . . . . . . . . . . . . . . . . . . vii Administrative Environment .................. . viii VI. STRUCTURE OF INDUSTRY . . . . . . . . . . . . . . . . . . . . . Pattern of Industrial Change . . . . . . . . . . . . . . . . . . 5 Industrial Concentration ....... .. .. .. .. . ... 6 Subsectoral Growth . . . . . . . . . . . . . . . . . . . . . . 11 Small Scale Industry ....... .. .. .. .. . ..... 13 Role of the Market .......... . .... ...... . 16 Geographical Trends in Industry . . . . . . . . . . . . . . . . 17 Industrial Finance and Enterprise Ownership . . . . . . . . . . 20 Equipment and Technology.. .. 22 Structure and Dynamics in Electronics, Consumer Durables and Steel . . . . . . . . . . . . . . . . . 23 Changing Industrial Contours . . . . . . . . . . . . . . . . . . 29  - iii - VII. CHINESE STATE ENTERPRISES AND THEIR ECONOMIC ENVIRONMENT . . . . 32 Background .... . . . . . . . ... . . . . . . . . . . . . 32 Enterprise Evolution . . . . . . . . . . . . . . . . . . . . 33 Labor Markets, Incentives and X-efficiency . . . . . . . . . . 35 Technological Change and Its Financing . . . . . . . . . . . . 41 Structure of the Enterprise . . . . . . . . . . . . . . . . . . 44 Resource Allocation .... . . . . ...... . . . . . . . . 48 A Direction for Reforms . . . . . . . . . . . . . . . . . . . . 49 VIII. REGIONAL INDUSTRIALIZATION AND MARKET INTEGRATION. . . . . . . . 53 Pattern of Industrialization in the U.S. . . . . . . . . . . . 54 China's Regional Development Policies, 1953-79 . . . . . . . . 56 Measuring the Cost of the Interior Development Strategy . . . . 61 Regional Development in China Compared with Other Countries . . 65 Subregional Industrial Policies .... . ..... . . . . . . 73 Two Regional Scenarios .... . . . .... . . . . . . . . . 74 Integrating Markets .... . . . . . . . . . . . . . . .. 80 Interprovincial Trade .... . . . ...... . . . . . . . . 80 Marketing ..... . . . . . . . . . . . . . . . . . . . .. 85 Transport ..... . . . . . ....... . . . . . . . . . . 86 Investment . . . . . . . . . . . . . I . . . . . . . . . . . . 94 Tariffs ..... . . . . . . ...... . . . . . . . . . . . 94 Modal Choice ......................... . 95 Strands of a Regional Strategy .... . . ..... . . . . . . 95 IX. ASPECTS OF INDUSTRIAL POLICY.. . . . . . . . . . . . . . . . 97 SECTION A: CHINA .... . . . . . . . . . . . . . . . . . . . 98 Legal Rules and Market Development . . . . . . . . . . . . . . 98 Industrial Policy . . . . . . . . . . . . . . . . . . . . . 103 Interfirm Linkages . ............... 103 Industrial Regulation and Barriers to Entry . . . . . . . . . 105 Price Competition . . . . . . . . . . . . . . . . . . . . . 107 Bankruptcy ................ 109 SECTION B: CROSS-COUNTRY EXPERIENCE . . . . . . . . . . . . . . 110 Antitrust Policy and Administrative Guidance . . . . . . . . . 111 Bankruptcy Law ................ 115 Board of Directors ................ 116 Takeovers ................ 117 A Recapitulation of the Main Points . . . . . . . . . . . . 118 Technology and Industrial Structure . . . . . . . . . . . . . 119 Role of Small Firms ................ 124 Industrial Policy Guidelines for China . . . . . . . . . . . 126 VOLUME III - Statistical Annex  - iv - TABLES IN TEXT - VOLUME I 1.1 Sectoral and Demand Linked Sources of Growth 1980-88 . . . . . 6 1.2 Savings and Investment, 1978-88. . . . . . . . . . . . . . . . 7 1.3 Measures of Inflation. . . . . . . . . . . . . . . . . . . . . 9 1.4 Sources of Growth Analysis . . . . . . . . . . . . . . . . . . 13 1.5 Relation between Output and Productivity Growth, 1975-1986 . . 16 1.6 Price Index of Non-Residential Industrial Construction, 1970-85. 16 1.7 Investment in Housing.. . . . . . . . . . . . . . . . . . . . 18 1.8 Exports of Selected Food Items . . . . . . . . . . . . . . . . 20 1.9 Exports of Commodities from China. . . . . . . . . . . . . . . 20 1.10 Imports of Commodities to China. . . . . . . . . . . . . . . . 21 1.11 Real Effective Exchange Rates . . . . . . . . . . . . . . . . 24 1.12 External Borrowing. . . . . . . . . . . . . . . . . . . . . . 27 2.1 Measures of Inflation . . . . . . . . . . . . . . . . . . . . 35 2.2 Quarterly Measures of Inflation. . . . . . . . . . . . . . 36 2.3 Nationwide Measures of Price and Wage Inflation . . . . . . . 36 2.4 Market Price Indices by Category of Commodity, 1981-87. . . . 37 2.5 Price Dispersion for Selected Products . . . . . . . . . . . 39 2.6 Growth Rates of Monetary Aggregates . . . . . . . . . . . . . 4. 2.7 Contributions to Liquidity Growth . . . . . . . . . . . . . . 45 2.8 Contribution to Reserve Money Growth . . . . . . . . . . . . 46 2.9 Monetary Control Ratios . . . . . . . . . . . . . . . . . . . 47 2.10 Share of Loans to Enterprises and Individuals in Total Lending 48 2.11 Sources of Domestic Credit Growth . . . . . . . . . . . . . . 49 2.12 Revenue From Money Creation . . . . . . . . . . . . . . . . . 49 2.13 Money Demand Parameters . . . . . . . . . . . . . . . . . . . 50 2.14 Trend in Velocity .... . . . . . ..... . . . . . . . . 50 2.15 Interest Rate Structure . . . . . . . . . . . . . . . . . . . 52 2.16 Industrial Wage and Productivity Indicts. . . . . . . . . . . 58 2.17 Industrial Wage and Productivity Growth Rates . . . . . . . . 58 3.1 Structure of Consolidated Government Revenue, 1978-1987 . . . 65 3.2 Developments in Government Reveaue, 1978-88. . . . . . . . . . 66 3.3 Structure of Government Expenditure, 1978-88 . . . . . . . . 67 3.4 Developments in Government Expenditure, 1978-88. . . . . . . . 68 3.5 Budget Deficit and its Financing, 1979-88. . . . . . . . . . . 68 3.6 Changing Fiscal Importance of the Central and Subnational Government Sectors . . . . . . 73 3.7 Simulation of Budget Deficits at Various Rates of Inflation, Real Growth and Interest Rates . . . . . . . . . 83 4.1 Gross Domestic Investment (GDI) as Percent of GDP. .86 4.2 Percent Share of Total Capital Construction Investment . . . . 87 4.3 Proportion of Total Output Under Central Allocation. . . . . . 89 4.4 Financing of Domestic Fixed Investment . . . . . . . . . . . . 92 4.5 Central Government Priority Investment . . . . . . . . . . . . 93 4.6 Uncompleted Construction .................. . 100 4.7 Composition of Saving, 1978-87 ... . . ..... . . . . . . 103 4.8 Gross Domestic Savings, Selected Countries, 1965-88. . . . . . 106 4.9 Household Savings Rates. . . . . . . . . . . . . . . . . . . . 106 4.10 Growth of Financial Savings Versus GDP Growth. . . . . . . . . 108 4.11 Rural-Urban Terms of Trade ...... ........ . .. . 109 4.12 Household Savings Rate in China, 1978-87 . . . . . . . . . . . 111 4.13 Financial Asset Holdings of Selected Countries . . . . . . . . 113 5.1 Current and Projected Per Capita Food Consumption. . . . . . . 120 5.2 Agricultural Indicators. . . . . . . . . . . . . . . . . . . . 120 5.3 Fresh Vegetable Mixed Average Retail Prices in Major Cities, China, May 1985 to Februarv 1988. . . . . . 12 E. Land Uinder VAa'ctnhles . .- 125  TABLES IN TEXT - VOLUME II 6.1 National Inco'ae by Provinco, 1986. . . . . . . . . . . . . . 1 6.2 Provincial Distribution of per capita Industrial Output, 1957, 1965, 1979, 1983 and 1986 . . . . . . . . . . . . . . 4 6.3 Summary Measures of Interprovincial Inequality in Gross Value of Agricultural Output (GVAO). . . . . . 5 6.4 Number of Industrial Enterprises . . . . . . . . . . . . . . . 7 6.5 Gross Value of Industrial Output . . . . . . . . . . . . . . . 8 6.6 Gross Value of Industrial Output per Enterprise in 1980 constant prices. . . . . . . . . . . . . . . . . . . 9 6.7 Summary Measures of Industrial Concentration of China, Korea and India . . . . . . . i . . . . . . . . . . . . . . 9 6.8 Gross Value of Industrial Output in 1980 constant prices, by Branch. . . . . . . . . . . . . . . 11 6.9 Number of Industrial Enterprises by Province . . . . . . . . . 12 6.10 Gross V7aiue of Industrial Output in 1980 Prices, by Province . 13 6.11 Industrial Shares of Township and Village Enterprises. . . . . 15 6.12 Ownership Structure of Industrial Output in 1987 . . . . . . . 18 6.13 Current Liabilities as a Percentage of Networth. . . . . . . . 21 6.14 Total Electronics Output Value in Top Four Regions . . . . . . 25 6.15 Share of Rolled Steel Production by Zone . . . . . . . . . . . 28 6.16 Share of Pig Iron Production by Zone . . . . . . . . . . . . . 28 7.1 Time Allocation by Managers. . . . . . . . . . . . . . . . . . 46 7.2 Structure of the Industrial Work Force, 1986 . . . . . . . 47 8.1 Personal Capita Income in Each Region as a Percentage of the U.S. Average, 1840-1980. . . . . . . . . . . . . . . . . 56 8.2 Agricultural Growth in Interior Provinces. . . . . . . . . . . 58 8.3 Regional Capital-Labor and Output-Labor Rates for Large- and Medium-Scale Industrial Enterprises in 1985. . . . . . . 62 8.4 Regional Differences in Large & Medium Enterprise Efficiency . 63 8.5 Net Material Product by Province (1985). . . . . . . . . . . . 69 8.6 Structure of Industry by Province in 1986. . . . . . . . . . . 70 8.7 Farm Incomes and Nonagricultural Employment by Province. . . . 72 8.8 Regional Inequality in China and the U.S. . . . . . . . . . . 73 8.9 The Percentage of Commodities Imported from Other Provinces by Commercial Establishments in Various Provinces and Municipalities in their Total Purchase of Commodities. . . . 83 8.10 Percentages of Main Industrial Products Produced by Coastal, Inland, Eastern, Central and Western Areas Respectively in China's Total Output. . . . . . . . . . . . . . . . . . . 83 8.11 Net Exports by Province, 1985. . . . . . . . . . . . . . . . . 84 8.12 Transport Investment vs Economic Output in China . . . . . . . 87 8.13 Railway and Road Network Density in Selected Countries . . 87 8.14 Distribution of Intercity Passenger Traffic by Mode China, U.S.S.R., India, Brazil and U.S. . . . . . . . . . . 88 8.15 Distribution of Freight Traffic by Mode. . . . . . . . . . . . 88 8.16 Freight Traffic Intensities. . . . . . . . . . . . . . . . . . 89 8.17 Indicators of Railway Asset Utilization, A Comparison between China, U.S.S.R., India and U.S.. . . . . . . . . . . 90 8.18 Transport Supply Developments. . . . . . . . . . . . . . . . . 92 8.19 Characteristics of Chinese Railway Freight Traffic . . . . . . 93  - vi - GRAPHS 2.1 Different Measures of Inflation. . . . . . . . . . . . . . . 34 2.2 Price Dispersion for Beer, Tea and Cake. . . . . . . . . . . . 40 6.1 Gross Value of Industrial Output, China. . 1 . . .0 6.2 Number of Industrial Enterprises, China. . . . .17 BOXES 1.1 Productivity Growth in China .... . . . . . . . . . . . . . 14 6.1 Causality between Agriculture and Industry . . . . . . . . . . 30-31 IBRD 21483 .... . . . . . . . . . . . . . . . . . . . . . . 2 IBRD 21484R. . . . . . . . . . . . . . . . . . . . . . . . . . 14 IBRD 21485 ..... . . . . . . . . . . . . . . . . . . . . . 59 IBRD 15512R3 . . . . . . . . . . . . . . . . . . . . . . . . . 128 IBRD 15525R2 .... . . . . . . . . . . . . . . . . . . . . . 138 The Report was prepared by a mission that visited China in June 1988. Mission members were Shahid Yusuf (Mission Leader), Gerd-Peter Dittus (AS3CO), Barry Naughton, Dwight Perkins (Consultants), Gyorgy Szapary (IMF), and Tejaswi Raparla (AS3CO). Background papers for the report were prepared by Thawat Watanatada (AS3TE), Peter Harrold (AS3CH), Andrew Feltenstein, Dorothy J. Solinger, Renee Schwartz and Robert M. Field (Consultants).  Executive Summary 1. For the past decade, Ghinese economic reforms have promoted rapid growth. Now, with inflation mounting, some hard choices lie ahead. Slowing the economy and putting ceztain proposed policies on hold is desirable in order to stabilize prices, but there is the risk that the strong momentum acquired by the reform drive will be weakened, inefficiencies will once again begin to accumuiate increasing the system's susceptability to price escalation, when reflationary policies are applied. To put it differently, measures that enhance productive efficiency, improve the trade-off between growth and inflation as rising productivity blunts cost pressures. A postponement of reforms is likely to have the reverse effect and will raise the core rate of inflation. 2. During the decade of the nineties, the principal sources of growtn and avenues for raising factor productivity will probably be found in the industrial sector. Both the objectives of growth as well as price stability would be best served if industrial reform continues unabated, even as macroeconomic policy takes the edge of demand-pull pressures. Volume II, therefore, concentrates on a range of industrial concerns that urgently require attention. These are: e national market integration, interprovincial trade and factor mobility. * industrial organization, in particular, the roalescence of enterprises through mergers into larger entities and the relationships between firms of different sizes. * institutional and administrative means for stimulating market competition. * enterprise management, the internal labor market and efficiency. The principal conclusions of the Report, that rest upon an analysis of the industrial system in China as well as cross-national experience are summarized below. They complement and in some instances, reinforce the proposals presented in the State Council's "Outline of Industrial Policy", issued on March 15, 1989. National Market Integration 3. A large domestic market can make an immeasurable contribution to industrial strength. China has yet to exploit fully the advantages of size which it enjoys over most other developing countries. Although reforms have brought with them the promise of closer market integration, China remains a collection of provincial subeconomies held together by the bonds of adminis- tration and political allegiance, but which are only now beginning to outgrow the long cultivated habit of autarchy. The tight web of economic relation- ships which would be normal for a country that has attained such a respectable level of industrialization is missing. It poses a problem for the near term, but presents opportunities over the longer horizon. Factor immobility, the modest volume of interprovincial trade, the smallness of the average  - ii - production unit and industrial duplication, all compromise allocative efficiency. An industrial strategy that is successful in accelerating market integration; in removing some of the barriers to dr:e flow of goods and factors across provincial boundaries; and in drawing China more firmly into the orbit of the international trading system, could provide a substantial windfall in terms of productivity gains, aside from the continuing benefits for growth and macro stability. 4. The long run goal of a regional strategy should be to create a national market in which goods, factors and information move with the minimum of friction or hindrance. This will optimize resource allocation and slowly eliminate income differentials. A start might be made with regional free trade groupings which, over time could coalesce into a single free trade area. Both the experience of the United States and of the EEC indicates that barriers to mobility should be the first priority. To reach this goal, a host of issues will have to be attended to. z Industrial policies of individual provinces will require some degree of harmonization. * A concerted effort will be needed to dismantle administrative and other barriers that segment the national economy. For instance, restrictions on trade with other provinces; sizable differences in sales and exciso taxes between contiguous provinces; procurement policies of local agencies; and bidding practices, in particular the virtual absence of open tendering that is subject to review by a central supervisory body. * Market initiatives, that lead to consolidation of enterprises into larger firms that sell nationwide, can provide tha organizational means for straddling provincial boundaries. The growth of the national market in the United States is inseparably associated with the appearance of large corporations operating multiple plants. * For smaller firms to develop markets for their products in distant parts of the country, an efficient, decentralized network of distributors, strongly linked to local retail outlets, will have to be assembled. National advertising; after sales service; parts distributors and the rest of the marketing infrastructure that had been reduced to a shrunken state, will have to be built up to normal proportions. * Inter- and intra-provincial migration has commenced. Peasants are permitted to take up residence in cities with less than 200,000 people; they can obtain temporary work permits in cities with up to half a million people; and thousands serve as construction workers and maids in the very large cities. Workers from the Northwest are to be found in Guangdong and temporary migrants from the interior have become a part of the service sector in many coastal cities. The loosening of barriers to labor mobility is a new and important development which is straining municipal services. Understandably the authorities are anxious to avoid opening the floodgates but, urban conditions permitting, a national labor market is definitely a vital component of a regional industrial strategy.  - iii - * Lastly, without a dense transport network the results of other efforts will be weakened. China has among the lowest, annual, intercity mobility rates per capita for any country in the world -- about 500 km as against 900 km in India. The modest share of investment in transport, averaging just 1.3% of GNP over the 1976-90 period, is to blame. By emphasizing provincial self- sufficiency and by tying the development of the railway system to defense needs and the distribution of coal, the state further hindered the emergence of transport linkages which would aid the cause of market unification. Another feature of the transport system based on the Soviet model, that sets China apart from other developing countries, is the heavy dependence on railways for the transport of both freight as well as passengers. Once again, this characteristic is associated with the importance attached to the transpcrt of a few bulky raw materials, and the minimal significance given to passenger traffic and the shipping of light manufactures. Consequently, road, water, and air transport were neglected. These deficiencies must be made good and inter-provincial trade relations cemented by an adequate multi-modal transport network. Directions for Industrial Policy 5. Efforts made to integrate the national economy must be matched by industrial policies to strengthen market forces, stimulate competition and nudge industrial organization towards greater efficiency. Industrial policy in China cannot harness market forces to obtain desired objectives, so long as the uncertainties besetting economic units, that have little familiarity with markets, cannot be reduced. The extent and definition of property rights remains vague. Further, the binding force of contracts together with the ease and predictability of legal redress, are in need of sustained attention from the authorities. Efficient markets built on a system of economic law that provides clear rules and generates stable expectations would greatly facilitate the shaping of the industrial structure calculated to maximize the growth of productivity. 6. The emergence of markets is no guarantee that resources will be put to the most productive use or that innovation will thrive. For that to happen both theory and practice unanimously extol the advantages of competition. How such competitiveness is to be arranged and what dose of competition is appropriate is the subject of much debate. At one extreme, the model of perfect competition requires numerous atomistic firms, offering a homogeneous product, in a market where there are no barriers to either the entry or the exit of suppliers. These criteria are difficult to satisfy and they do not recognize that competition can take many different forms and occurs at various levels, stretching from product markets to financial ones. A variety of regulations to encourage competitive behavior have been tried by the industrialized countries, depending on their historical circumstances and business traditions. They have failed to achieve perfection but the experience gained is nevertheless, instructive. * Developed market economies have been unable to avoid industrial concentration. They have also found that so long as "excessive" collusion is kept at bay, it need not impair allocative mechanisms.  - iv - * The concept of perfect competition is of limited utility in deriving criteria for measuring levels of market competitiveness or as a yardstick for the making and administering of antitrust laws. X Averting deleterious collusion requires strong public sentiment against concentration and a powerful, independent judiciary. Or administrative guidance by the state must keep competition alive between oligepolists. * Barriers to entry, especially regulatory ones, are major impediments to market contestability in China today. Removing these can do more for competitiveness than sophisticated antitrust laws or powerful supervisory agencies. Entry into or exit from the state and collective sectors in China is strewn with red tape. Research conducted during the early eighties suggests that exit by firms from old lines, even in times of slack demand., is quite rare. Nor do the State and collective industries respond speedily to customer needs by modifying products or entering new markets. In part this is the result of managerial lethargy that time and a market environment will erode. But clearing regulatory impedimentia could lead to signal improvements. - Bankruptcy laws are principally concerned with debt collection and their significance for competition in market economies is not very large. The value of such laws in the Chinese milieu would be in providing criteria for determinlng how and when to assist ailing firas, as well as to coordinate labor, environment and tax issues that arise when an enterprise is closed down. _ Company boards hold much promise in theory but have often failed to meet expectations in practice. The institution will have to be so designed as to prevent the board of directors from becoming ministerial surrogates, or from being coopted by enterprise management as they have been in other countries. * Takeovers have spread apprehension through the corporate ranks in the U.S. and Europe but the gains in terms of efficiency have been surprisingly meager. It is difficult to claim that open and competitive capital markets have improved the efficiency of industrial activity by simplifying corporate raiding. Hence, administratively ordained mergers between Chinese enterprises might be of doubtful value. * Perhaps the most important lesson is that the competitiveness of markets seems linked to the structure of industry and its influence on factor productivity as well as innovativeness. Until the early seventies it looked as though large, vertically integrated companies, exploiting scale economies and oriented towards mass markets, held a commanding lead. Such corporate firms squeezed the most product from society's resource base and were best equipped to satisfy the wants of modern consumers. This essentially American model, has been eclipsed in the transport, machinery and consumer durable subsectors by a Japanese-European model resting on a symbiosis between large and  - v - small enterprises. Prior to the early eighties most Chinese enter- prises sought vertical integration to lessen their dependence on unreliable suppliers. Since that time planners have begun experi- menting with horizontal consolidation, conglomerates and industry groups. Meanwhile, thousands of small township, village and coopera- tive enterprises are entering the lists. What kind of market struc- tures are conducive to efficiency? This is a question for which there is no unequivocal answer but research from developed and devel- oping countries described below provides pointers. 7. Japanese and some German companies have moved the farthest in realiz- ing the potential of the new breed of large corporation. The principal goal of the large Japanese manufacturing company is to improve the existing product line and to introduce new products. Next comes market share. By cementing close links with a major bank, it gains valuable financial depth and the stable supply of funds that can sustain investment in the troughs of business cycles. The effort to economize on overheads and promote horizontal communication results in a relatively flat hierarchical pyramid. Concern for overheads, plus the knowledge that efficiency stems from specialization, induces the firm to locate itself at the center of a network composed of subsidiaries and associated companies, all bound together to the leading corporation as well as the main bank by cross-shareholding, board representation and long-standing commitments. Bigger companies can buy two thirds or more of their components from subcontractors. The network serves as an internal market for information. It also pools the technical expertise of all network members. While the large firms encourage their subcontractors to evolve independent design and research capability, they import much technical knowle,. e through the cooperative ventures undergirding manufacturing projects. 8. Managing a network of subsidiaries and subcontractors bound by long- term relations instead of a vast, integrated, multidivisional production apparatus permits a freer flow of information, makes for greater flexibility in response to the market, cultivates multiple foci for technological progress and does away with the large, remote bureaucracies that compromise the competitiveness of vertically integrated corporations. Emphasis on innovation and improvement motivates research. 9. Network manufacturing, anchored by leading corporations and invest- ment banks, is the regnant organizational mode in the automotive and consumer electronic subsectors in Japan. It has also taken hold in the German automo- tive components and textile machinery industries. These arrangements, along with recent trends in the U.S. and the East Asian NICs are helping to define a niche for small enterprises. Role of Small Firms 10. Policy towards small firms throughout the developing world has been blurred by various misconceptions. On the one hand, they have been accused of inefficiency and poor quality. On the other, they emerged in the seventies as the torchbearers of appropriate, labor-intensive technolcgy in developing countries and the cutting edge of the new entrepreneurial wave sweeping the advanced sectors in the industrial economies. With the passage of time has come a better understanding of what small companies can contribute.  - vi - 11. Within the environs of manufacturing, small companies are likely to be the pace setters in three areas: * Where design concerns are paramount and production is usually in small batches aimed at differentiated clienteles. Clothing, leather goods and jewelry fall most readily into this category. * Where total innovation using skilled labor is the principal objective, entry barriers are low and there is a premium on entrepreneurial initiative. Advantage in innovation relates to the ease of internal communication which a resourceful entrepreneur can use to integrate research, production and marketing. Information, electronics and biotechnology have filled these requirements, except that all of these are now entering the stage in their life cycle when large, capital- intensive firms, with a broad operational scope, are gaining an advantage in generating innovations and, more importantly, marketing them commercially. The contrasting experience of the electronics industry in Taiwan (China) and Korea pushes the point home. Taiwan (China) enjoyed a headstart and its small firms became proficient manufacturers under license or through direct investment of semiconductors, keyboards, monitors and disk drives. But, by remaining small, these firms are being overtaken by the Korean conglomerates able to commit large resources to research and production facilities. _ The network milieu described above. Here the path taken by Japanese machinery firms offers a few guideposts. Most firms are of medium and or small size. Specialization and subcontracting is the rule--fully 70% of all firms subcontract, even the smallest. The sector emerged in the fifties and has flourished since for several reasons. A reservoir of skills, low entry barriers and the financing provided by rural and small business credit institutions attracted small businessmen to the industry. A highly competitive environment emerged which stimulated the search for new technology and market niches. Other factors were an expanding market, both domestic and overseas; refinement and extension of technology licensed from overseas; incentives and support from large corporace buyers to produce sophisticated items; and the fruitfulness of cooperative specialization. In capsule, a vibrant industry comprised of small firms needs adequate institutional finance, sources of technology, growing competitive markets and specialization within an interconnected network. 12. Reform has drawn thousands of new entrants into the least regulated township, cooperative and village sectors of Chinese industry. They have began to fill the ranks left depleted by three decades of socialist planning. While these new enterprises may bring balance to the industrial mix and pro- vide employment, growth of the small-scale sector should be brought within the purview of industrial policy by removing price distortions, entry barriers to large firms and local trade restrictions which encourage uneconomic small scale investments. 13. Making industrial policy in a pluralistic market economy such as the U.S. presents serious difficulties, but the belief in the desirability of coherent long-run guidance by the government continues to spread. China is  - vii - much better equipped in terms of tradition and instruments to pursue an industrial strategy. At a time when reform has loosened many constraints on structural change, strategic guidance by the central government can serve as the framework within which firms interpret market signals and avert the entrenching of provincial industrial bases feeding local markets. It will also be up to the government to prevent the division of the market by bureaucratic conglomerates that are neither efficient nor innovative. 14. The fine print of strategy is for Chinese policymakers to decide. What they might treat as constants for their purposes are the following: * Price and product competition is the most important aspect of market activity. Competition can accelerate the growth of total factor productivity and it may be more important than firm size in determining innovativeness. Industrial structure, entry barriers, financial markets and other factors mentioned in this chapter influence competition. East Asian and American experience also brings out the salience of competition from trade. Not only has this spurred Asian companies to excel, it has, more recent'y, forced U.S. firms to try and regain the technological strength sapped by an existence in which there was no challenge. * MITI's sedulously researched long-term vision of the industrial future influenced Japanese decision-makers in all walks of the economy. The government-instigated, informal consultative process reinforced policy, provided feedback and started a flow of information that energized the myriad interlinked networks of Japanese industry. Both the vision and the dialogue are components of strategy that could serve Chinese planners well into the next century. Enterprise Microeconomics 15. Labor productivity within the typical Chinese enterprise suffers because the compensation, tenurial and assignment arrangements do little to sharpen motivation. Earnings do not seem to be tightly linked to the short- run of the enterprise. Furthec, the distribution of bonuses does not establish a clear link between individual worker performance, and material reward. 16. In Japan, for instance, the lifetime compensation of a worker is bound to th; performance of his firm in the market. Profits (and thus the amount available for distribution to workers) depend upon success in the marketplace. The chances of advancement within the firm are enhanced if the firm is able to expand. In China this link is greatly attenuated. The Chinese enterprise continues to face a "low powered" incentive environment, in which rewards and penalties are subject to constant renegotiation with superiors. There are, in addition, serious constraints on the firm's ability to expand, and in particular to diversify into related markets which make it difficult for the Chinese worker to reliably associate the enterprise's performance with his or her own future career, or lifetime compensation package. All these considerations suggest that the incentive mechanisms are seriously flawed and act as a brake on efficiency.  - viii - 17. A freeing of labor markets, alongside housing reforms, might be the long-term solution. In the near future, a number of partira remedies could be considered, e.g., (a) Permit new workers a period of job flexibility during which they are encouraged to search for the most satisfying position; (b) Spread seniority wage systems to enhance the long-term link between the worker and the enterprise. These would reduce some of the costs of the permanent employment system; (c) Provide closer links between worker career paths and enterprise evolution. This requires both more flexible promotion paths than appear to characterize Chinese industry currently, and measures to allow the enterprise more flexible strategies for expansion. 18. The strength of workers' commitment to the enterprise crucially affects productivity and cost competitiveness through the quality of effort, diligence and absenteei3m. Employees are likely to give their best when they are trustful of management, there is a sense of common objectives and the identification with the enterprise is strong. Unimpeded two-way flow of information between management and workers in an enterprise is one way of winning commitment. The ability of managers to allocate rewards in a fair and discriminating manner encourages effort; while active soliciting of opinions and suggestions from the grass roots does generate feelings of involvement. 19. So far, the manager of the average state enterprise has made limited progress in these areas. While his formal authority may be substantial, the actual latitude he enjoys on matters pertaining to personnel, wage scales and bonuses is extremely narrow. He is not well served by the enterprise communications system as it was designed for the purposes of supervisory agencies seeking information. The obtrusive behavior of supervisory bodies is intensely preoccupying. Accommodating their occasionally capricious requests, absorbs so much of the manager's energy that other kinds of communication with workers, suppliers and buyers are neglected. The manager's ambivalent position vis-a-vis the administrative bureaucracy and the enterprises' own lack of autonomy make it very difficult to build trust or forge commitment. Those at the firms' helm have neither the authority, nor the control over incentives nor the time to define enterprise objectives and persuade workers to pursue them with dedication. Future enterprise reform must concentrate on redefining the manager's role. 20. Enterprise reforms have snipped away at the complex hierarchy that bound enterprises to administrative organs. For many collectives, and township and village enterprises, supervisory interference has been much diminished. They have gained meaningful autonomy. State firms have been less successful in extricating themselves from the bureaucratic web even after decentralization, because provincial administrative hierarchies, binding sub- ordinate to supervisory units, remain intact. They may possibly have gained in strength following the partial withdrawal of central controls. 21. While an attempt has been made to legislate a modicum of autonomy for the enterprise, superior organs have a large sphere of authority within which their orders to enterprises have presumptive validity. The survival of a large area of presumptive authority remains with the extraordinarily wide range of benefits and penalties that supervisors can impose on enterprises in response to actions outside the authority relationship. These maintain the dependence of the enterprise on its superiors. This implies, in turn, that a significant part of enterprise decision-making is actually slaved to the wishes and objectives of superiors, and enterprises can rarely be held fully responsible for their actions as would truly independent agents.  - ix - Administrative Environment 22. The administrative system in the provinces is divided into three tiers. First come the comprehensive departments that draft broad industrial guidelines and the industrial bureaux, which direct the activities of firms in their subsectoral domains. The bureaux claim responsibilities over administrative, strategic, marketing and social matters. Industrial bureaux also determine how raw materials at fixed prices are allocated; they ensure that enterprises meet mandatory production t4rgets; and they, along with pricing agencies, set the rates at which goods subject to full control or to flexible pricing, are sold. 23. So far, the enterprise lacks the credible protection that tested enterprise law could provide from arbitrary interference by superior agencies. Further, the distribution of responsibilities across the tiers means that the enterprise exerts only partial control over decisions vital to its profitability and growth: R&D, product development, deployment of new machines, automation, energy conservation pricing and personnel policies must all be settled through negotiation with the corporation and the bureau. Decentralization, by transferring more power to the provincial authorities that interact dWrectly with enterprises, has increased the amount of bargaining and moved the relationship closer to a pure bilateral monopoly. In certain respects this is less desirable than the conditions prevailing under centralized control. A centralized system monitors a large number of firms by reference to a comparative standard, and the costs to the center of applying sanctions are reduced by the alternative ways of exploiting task specific capital. 24. The current arrangements are unsatisfactory for at least three reasons. Dividing critical responsibilities between the supervising bureau- cracy and the enterprise, rather than concentrat-ng all vital functions within the firm, ties the latter's hand and renders effective participation in the market impossible. Second, the enterprise cannot evolve the organizational superstructure required for autonomous management of the entire range of func- tions covered by the company in market economies. Lastly, bilateral monopoly is not a preferred state of affairs even when it strengthens the enterprises' bargaining position, because it slows decision-making and deflects it away from rational economic criteria. The reaction to market signals is long delayed and the translation of these signals itself is distorted by the bureaucratic tug-of-war. In the next phase, enterprise reform must enable firms to gain organizational maturity and arrive at arms-length relationships with regulatory agencies that are subject to legally binding rules.  -1- VI. STRUCTURE OF INDUSTRY 6.1 China derives nearly 47Z of its GDP from industry. No other large country has attained a comparable degree of industrialization in the develop- ing world. Equally remarkable is the spread of industry to some of China's poorest provinces. While the industrial heartland remains in the eastern and northeastern parts of the country, the industrial sector accounts for a third or more of the national income 1/ in Guizhou, Yunnan, Anhui and Gansu. Industry's share was below one third in just three provinces--Guangxi, Xinj_.ang, and Tibet (see Table 6.1). Such uniformity has been attained through deliberate effort which commenced with the First Five-Year Plan.2/ Table 6.1: NATIONAL INCOME BY PROVINCE, 1986 Share in National Income in X of National Income Construction, per capita Transportation (Yuan in 1988) Agriculture Industry and Commerce Beijing 2,130 9.1 62.8 37.7 Tianjin 2,040 10.2 82.7 27.1 Hebei 673 32.0 49.5 18.5 Liaoning 1,299 18.6 82.9 18.6 Shanghai 3,471 4.4 71.9 28.7 Jiangsu 1,084 32.9 61.1 16.0 Zhejiang 1,042 31.7 40.3 20.0 Shandong 770 41.3 s2.2 16.6 Guangdong 897 37.1 36.0 26.9 Fujian 672 38.9 $8.) 23.0 Shanxi 682 21.1 S3.9 26.0 Jilin 823 33.2 47.6 19.3 Heilongjlang 997 27.2 66.2 17.6 Anhui 699 48.7 34.7 16.6 Jiangxi 643 47.2 36.2 17.8 Henan 540 41.6 39.2 19.2 Hubei 805 40.3 41.4 18.3 Hunan 603 47.8 34.4 17.8 Guangxi 460 47.6 81.3 21.1 IMAR 606 41.6 37.1 21.3 Sichuan 616 43.4 36.4 20.2 Guizhou 406 46.0 35.0 19.0 Yunnan 453 45.4 35.9 18.7 Tibet 661 69.4 7.7 22.9 Shaanxi 631 34.9 43.7 21.4 Cansu 670 29.8 42.8 27.4 Xinjiang 740 44.9 31.8 23.3 Qinghai 698 34.8 34.8 30.4 Ningxia 616 38.4 36.0 25.6 National average 748 33.8 46.7 20.4 Source: State Statistical Bureau, Statistical Yearbook of China, 1988, p. 55 and 57. 1/ National Income, or net material product as the Chinese define it, is the sum of the primary incomes of the population and enterprise. 21 Semi-autarkic development by individual provinces is also a part of the explanation for what may be an overexpansion of intermediate product industries and consequent provincial underspecialization. See The Distorted World of Soviet-Type Economies, by J. Winiecki, University of Pittsburgh Press, 1988, Ch. 3.  -~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~U S. S. R. } Bs U. S. S. R. It < 8 C s d g~~~~~~~~~~~~~~~~~LAW- L H