The institutional foundations of China's market transition

Annual Bank Conference on Development Economics The Institutional Foundations of China's Market Transition Yingyi Qian Stanford University April 28 to 30, 1999 Washington, D.C.   The Institutional Foundations of China's Market Transition Yingyi Qian StanfordUniversity I appreciatethe commentsof Masahiko Aoki, Nicholas Hope, LawrenceLau, Boris Pleskovic, Gerard Roland, Andrew Walder, and three anonymousreviewers. Paper prepared for the Annual World Bank Conference on Development Economics, Washington, D.C., April 28-30, 1999. The findings, interpretations,and conclusions expressed in this paper are entirely those of the author. They do not necessarily represent the views of the World Bank,its Executive Directors, or the countriesthey represent.   The Institutional Foundations of China's Market Transition Yingyi Qian Stanford University This paper intendsto properly account for China's two decadesof market transition by examiningits institutionalfoundations. Thejourney of transitionis analyzedas a two-stage process. Inthe first stage(1978- 93), the system was reformed to unleash the standard forces of incentives, hard budget constraints, and competition, but the underlying institutional forms and mechanisms are far from conventional: reforming government through regional decentralization; entry and expansion of nonstate (mostly local government) enterprises;financial stabilitythrough "financialdualism;"and a dual-track approachto market liberalization. In the second stage, Chinaaimed to build a rule-based market systemincorporatinginternationalbest practice institutions but proceeded in its own way. Major progress was made in the first five years (1994-98) on the unification of exchange rates and convertability of the current account; the overhaul of the tax and fiscal systems; reorganizationof thecentralbank, downsizingof the governmentbureaucracy; andprivatizationand restructuring of state-owned enterprises. To complete its transition to markets, China still faces serious challenges,especially in transforming its financial systemand state-owned enterprises and in establishing the rule of law. The paper concludes by reflecting on the economics of reform and institutional change from the Chinese experience. The main lesson learned is that considerablegrowth is possible with sensible but not perfect institutions,andthat someunconventional"transitionalinstitutions"canbe moreeffectivethanthe best practice institutions for a period of time because of the second-best principle. Specific lessons include: incentives, hard budget constraints,and competition should apply not only to firmsbut also to governments; reforms can be implemented without creatingmany or big losers; and successfulreforms requireappropriate, but not necessarily optimal, sequencing.   TheInstitutional Foundationsof China's Market Transition Yingyi Qian 1. Interpreting China's Transitionto Markets: The InstitutionalPerspective 2. Reforming the System: 1979-93 A. Regional Decentralization of the Government B. Entry and Expansion of Non-State (Mostly Local Government) Firms C. "Financial Dualism" D. Market Liberalizationthrough the Dual-Track Approach E. An Assessment 3. Replacing the System: Since 1994 A. The Strategic Move: Setting the Goal for a Market System B. Major Accomplishments in the First Five Years (1994-98) C. The PoliticalEconomy of Reform and the Dynamics of Transition 4. Completing China's Transition:Challenges Ahead and Priority Research Agenda A. The Financial System B. State-Owned Enterprises and Corporate Governance C. The Rule of Law 5. Reflections on the Economicsof Reform and Institutional Change: Lessons from China A. Reflections on the Principles of System Change B. Reflections on the Process of Reform C. Reflections on the Theory and Practice of Transition   1. Interpreting China's Transitionto Markets: The Institutional Perspective In the two decades between 1978 and 1998,China has transformed itself from a centrally plamed economytoanemergingmarketeconomyandatthesametimehas achievednearly a 10percent averagegrowth rate. Duringthis period,China's per capitaGDPhas morethanquadrupledandthe livingstandardof ordinary Chinesepeople has improved significantly. For instance,per capita consumptionhas increasedfour times for eggs and eight times for poultry, the per person living space has more than doubled in the urban areas and nearly tripled in the rural areas,and total householdbank deposits,measured against the GDP, increasedfrom less than 6 percent in 1978to more than 60 percent in 1998. The benefits of the reform were also shared by the people on a broad basis. The number of people living in absolutepoverty has been substantiallyreduced fromover 250 million to about 50 million in two decades,a declinefromone-third to a twenty-fifthof China's population. Lifeexpectancy on the other hand has increased from64.37 in the 1970sto 70.80 in 1996(68.71 for men and 73.04 for women), with infantmortalityfallingfromover50per thousand inthe 1970sto less than 30 per thousand in the 1990s(ChinaStatistical Yearbook,1997;Almanac of China'sPopulation, 1997). In 1998, the World Bank moved China's ranking up from a low-incometo a lower-middle-incomecountry.' Such a performance appears more impressive when compared with the average performance of the transition economies in Eastern Europe and the former Soviet Union. By 1998,with only a few exceptions, the greatmajority of thesecountries stillhave not recoveredto their 1989output levels accordingto theofficial statistics. The Chineseperformance looks even more impressivewhen consideringthe fact that transforming large countries is much more complicated than transforming smaller ones; conceivably, the tasks of transforming Russia or China are more challenging than those of transforming Poland or Vietnam. At the outset, China's reform went against all odds: Coming out of the disastrousdecadeof the Cultural Revolution, it was poor, over-populated,lacked human capital and natural resources, and was constrained by adverse ' Centrally planned economies also had a high growth period (such as the Soviet Union in the 1930sand 1950s, Eastern European countries in the 1950sand 1960s, and China in the 1950s). However, it is well known that such a growth rate was based on heavy industry expansion at the sacrificeof consumer industry and thus the people's living standards, and it was always associated with chronic shortages (Kornai, 1980). China's high growth in the past two decades was different: consumer and export industries boomed, the people's living standards improved, and chronic shortages disappeared.  ideology and political opposition. Two decades ago few economists would have bet on today's outcome of reform in China. Even so, China's reform experience has been always viewed as an anomaly in terms of transition to a market economy, and it has not been properly accounted for by mainstreameconomics and thus appreciated by mainstream economists. For example, From Plan to Market: World Development Report 1996 on transition economies (World Bank, 1996)gave China short shrift because it couldn't figure out where to put China on the various measurementparameters, and instead illustratedthe Chinese experiencemainly in boxes rather than in the text. China simply does not fit the general descriptionof thereport. However, the data point of China is too important to ignore: It has been oneof the most successful transitioneconomies, it produced morethan all othertransitioneconomiescombinedin 1998in terms of GDP, and,moreover, its per capita GDP is very likely to surpass that of the 15former SovietUnioncountriesin thenext decade, which was unthinkable a decade ago.2 Still, economists tend to underestimate the significance of China's reform experience. The most popular argument is that China was a poor agricultural country and thus reform was easy. Of course China was much less developedthanEastern Europe andtheformerSovietUnion at the outsetof reform and thelatter faced some difficulties that China did not have, such as problems of excess industrial capacity and comprehensivewelfare coverage. However, this argument does not explain how and why China's reform was successful, especially considering that it faced double difficulties: As a planned economy, China faced many problems similar, although not identical, to Eastern Europe and the former Soviet Union, such as a lack of property rights and markets, persistenceof a predatory government,and the difficultyof maintainingfinancial stability. In addition, as an underdeveloped country, China also faced many problems that do not exist in Eastern Europeand theformer SovietUnion, suchasenormouspopulationpressure, severeshortagesof human capital and naturalresources, very poor industrialand infrastructurebases, and a lack of democracy. The fact that China faced the double problem of transition and development presented a bigger challengeand it is far According to Maddison's (1998) calculation based on purchasing power parity, without taking into account the 1998 Russian economic crisis, China's per capita GDP will surpass that of the 15 former Soviet Union countries by 2010.  from clear how China managed to succeed. After all, there are many poor countries that do not grow. The reasons why China's reforms are not properly understood and thus appreciated by mainstream economists areprofound. There are strong prior beliefs, based on the existingknowledgeof economics, about the formulation that a transition should use. Furthermore, such beliefs are supported by the strong evidence from the failed economic reform in Eastern Europe and the former Soviet Union prior to 1990 which did not follow that formulation. The theory and evidence together formed a powerful "conventional wisdom" about a set of necessary and sufficient conditions for a successful transition, that is, stabilization, liberalization, privatization, and democratization. Leaving aside the issue of whether they are sufficient to the experts on Eastern Europe and the former Soviet Union, the Chinese path of reform and its associated rapid growth seemed to defy the necessity part of the conventional wisdom: Although China has adopted many of the policies advocated by economists, such as being open to trade and foreign investment and macroeconomic stability, violations of the standard policy prescriptions are also striking. For most of the past two decades, China's reform succeeded without complete market liberalization, without privatization and secure private property rights, and withoutdemocracy. Onemight have thoughtthat in the absenceof these "essential"factors reform would fail. Why has China grown so fast when conditions thought to be necessary for growth were absent? asked Blanchard and Fischer (1993). One might have reasoned that coexistence of the planning mechanism with partial liberalization would only cause more distortion and be a source of disruption, not growth. Without privatization and secure private property rights, one might conclude that there could not be genuine market incentives. Without democracy, economicreform lacks a politicalbasis and commitment to a market and thus is vulnerable. The frustration and failure of reforms in Hungary, Poland, and the Soviet Union prior to 1990 only reinforced these views. The actual performance of the Chinese reform provides a striking contrast to these expectations. Although China's market system remains highly imperfect even after two decades of reform, looking for a system like that which exists in the developedWest has often confused the analyses on transition. China still needs a decade, probably more, to complete its transition to markets. Yet governments are not completely  unconstrained; property rights are not completely insecure; and markets are not as restricted as many would think. A basic fact of transitioneconomies is thatthe startingpoint of reformis theplanning systemwhich was extremely inefficient because of allocative distortions and, more significantly, perverse incentives. Consequently,the economies operated not only far away from the Pareto frontier (and along the production possibility frontier) because of the enormous allocative distortions, but also deep inside the production possibility set because of poor incentives. There was a lot of room for efficiency improvement. However, as the failureof Eastern European reform prior to 1989attested, it is not easy to translate such an opportunity into sustainedgrowth. Therefore,oneneeds to carefullyexaminewhat has changed. One bigchangewas openingup theChineseeconomytothe outsideworld. However, for a largecountry likeChina, foreign trade and investmentper se are unlikely to be quantitativelyas important as for smallcountries. The moreimportantcontributionsof opennessarethenew ideasandtechnology andincreasedcompetition,but their effects ultimately depend on internal changes, which will be the focal point of my analysis. In this paper I demonstratethat for the past twodecadesChina has been undergoing highly dynamic, profound, yet smooth, internalinstitutionalchanges. I arguethat these changes unleashed the standard forces of incentives,hard budget constraints,and competition for growth, but the path of transitionChina took was unusual and many of its underlyinginstitutionalforms and mechanismswerefar fromconventional. By using the analyticaltools of mainstreameconomics and stretchingthe existingtheories to consider the institutional featuresof the transition, I can better accountfor the Chinesereformexperience. This approach allows us not only toexplainthe successfulaspects of China'sreform, but alsotopinpoint theproblems it generatedand thus the challenges that lie ahead. In doing so, I hope to improve our understanding of China's reform and, at the sametime, to develop a new paradigmfor the study of reform and institutional changes in general. I analyzethejourney of China's transition to markets as a two-stageprocess, using Kornai's (1992) framework for analyzing system changes in socialist countries. In Section 2, I consider the first stage, correspondingto the first fifteenyears between 1979and 1993. In this stage, the old systemwas reformed to improve incentives, harden budget constraints, and create competition. I analyze four institutional pillars: regionaldecentralizationof government,entryandexpansionof nonstate(mostlylocalgovernment)enterprises,  financialstabilitythroughfinancialdualism, and a dual-trackapproachto marketliberalization. Eachof them played a crucial role in moving China away from the planning system and at the same time contributing to economic growth,but none are conventional or were recommendedby economists at the outset of reform. In Section3, I examinethesecondstage. Since 1994,China has set a goalof establishinga rule-based market systemas well as privatization and restructuring of state-ownedenterprises. China appears to be the first andonlycountryunderCommunistPartyto madesuchadramaticideologicalshiftanditoccurredwithout apoliticalrevolution. Inthefirstfiveyearsbetween 1994and 1998,Chinaunifiedtheforeignexchangemarket and made its current account convertible; overhauled the tax and fiscal systems according to international practice; centralizedthecentralbank operation,downsizeditsgovernmentbureaucracy andforcedthemilitary to give up their commercial operations, and started to privatize state-owned enterprises and lay off their workers. Both the ideological shift and the significant progress made so far have demonstratedthat China's early reform built constituenciesand momentumfor further reform, rather than created obstacles to block it. Thepoliticaleconomyof reformandthedynamicsof transitioninChinafollowedapattern whichis alsohardly conventional. To complete its market transition, China will still face many serious challenges. In section 4, I highlightthethreemost importantones:transformingthefinancialsystem,restructuringstateamdenterprises and corporategovernance, and establishingthe rule of law. I will examine the major difficulties involved in further reforms, outline the required deeper institutional changes, suggest some ways to achieve them, and propose future research topics. The study on these three areas should be the priority on the research agenda for China to successfullycomplete its transition to markets. Although there is no guarantee that China can achievethat, evidence suggeststhat it has a good chance. In section 5, I reflect on the economics of reform and institutional changes from the Chinese experience. In Eastern Europe, reforms startedas early as 1968in Hungary, 1980in Poland, and 1985in the SovietUnion. China, Hungary,Poland, and the Soviet Union went through a similar two-stageprocess: first reforming theplanned systemand then replacing it with a market system. Thebig differenceis that in Eastern Europe, piecemeal reform in the first stagefailed, and the second stage was jump-started in a revolutionary  manner. In contrast, in China thefirst stagewas remarkably successful, which allowedthe secondstageto be built upon its momentum without a politicalrevolution. China's first stageof reform was much moreradical than that in Eastern Europe, its second stage less so, and overall it has been a smoother process. While the Chinese experience of transition in no way violates economic laws and is unlikely to provide a model for Eastern Europe, it does challenge the conventionalwisdom on systemchanges and shows that some planned economies can be reformed; such a reform can be deepened into a full scale transition to market without a political revolution; and there may well be diverse paths of successfultransition to markets. It is easyto criticizeChina'sreform in specificareas as well asin overallsequencing,and alsopossible to show that even better results could have been achieved if some alternative strategies had been followed. However, because to many economists surprise, China's reform has been an overall successin spiteof many obvious problems, it needs first to be understood from a positive rather than normative perspective. In this view, themain lesson fromtheChineseexperienceis that considerablegrowthispossiblewith sensiblebut not perfect institutions, and that some "transitional institutions" can be more effective than the best practice institutionsfor a period of timebecauseof the second-bestprinciple:removingonedistortionmay be counter- productivein thepresence of another distortion. Specificlessons include: incentives,hard budget constraints, and competition should not only be applied to firms but also to governments; reforms can be implemented without creating many or big losers; and, successfulreforms require appropriate, not necessarily optimal, sequencing. Studying China's experience should augment our knowledge about reform and institutional changes in general, and transition to markets in particular. 2. Reforming the System: 1979-93 Thehistoricdecisionon "reformand opening up"made at theThirdPlenumof theEleventhCongress of the Chinese CommunistParty on December 18-22, 1978,marked the beginning of China's reform era. At the timeChina had a clear desireto increaseproductivity and raise living standardsby reformingits economic system and structure, but it did not have a clear objective of what the new system would be like and thus proceeded with the reformas though "crossingthe river by touching stones." In the first fifteen years, China  did not establish uniform rules or international best practice institutions as we know them; nevertheless, it underwentdynamicandfundamentalinstitutionalchanges. BelowIdescribethefourpillarsof this institutional change for reforming the government, firms, the financial system, and markets respectively. I will arguethat thesechanges haveunleashed the standard forces for growth:positiveincentives,hard budget constraints,and competition, but in novel ways. A. Regional Decentralization of the Government Thefirstpillar of institutionalchangecomesfromanunlikelysource(inaneconomist'sview): regional decentralization of the government. Although China dejure is a unitary state, it functions defacto in many wayslikeafederaliststate. ItsdecentralizedgovernmenthasbeencalledFederalism,ChineseStyle(Montinola, Qian, Weingast, 1995;Jin, Qian, and Weingast, 1999). As early as 1979,China startedto devolvegovernment authority fiomcentralto locallevels, the latter includingprovinces, prefectures,counties,townships,and villages(municipalitiesbeingoneof thefirstthree). Local governments supervisedabout threequartersof the stateindustrial firms in terms of output and alsohad major responsibility for state fixed investments, initially in industry but increasingly in the infrastructure. Local governments at the township and villagelevels directlycontrolledtownship-villageenterprises(TVEs). As a regulator of the local economy, local governments issued business licenses,coordinated local business development, resolved business disputes, and engaged in tax policies. Local governments also acquired the authority to determine the structureof local expenditure, and they were responsiblefor local public goods provision, such as schools,health care, utilities, price subsidies,urban development,etc. In particular, local governments played an importantrole in attracting foreign investment into their localities. The first generation theories of federalism focus on the information advantage of decentralization (Hayek, 1945). They arguethat local governments are in a better positionto provide local public goods than the national government because they have access to better local information,or because inter-jurisdictional competition provides a sorting mechanism to better suit consumers' preferences (Tiebout 1956). Decentralization also allows for "laboratory federalism" under which some localities can carry out diverse  policies (Oates, 1972). Onenotable featureof China'sreform approach has been regionalexperimentation,which is possible because of regionaldecentralization(Qian and Xu, 1993;Qian, Roland, and Xu, 1999). Experimentation is useful because reform is a highly uncertainevent and our knowledge about it is very limited. Reform cannot have a well-articulatedblueprint, and evenif sucha blueprint existed,itsimplementation might stillposemany problems. In the presenceof high uncertainty,experimentationis a way to minimize costs through structured learning. One exampleis the successfulagriculturalreform. The household responsibility system in rural areas was developed through the initiativesof local governments. In 1978when the rest of the Chinese rural areas were operating under the collectivefarming system, in Fengyang County of Anhui Province, several households in a village began to contract with the local government for delivering a fixed quota of grain in exchangefor farming on a household basis. The practice was imitated by other counties in the province and promoted by the provincial government before it was promotedby the centralgovernment. By 1984,almost all farm households across China had adopted this method. Another example concerns famous special economic zones. In 1980,China establishedfour such zones in Shenzhen, Zhuhai, Shantou, and Xiarnen to allow foreign investments and market mechanisms to work when the rest of China was still under central planning. Later, many successful practices experimentedwith inside these zones, such as new accounting methods, employmentpractices, and marketing techniques, were adoptedelsewhere. The second generation theories of federalism extend the traditional approaches by systematically studying the role of government incentives in economic performance (Qian and Weingast, 1997). Because governments in developing and transition economies have often been the central barriers to economic development, providing these governments with the incentives to promote markets is especially critical. Specifically,the"market-preservingfederalism"theory (e.g.,Weingast, 1995;Montinola,Qian, andWeingast, 1995)argues that by devolvingregulatory authority fromthe centralto local governments, the interventionist role of the central governmentcanbe limited. The theoryprovides two possible mechanisms for aligninglocal governments' interests with promoting markets. One is through inter-jurisdictionalcompetitionunder factor andgoods mobilitytodisciplineinterventionistlocalgovernments. Anotheristhroughlinkinglocalgovernment  expenditure with the revenue generated to ensurethat the local governments face the financial consequences of their decisions. The devolutionof authority in China was also accompaniedby the provision of fiscal incentivesand local governments were encouraged and rewarded by promoting the economic development of their local economies. For the formal budgetary revenue starting in 1980, the "fiscal contracting system" (caizheng chengbaozhi)knownby thenicknameof "eatingfromseparatekitchens"(fenzaochifan),replacedtheprevious systemof "unifiedrevenuecollectionandunified spending"(tongshou tongzhi),known as "eatingfromonebig pot" (chidaguofan). Under thenew fiscalsystemlocal governmentsenteredintolong-term(usually five-year) fiscal contracts with higher level governments, and many were allowed to retain 100percent at the margin to makethem "residualclaimants." In addition,local governmentsalsoreceived "extra-budgetaryfunds," which were not subject to sharing, and "off budget funds," which were not even incorporated into the budgetary process and thus not recorded. Using provincial panel data between 1982and 1992,Jin, Qian, and Weingast (1999)reported three major findings about the role of decentralization and fiscal incentives in the central-provincial relationship. First, they found a very strong correlation between marginal budgetary revenue collection and marginal budgetary expenditure under the fiscal contracting system, as compared with a very weak correlation in the 1970s, 0.75 vs. 0.18. Thus, China's fiscal contracting system provided local governments with strong (marginal) fiscal incentives. Second, even so, they found some evidence that horizontal distribution in per capita budgetary spendingactually improvedover time, the coefficientof variation fallingf~om0.68 in 1982 to 0.52 in 1992. This is because strong marginal incentives were provided together with the infra-marginal redistribution of budgetary revenue. Third, they also found that stronger fiscal incentives, measured in terms of a higher contractualmarginal revenueretentionrate, were associated with faster development of non-state enterprises and more reform in state-owned enterprises (such as a faster increase of the share of contract workers in total state employment). Theseresults were compared with Russia's. Using the data of 35 cities for 1992-1997, Zhuravskaya (1998) regressed the change in "shared revenues" (with the upper level government) on changein "own revenue," and foundthe coefficient was -0.90, which means that any increase  in a city's budget by 1ruble is offset by the decrease in shared revenues by 0.90 ruble. She also relates the perverse incentives of local governments to their predatory behavior towards private businesses. It is this "grabbing hands" of local governmentsthat were regarded as a major cause of the failure of Russian reform (Shleifer, 1997;Frye and Shleifer 1997). Interestingly, China's regional decentralization and the fiscal contracting system have often been criticized by economists. The conventional view holds that economicreform means liberalizationof markets and autonomy of enterprises and households, not decentralization within the government organization. Especially,many Chineseeconomistsconsideredregionaldecentralizationtobethewrongdirectionfor reform because it looked similar to "administrative decentralization" under Mao Zedong. China's fiscal decentralization emphasizinglocal revenue self-sufficiencywas seen as highlyproblematic and dysfunctional by public financeexperts, whobelieved that it distortedresourceallocation,generated regional inequality, and underminedthe central government'sfiscalpolicy (Wong, 1991). While someof the criticisms arevalid,they failed to recognizethe more significantpositivecontributionsof regionaldecentralizationon economic reform because they largely ignored the need for regional experimentation,and more importantly, the importanceof the governments' incentives. B. Entry and Expansion of Non-State (MostlyLocal Government)Firms It is well known that agricultural reform was the first reform success in China. But a bigger achievementlieselsewhere;infact,most growthcamefromthenon-agriculturalsector,especiallytheindustrial sector. In 1998,the agricultural shareof China's GDP was 16percent, about the samelevel as in Poland and the Soviet Union in the 1980s. The second pillar of institutional change concerns the innovative ownership forms of non-agriculturalfirms. TheChineseeconomyis divided into "urban" and "rural"areas, which is an administrativerather than aneconomicconcept. Firmsintheurbanareaconsistof state-ownedenterprises(SOEs),collectiveenterprises, privatefirms, and other types of firmswhich includeforeignfirms,joint ventures,stockcompanies,etc. Firms intheruralareaconsistoftwoownershiptypes:townshipand villageenterprises(TVEs)which arecommunity  public firms, and private firms. In China, the state sector refers to SOEs in the urban area and the non-state sector refers to the rest. Evaluation of SOE reform has generated heated debate^,^ but all agree that the engine of growth in China came not from state enterprises, but non-state enterprises. Between 1978 and 1993 the share of non- state enterprises increased from 22 percent to 57 percent, which happened without any privatization of SOEs and was entirely the result of fast entry and expansion of new non-state enterprises. Therefore, the growth of the non-state sector is the key to a better understanding of China's reform (Qian and Xu, 1993). Thus, China shares common ground with post-1990 Eastern Europe and Russia in that new entry firms, rather than old state firms or even privatized firms, are the driving force of growth. But China differs from the latter in an important aspect: between 1979 and 1993, most of the new Chinese firms are not private firms, but local government firms. Private enterprises played only a minor role; in 1993 they contributed to less than 15 percent of the national industrial output. The most important part of local government firms are TVEs, which numbered 1.5 million with employment of 52 million in 1993. The shares of TVE output and employment in rural industry were 72 percent and 58 percent respectively (China Township Enterprises Statistical Yearbook, 1994). The TVEs are significant by both absolute and relative measures. This is the singlemost important factor that makesChina'sreform fundamentallydifferentfromthat of Hungary or Poland before 1990, where enterprise development outside the state sector was small and restricted to services. The rise of TVEs has been unexpected, even by the Chinese reformers thern~elves.~Like regional decentralization, TVEs and the associated "local industrialization" have been frequently criticized by economists, and in this case, from both conservative and liberal camps simply because TVEs do not fit either the central planning or market models. TVEs werecriticizedas disrupting the state sector on the onehand, and having too much local government intervention on the other, and both sides see them as inefficiently run. 'Jefferson and Rawski (1994),Groves et. al. (1994),and Li (1997)found significant positive productivitygrowth, which is attributed to better incentives by Groves et. al. and to increased competitionby Li respectively. On the other hand, Woo et. al. (1994)found little productivitygrowth. I will discuss SOE reform in sections 3 and 4. Deng Xiaoping said on June 12, 1987: "The greatest achievement that was totally out of our expectation is that rural enterprises [TVEs and private enterprises] have developed" (EconomicDaily,June 13, 1993).  China's reform performance would look very different without TVEs, and therefore it is not possible to understand industrial reform in China without appropriately accounting for them (Weitzman and Xu, 1994). The crucial feature of TVEs is the community (i.e., township or village) government control of firms, in contrast withprivateorcentralgovernmentcontrol. Butthecomparative advantagesof communitygovernment ownership of firms over private ownership is far from clear, given the obvious costs associated with government intervention. New theories, three of which I highlight, have been developed by considering the imperfections of the institutional environment in China of insecure property rights and imperfect capital markets respectively, as well as the particular features of the fiscal system. The community governmentplays a criticalrole in protecting TVEs in an environmentlacking secure property rights (Chang and Wang, 1994; Li, 1996). Without a rule of law and with strong anti-private property ideology, private enterprises in China were often attacked, for example, during the "anti-spiritual pollution campaign" of 1983, the "anti-bourgeois liberalization campaign" of 1987, and after the Tiananmen incident of 1989. But the property rights of local governrnent-owned firms (such as TVEs) are more secure in this institutional environment. Che and Qian (1998b) developed a theory of local government ownership based on incomplete contracting (Hart, 1996). They argue that the community governments' feature of engagingin both thegovernmentactivity of providing localpublic goodsandthebusiness activityof controlling TVEs, which is usually considered negative, has an advantageunder insecure property rights. This is because community government is more likely to invest revenue in localpublic goods than private entrepreneurs would be, which in turn will benefit the higher levels of government in the future. Knowing this, the higher government rationally preys less on TVEs than on private enterprises and the TVEs are less worried about revenue confiscation. In fact, TVE after-tax profits were mostly used for two purposes: reinvestment and provision of local public goods. For example, in 1992, 59 percent of the after-tax profits of TVEs were reinvestedand40 percent were used for local public expenditure(AStatistical Survey of China, 1993). Hence, local government control over firms can not only benefit governments,but also be efficiency improving on the grounds of more secure property rights and more local public goods investment. In transition and developingeconomies,capital is oneof the most scarceresources,and new entryf m  have great difficulty obtaining it. TVEs, with community government control, have several advantages in financinginvestmentcomparedtoprivateenterprises. Thecommunitygovernmentcanmakeuseof itspolitical connections with the statebanks to channel loans to TVEs, and the statebanks are also more willing to lend to TVEs because discriminationagainst privateenterprises makes lendingto the latter politically more risky. On economicgrounds,thecommunitygovernmentis abletoreducetherisks borneby thebanks through cross- subsidizationamongits many diversifiedenterprises (Byrd, 1990),or it can use accumulatedcollectiveassets as collateralor as co-investmentfunds to reducepotential hazards in the lending-borrowingrelationship(Che and Qian, 1998a). Also, the community government can reduce informationasymmetry involved in market transactions by integrating a number of investments,sincemarket observations drawn fiom these transaction are much more informative than they are when drawn from transactions resulting from unorganizedprivate investments (Che, 1998). Insecureproperty rights and imperfectcapitalmarketsarealsothecommonfeaturesof othertransition and developing economies but why don't we see TVEs or similar types of firms elsewheremore often? The regional decentralization in China described above appears to have played a central role, because local governments at township and villagelevels are empowered with comprehensive authority for local economic development,and they arealsoprovided with theincentivesto do sosincethey cankeep therevenuesgenerated (Byrdand Gelb, 1990;Oi, 1992). Elsewhere, the tasks of governmentbureaucratsare simplycollectingtaxes and passingthemup to thehigher level governments. But a deeperquestionis: why can'tthe local government get more revenue by taxing private firms than by developingtheir own firms? Che and Qian (1998b), using the incompletecontractingframework,arguethat ownershiprights givethegovernmentcontroloverthe firms' financial accounts and thus make it less costly to extract revenues from them than taxing private firms. For the samereason, when local governmentscontrol firms, it is also harder forthe central government to extract revenuefromthem, andthus revenueis morelikelyto stayin thelocalareas. Therefore,ownershipand control make the difference. Econometric studies on the data from China's rural industry provides some evidence to support the abovetheoretical arguments. Using panel data from 28 provinces in China between 1986and 1993,Jin and  Qian (1998)foundthat theshareof TVEsrelativetoprivateenterprisesinruralindustry in a provinceis higher if the initial collective assets under the control of community government is larger, or if the local political strength toresist pressure fromhigher level government (appropriately measured) is higher. This evidenceis consistent to the theory that local government ownershipof firmsis related to the institutionalenvironment. They also examined the consequence of ownership of firms on the revenue distribution among the national government,community government,and households. They found that a one percent increase in the shareof TVEsrelativetoprivateenterprises is associatedwith a 0.11percent increase in the sharesof revenueaccrued tothe nationalgovernmentand a 0.24 percent increasein the sharesofrevenueaccruedtothetownship/village governments. These results confirm the fiscal incentives of the local governments in developing TVEs, and also show that government control of firms plays an important role of substitutingfor taxation institutions. C. "FinancialDualism" China has generally managed macroeconomic stability well except for the periods of 1988-89and 1993-94. China, no less than Russia, experienced a sharp government tax revenue decline. Then, what are the microeconomic and institutional foundations for its financial stability? The third institutional pillar of reform is "financialdualism" (McKinnon, 1993;Bai et al., 1999). There are two aspects of financialdualism. One aspect concerns governmentrevenue: although tax revenuesharplydeclined,it was accompanied, andthus partiallycompensated,by anincreaseof "quasi-fiscal" revenuefromimpressive financialdeepening. This provides a basis forChina's macroeconomic stabilityand avoids a financial crisis like Russia's (McKinnon, 1993). In China, consolidated government budgetary revenueas a share of GDP declined from31percent in 1978to 13percent in 1993. Taking into account the extra-budgetary andoff-budgetrevenues, totaltaxrevenuealsodeclineddramatically,from40percentof GDP in 1978to about 19percent in 1993(Bai et al., 1999). On the other hand, cash in circulationas a percentage of GDP was less than 6 percent in 1978,and increased to 16percent in 1993. Total household bank deposits were less than 6 percent of the GDP in 1978,and they increasedto about 50percent in 1993and furtherto 62 percent in 1997. TheM2 toGDPratiocontinuedto climb,fromlessthan 50 percent beforethe reformto more  than 100percent inthe 1990s(Almanacof China'sFinance andBanking, 1996). What seems to be surprising is that the financial buildup lasted much longer than most economists expected. The result has been that the government was able to benefit from this financial buildup. By one estimation, between 1986 and 1994, the government collected quasi-fiscal revenuefrom the banking sector, averaging about 9 percent of the GDP, or more than one half of the budgetary revenue (Bai et al., 1999). Bai et al. (1999) go one step beyond the macroeconomicissue of government revenue and study more fundamental microeconomic implications of fiscal-decline-cum-financial-deepening. They highlight the coexistence of two institutional arrangements in China's financial system. The first is the well-known one of financial repression, that is, a combinationof governmentcontrol on internationalcapital flows with restriction on domestic interest rates and private financial activities. The second is what they called "anonymous banking,"which is a combination of the government'srelaxed regulation on theuse of cash fortransactions and permission to use anonymous household savings deposits. They arguethat anonymous banking together with financial repression implies some major advantages over direct taxation in the institutional environment of China. The conventional wisdom holds that taxation is less distortionary than revenue extraction from financial repression. But this view ignores the government behavior on taxation. In China, as in many developing and transition economies, because there is a lack of rule of law, the government has difficulties committing itself to fixed tax rates, let alone to low tax rates. Such a commitmentproblem undermines private incentives and is often regarded as a major obstacleto economicdevelopmentas well as reform (North, 1997; Williamson, 1994). Bai et al. (1999) argue that anonymous banking provides a simple and effective commitment device to limit the government's predatory behavior and create private incentives. When transactions are made through cash rather than bank transfers, it is difficult for the government to monitor business transactions and thus to tax away the generated revenue. When bank deposits are anonymous, the government does not know the identity of depositors and thus is unable to target a particular person and confiscatehis financial wealth. Although the governmentcan still "tax" financial savings through inflation or regulating the interest rate, this method of revenue extraction is indiscriminate. In their model, Bai et al. show  that revenueextraction from the financial systemcan be costly to the governmentand thus it imposesa limit. Therefore,through anonymous banking, the government is ableto achievea crediblecommitmentfor creating private incentives. Through financial repression, although the government can acquire some quasi-fiscal revenue, it is more limitedthandiscretionaryta~ation.~They concludethat indirect revenueextractionthrough the banking system has not just prevented revenue collapses, but more importantly, it has bound the government's hands and limited its ability for revenue extraction and thus is conduciveto private incentives. Theother aspect of financialdualismconcerns the lending sideof the financialsystem. There was an asymmetry: Stateenterprisesreceived the most credit from the state banks and faced soft budget constraints, whilenonstateenterprisesreceivedonly limitedcreditandfacedmuch harderbudget constraints. For example, the total size of the SOE industrial output was about twice that of TVEs in the late 1980s and early 1990s. However, loans to rural enterprises (mainlyTVEs) accounted for only about 8percent of all non-agricultural loans, whileloans to SOEsaccountedfor about86percent (Almanacof China's Finance andBanking, 1993). While credit discrimination against non-state firms was often complained, such a discrimination became a blessingbecause when the non-statesector was subjectto a hard budget constraint,it was moredisciplinedand performed better. An intriguing question is why the state sector is subject to soft budget constraints and the non-state sector is subjecttohard budget constraints. Onemainreason concernsthepoliticalbenefitsof the government. Historically, the governmenthas been committedto the welfareof workers in the state sector in exchangefor their political support,but not tothoseinthenon-statesector. Therefore,when stateenterprisesperformbadly, because the government valuesworkers' employment,it will bail out them. Another main reasonconcerns the government's financial objective. In Bai et al. (1999) the government requires state firms to conduct transactionsthroughstatebanks soit canconvenientlyobservethemandtax themaccordingly. Incomparison, non-statefirms oftenusecashfortransactions and the governmentfindsit hard tomonitor andtax them. Given As a result, financial repression in China was "mild"because the real interest rate was not too negative. Indeed, during the past two decades, inflation was generallybelow 10percent. In two periods of 1988-89and 1993-94when inflation rose to more than 20 percent per year, the government quickly indexed time deposits (over a three year maturity) to ensure a non-negative real interest rate.  this difference, the government would prefer to provide credits to state firms rather than to private firms because of its own revenue concerns. The downside of providing credit to state firms is their productivity, which implies a lower potential tax revenue. In Che and Qian (1998a),the differencecomes from the control structure. In the case of an SOE, the governmentcontrolsboth the enterpriseand the state bank. It therefore receives all thebenefits fromrefinancinga project after sunkinvestments. This is expost efficient,but makes an ex ante commitment to no refinancing less credible. In the case of TVEs, the community government controls only the TVEs but not state banks. This separation of control over firms and funds induces information asymmetry between the creditor (the state bank) and borrower (the community government on behalf of TVEs). Followingthelogic of DewatripontandMaskin (1995),this informationasymmetryreduces the benefits the statebank receives fromrefinancinga project after sunkinvestment. This in turn increases the exante credibilityof no refinancing. Therefore,limitedauthorityof a communitygovernmentbecomes a good thing and it serves as a commitment deviceto harden budget constraints. D. Market Liberalization through the Dual-Track Approach By the mid-1990s, prices of most products in China were completely liberalized. But the way the Chinese achleved this result is quite different from the way it was done in Eastern Europe. In Hungary, for example, after the 1968reform, althoughall mandatory planning was abolished,prices were still determined administrativelyby bureaucrats subject to political bargaining. There was no real market, only a simulated market (Kornai, 1986). After 1990,onthe other hand,priceswereswiftlyliberalizedinone stroke. Chinatook a "dual-track approachtopriceliberalizationunder which the market was first liberalizedat the margin while (inframarginal) plamed prices and quotas were maintained and then phased out later. Under the plan track, economic agents were assigned rights to and obligationsfor fixed quantities of goods at fixed plan prices as specified in the pre-existing plan. In addition, a market track was introduced under which economic agents participated in the market at free market prices, provided that they fulfilled their obligations under the pre- existing plan. With this approach, real market prices and markets as a resource allocation institution were created in China in the very early stages of reform, which clearly differed from the Eastern European  experienceprior to 1990. Again the dual-trackapproach was often criticizedby the economists who view it as a partial reform lacking the completeness of liberalization. But Lau, Qian, and Roland (1997, 1999) argue that such a perception is not correct, and the dual-track approach to market liberalization in fact has two advantages: it can liberalize markets without creating losers and thus is politically appealing, and it can also achieve efficiency under certain conditions. They show, in both partial and general equilibrium models, that independent of the initial conditions concerning supply and demand (such as whether planned prices or quantitiesare aboveor below the marketequilibrium),as long as the pre-existingfeasibleplan continuestobe enforced appropriately, the dual-track approach to market liberalization is always Pareto-improving. In addition,italsoachievesefficiencyunderusualconditionssuchasprofitmaximizationandperfect competition, provided market resales and market purchases for redelivery are all allowed. Efficiency-enhancingeconomicreformshouldpotentiallyallowwinners tocompensatelosers,thereby making the reform Pareto-improving. However, in practice, it seems very difficult to find mechanisms that make economic reform Pareto-improving, and even more difficult for reform to be simultaneously Pareto- improving and efficient, because of the distortionary costs of compensation or a lack of credibility in its implementation. Thedual-trackapproachprovides onemechanismfor theimplementationof efficientPareto- improving reform The introduction of the market track provides the opportunity for economic agents who participate in it to be better off, whereas the maintenance of the plan track provides implicit transfers to compensatepotentiallosersfrommarket liberalizationbyprotectingthestatusquorents under thepre-existing plan. Thus,thedual-trackapproach is,by design,Pareto-improving. Moreover, as thecompensatorytransfers areinfrarnarginalandthus lumpsuminnature,thedual-trackapproachcanbe efficienttoo. Whilesingle-track (or "big-bang") market liberalization will lead to efficiency under the usual conditions (such as profit maximizationandperfect competition)Pareto-improvementcannotbeassured. Furthermore,withthepresence of somemarketimperfection(suchas searchfrictionsorimperfectcompetition),single-trackliberalizationmay cause a decline in aggregate output, as shown in the models of Blanchard and Kremer (1997), Roland and Verdier (1999), and Li (1999),but the dual-track approach can avoid this.  It is clearthat enforcement of the plan track is crucial for preservingthepre-existingrents. However, sufficient state enforcement power is needed not to implement an unpopular reform, but to carry out one that creates no losers, only winners. One desirable feature of the dual-track approach is its minimal additional informationaland institutionalrequirements: It btilizes the existinginformationcontainedin the originalplan and enforces the plan through existingplanning institutions. No new information and no new institutions are necessary. Agriculturalmarketliberalizationillustratesthat thedual-trackapproachcanbebothPareto-improving and efficient. The commune(and later the households) was assignedthe obligationto sell a fixed quantity of output to the stateprocurement agencyas previouslymandated under theplan at predeterminedplan prices and to pay a fixed tax to the government. It also had the right to receive a fixed quantity of inputs, principally chemical fertilizers, from state-owned suppliers at predetermined plan prices. Subject to fulfilling these conditions,the communewas freetoproduceand sellwhatever itconsideredprofitable, andretained anyprofit. Moreover, the communeand households could purchase grain (or other) outputs from the market for resale to the state to fulfill its responsibility. Under the dual-track, the state procurement of domestically produced grains between 1978and 1988remained essentiallyfixed, while therewas almost a one-third increase in grain output. Industrial liberalization also shows how markets could grow out of plans (Byrd, 1991; Naughton, 1995). For coal, China's principal energy source, the planned delivery was increased somewhat from 329 million tons in 1981 to 427 million tons in 1989(mainly because new state coal mines were opened),but the market track increased dramatically from 293 million tons to 628 million tons in the same period. The increments came mainly from small rural coal mines runby individualsand TVEs. For steel, another China's major industrial material, the plan track in absoluteterms was quite stable,but the share of plan allocationfell from 52 percent in 1981 to 30 percent in 1990. Unlike coal, the supply response in steel came mainly from large SOEs rather than small non-state firms. In the cases of both coal and steel, because the plan track was basically "frozen,"the economy was able to grow out of the plan on the basis of the market track expansion by state or non-state firms.  E. An Assessment China's first fifteen years of reform was a remarkable success,judging by the results of fast GDP growth,eliminationof shortages, anddramaticimprovement inthelivingstandardsof ordinarypeople. By the end of 1993,reform was supportedby people in all walks of life simplybecause everyonebenefittedfrom it. Thiswas in sharpcontrastwith thefrustrationof EasternEuropeanreformersin thelate 1980s,when they saw only a dead end to their reform efforts of decades. Central planning has long been criticized as an inefficientresourceallocation mechanism compared with the market, but its failure has deeper institutional problems than simply planning mistakes or rushed development strategies. Fundamentally,the systemis unable, in a credibleway, to providepositive incentives toeconomicagentsandtoimposefinancialdisciplineupon them,andit alsofailstocreategenuinecompetition. This had remained the case in Eastern Europe even during the economic reform in the 1970s and 1980s (Kornai, 1986). China was able to avoid the fate of Eastern European reform prior to 1990because of its deeper institutionalchanges. Each of the four pillars of institutional change analyzed abovecontributed to China's reform success sincethey changedthefunctioningof the government,firms,the financial system, and markets to unleash theforces of positive incentives, hard budget constraints,and competition,but in novel ways. For example, positive incentives were provided through a variety of means, such as fiscal contracting under regionaldecentralization,localgovernmentownership,and informationdecentralizationthroughtherelaxation of the regulation on cash and permission of anonymous bank accounts. Harder budget constraints were imposed in circumstances when thereareconstraints imposed on the government,for examplethrough control rights and informationstructures. Finally,competition was creatednot only amongfirms (bothstateand non- state)but alsoamonglocal governmentsat provincial,city,county,township,and villagelevels. TheChinese experiencehas demonstrated that reformingthe government and providingit with incentives is as crucial as reforming the economy; non-private and non-state ownershipcan be an engineof growth; financial stability can be obtainedfor an extendedperiod through quasi-fiscalrevenuesfromthebanking system;and dualtrack liberalizationprovidesonemechanismto minimizethenumber of losersof reform. Interestingly,noneof these  methods were recommendedby economists;to the contrary, all of them were criticized. Despitetheseimpressiveachievements,thereweremany seriousproblems duringthis stageof reform. First, some mistakes were made. For example, decentralization of government went too far in the areas of monetary policy: local governments gained substantial control over the credit supply, and at one point, the bonuses of the centralbank's localbranches wereeven linked to the amount of credit they extended. This was a sourceof soft budget constraints of local governments and SOEs and of inflation as well (Qian and Roland, 1998). Second, many difficultreforms were delayed. For example, no singlestateenterprisewas privatized and almost none went bankrupt. This is in turn because of the delay of establishing a socialsafetynet. There was also no effort made in establishingproperty rights protected by the rule of law and contract enforcement mechanisms. Although establishing a rule-based tax system was attempted, it failed and then delayed as well (Shirk, 1993). Third, and most important, the achievements up to 1993were made basically through institutional innovations which were either ad hoc responses to particular constraints in the planning system or took advantages of theloopholesinit. Thevarietiesof contractingpracticesbetween differentlevelsof government and between government and enterprises are good examples. Although they were effective in breaking the central command, they were ad hoc and subject to frequent renegotiation and change. In their empirical investigation,Jin, Qian, and Weingast (1999)foundevidenceof the "ratcheteffect"over time under the fiscal contracting system: during 1982and 1992and on average, a 1 yuan increase of revenuecollection this year leadsto a 0.24 yuan increaseofrevenueremittance(or decreaseof subsidies)inthenext year. They alsofound that a majority of provinces received extra, though limited, subsidies beyond contractual stipulation, an indication of some soft budget constraints. Whilethe adverseincentiveeffect of these problems in the case of inter-governmentalrelationshipsmight be modest, it could be much more seriousin the case of themanagerial contract responsibility schemes in the SOE reform (Wu, 1995;Qian, 1996).  3. Replacing the System: Since 1994 Since 1994, China's transition has moved into the second stage which aimed to replace the planned systemwith a market system. I will addressthreeissuesin this section. First, I will show that China set a goali becomingclearer over time, to establish a rule-based market economyincorporatinginternationalbest practice institutions as we know them. In fact, China has become the first and the only country in which the ruling Communist Party voluntarilyshifted its official ideology to embrace a market system and private ownership. Because many people outside China are stillunawareof it, I will provide somedetailed evidenceto show that this is indeed the case. Second,I will examineadvancementin severalmajor areas toward this goal in the first fiveyears of thesecond stage (between 1994and 1998). The evidenceshowsthat significantprogress has been made, which should clarify many doubts over whether China's reform is continuing. Finally, I will providean analysis of the political economyof reform and the dynamicsof transition, focusingon how the early reforms created constituenciesand momentum for further reform without generating obstacles to block it. A. The Strategic Move: Setting the Goalfor a Market System At the outset of reform, China desired reform in order to increase productivity and improve living standards, but at no time did the leadershipthink that it was to go for a full market system (Perkins, 1994). This started to change in the early 1990s. However, establishing that goal in China was an evolutionary process, and in that aspect, China is unlike someEasternEuropean countries whose goal was very specificat thebeginning of transition, that is, to build a marketeconomyliketheir neighbors andjoin theEuropean Union. I will highlight four consecutivemilestoneevents in September 1992,November 1993, September 1997, and March 1999,respectively,to show how this strategic move has evolved progressivelyover time. The Fourteenth Party Congress of September 1992. During much of the first stage of reform, the official ideologywas the oneof "combiningplan and market together." A moreconservativeversion of it was "planningsupplementedby market" and a more liberal version was "plannedcommodity economy." Clearly, the goal of reform was not a market system. In the spring of 1992Deng Xiaoping madehis famous Southern tour to mobilize local support for further and more radical reform. Thebig ideologicalbreakthrough occurred  afterwards at the Fourteenth Party Congress in September 1992 when the Party, for the first time, endorsed the "socialistmarket economy" as China's goal of reform. It is important to distinguishthe Chinese socialist market economy from "marketsocialism" as advocated by someEastern European reformers in the 1970sand 1980s. In market socialism, market is asimulated one to serve the purpose of socialism based on public ownership (Kornai, 1992). In contrast, in a socialist market economy, "marketeconomy" is the goal and the word "socialist"in an adjective. Therefore, a socialist market economy differs from a market socialism in a fundamental way while it is closer to the "socialmarket economy"of Germany. The Decision of November 1993. The contents of transition to "socialist market economy" only becameclearer oneyear later. In 1993,theCommunistParty'sEconomicsandFinanceLeadingGroup, headed by Party Secretary General Jiang Zernin, worked together with economists to prepare a grand strategy of transition to a market system. Several research teams were formed to study various aspects of transition, ranging from taxation, the fiscal system, the financial system, and enterprises, to foreign trade. The final output was the "Decision on Issues Concerning the Establishment of a SocialistMarket Economic Structure" adoptedby the Third Plenum of the Fourteenth Party Congress in November 1993.6 With the objectiveof a market system in mind, this landmarkdocument made four major advances in the areas of reform strategy, a rule-based system, building market-supportinginstitutions, and property rights and ownership respectively. It was the turning point on China's road to markets. First, unliketheprevious strategyof "gropingfor stonesto cross the river,"the "Decision"emphasized the importance of coordination among various aspects of reforms. It advocated a coherent package and an appropriate sequencingof reforms, known as "combiningpackage reform with breakthrough in key areas." Second, in the first stage of reform, particularistic contractingplayed a dominant role, such as fiscal contracting, managerial contracting, and household contracting. For the first time, the "Decision"called for a rule-based market system to create a level playing field. This included the decision to unify the foreign exchange rate and tax rates among all enterprises regardless of ownership. Shortly before the "Decision," China already had adopted Western accountingrules in its enterprises. For the full text of the "Decision,"see China Daily, Supplement, November 17, 1993. 23  Third, the "Decision"focused on thebuilding of market-supportinginstitutions, such as formalfiscal federalism,a centralizedmonetarysystem,and a socialsafetynet. Forexample,separationof centraland local taxes and their administrationwas acriticalstepin movingtoward formalfiscalfederalism. Revenuetransfers between the central and provincial governments were to be based on a fixed formula rather than bargaining. Another example was centralization of the operation of the centralbank to minimize the local government's influenceon monetary policies. Finally,the"Decision"addressedtheenterprisereformissueinterms of property rights andownership, rather than, as before,one of "expandingenterpriseautonomy." It intended to transform SOEs into "modern enterprises" with "clarified property rights, clearly defined responsibility and authority, separation of enterprises from the government, and scientificinternal management." It has also, for the first time, left the door open regarding theprivatizationof SOEs: "Asfor the small stateowned enterprises,the managementof some can be contracted out or leased; others can be shifted to the partnership system in the form of stock sharing,or sold to collectivesand individuals." But the major breakthrough on ownershipissueshad to wait awhile longer. The Fifteenth Party Congress of September 1997. In the "Decision" of November 1993, state ownership was still regarded as a "principalcomponent of the economy" while private ownership was a "supplementarycomponent of the economy." TheFifteenthParty Congressheld in September 1997made a major breakthrough on ownershipissues: Stateownership was downgraded to a "pillarof the economy" and private ownershipwas elevatedtoan "importantcomponentof the economy." In Chinesepolitics, these subtle changes of rhetoric mean a big change in ideology. The document recognized that "varieties of ownership should developtogether,"but because private ownershipwas discriminated against for decades,the only new information here was that private ownership had gained legitimacy. Furthermore, although the rhetoric of public ownership was maintained, its meaning was redefined, because public ownership may have many "differentrealization forms,"such asjoint stockcorporations with investmentby many owners. At this time, the officialideology toward private ownershipfinallybecame "friendly."  The second major breakthrough of the Fifteenth Party Congress was its emphasis on the rule of law. The rule of law is not the sameas democracy. For example, the two most free market economies, Hong Kong and Singapore, have the rule of law but are not democracies, by Western standards. Chlna seemedto decide to give priority to the rule of law rather than democracy in its sequencingof political reforms and to consider the rule of law crucial for a modern market economy to work well7 As always in China, the content of the rule of law will evolve over time. The Constitutional amendments of March 1999. Private ownership and the rule of law were incorporated into the Chinese Constitution in March 1999.~An amendment of Article 11of the Constitution places private businesses on an equalfootingwiththe public sectorby changingtheoriginalclause "theprivate economy is a supplement to public ownership" to "the non-public sector, including individual and private businesses, is an important component of the socialist market economy" (China Daily, March 16, 1999). Immediately after the amendment, local governments started to relax local restrictionson private enterprises. For instance, the Jiangsu provincial government adopted a new policy to give private enterprises equal treatment as state-owned and collectiveenterprises in the areas of grantingbusiness scopes and credit access (People's Daily, April 9, 1999). Furthermore, Article 5 of the Constitution was amended to include the principle of "governingthe country accordingto law" (ChinaDaily, March 16, 1999). These Constitutional amendments have demonstratedChina's commitment to a full market systembased on the rule of law. The significance of the strategic move. The failure of Eastern European reform prior to 1990 has madepersuasiveargumentsfor thenecessityof havingdemocraticreformprecedeeconomictransition (Kornai, 1992). The Communist Parties there were unwillingto changetheir ideology. Thecollapse of the Communist Parties in Eastern Europe was the logical consequence. China provided a case that proved impossible in Eastern Europe and elsewhere: the Communist Party of China itself made the strategic shift voluntarily. It appears that China is the first and only country under the Communist Party to embraceprivate ownershipand 'Kornai (1998)has emphasized that democracy is not a necessary basis of a market system but a political power that is friendly to private property and the market is. '"ToplawmakersyesterdayoverwhelminglyendorsedChina'slandmarkconstitutionalamendmentswhichenshrine the 'ruleof law' and bolster the statusof private businesses" (ChinaDaily, March 16, 1999).  the rule of law in its Constitution. It is quiteremarkable for China to have overcomeideological and political opposition to embrace the market system and private ownership without a political revolution. There were both internal and external reasons. The internal reason was that by 1993 reform in China had benefitted almost everybody, who envisioned bigger benefits from furtherreform. Solidpolitical support for further reform came from both the top leaders and the ordinary people, which provided a political basis for ideologicalchange (more on this in subsection C below). The external reason was that the outside pressure from East Asian countries was enormous; their extra-ordinary performance pressed China to move forward. At the same time, competitive pressure fromtheEasternEuropean transitionto markets was alsosignificant. TheChinesegovernment feared that thesetransition economieswould sooncatch up with China, whichmight undermineits legitimacythat was built entirely upon the economicperformance of the country. Thepopular sentimentin China for a transition to a conventionalmarket economy can be sensedfrom the two phrases which have been popular in the 1990s:yu guoji jiegui, which means comect to (or join) the international track (or practice, or standard); and guifan hua, which means standardization. In November 1998, major newspapers in ChinapublishedJoseph Stiglitz's(1998) article "Second-GenerationStrategies for Reform for China," which contains policy recommendations for China for deeper institutionalrestructuring to completeits transition. This can be interpreted as a strong determinationfrom the top leadership to complete China's move to markets. B. Major Accomplishments in the First Five Years (1994-98) Following the "Decision"of November 1993, a series of radical reforms were launched starting in January 1994. In building market institutions, China started a little bit late compared to Eastern Europe or even Russia. Today, it still lags behind the star countries in Eastern Europe such as Poland, Hungary, and the Baltic countries. But this group of countries may be exceptional because of their aspirations to join the European Union. So far, China's progress has been steady, and it has been able to avoid bad mistakes made by some other transition economies.  In building a market system, China continued its previous practices that were useful, such as government decentralization,financialstability,andcompensationforlosersof thereform. It began to address the three problems left from the first stage. First, it corrected some early mistakes, such as monetary decentralizationand softbudget constraintson localgovernmentsandSOEs. Second,itbegan delayedreforms, such as privatization of state enterprises and commercialization of state banks. Third, and most important, China started to incorporate internationalbest practice market institutionsbased on uniform rules, but while doing so, it first created new institutions before destroying the old ones. Below, I examine some major accomplishments in the first five years. Many of the reforms will continue into the next decade, but the evidenceso far shows that China is moving in the right direction and proceeding at a steady pace. Unification of foreign exchange rates and convertibility of the current account. Before 1994, liberalizationof foreignexchangemarkets, likemany other markets,followeda dual-track approach and there existed an officialrate and a "swaprate" (i.e., the market rate). Becauseof the dramatic growth of the market track, by 1993the share of the plan allocated foreign exchangehad fallen to less than 20 percent of the total. On January 1, 1994, plan allocationof foreign exchange was completely abolished, and the two tracks were merged into a single market track. However, for those organizations which were used to receiving cheap foreignexchange,annual lump-sumsubsidiesinthe domesticcurrency sufficient to enablethe purchase of the previous allocationof foreignexchangewere offered for a period of threeyears to compensatefor their losses. In December of 1996, China went one step further to announcecurrent account convertibilityof its currency. However, it did not moveto capital account convertibilityand yet still maintained capital control. This is one important reason that China weathered the Asian financialcrisis rather well. Between 1994 and 1998, the exchangerate remained stable and even appreciated slightly from 8.7 yuan per US$ to 8.3 yuan per US$. Both exports and foreign direct investment increased dramatically, and the country's foreign reserves increasedfrom 21billion US$ to 145billion US$. Despite the Asian financial crisis, China continuedto attract foreigndirect investmentof about45 billion US$ annually in 1997and 1998. The overhaul of the tax andfiscal systems. Before 1994,the fiscal contracting systemhad played a positiverole of providingbadly needed incentives for localgovernments. But the fiscalcontractingwas ad hoc  and was not rule-based. Also, China did not have a national tax bureau, and all taxes were collected by local governments,which oftenreduced or exempted taxes that were supposed to be paid to thecentralgovernment. On January 1, 1994,China introduced major tax and fiscal reforms more aligned with international practices. This reformintroducedacleardistinctionbetween nationalandlocaltaxes andestablisheda national tax bureau and localtax bureaus,eachresponsiblefor its own tax collection. Thistax reformhas madeit very difficult for local governments to reduce national taxes as they did in the past (Dong, 1997). Reform also established fixed tax rules between the national and local governments. For example, under the new system, the value added tax (VAT) became the major indirect tax shared by the national and local governments at a fixed ratio of 7525. But local govenunentswerecompensated for their revenue losses for three years. In 1995,thenew "BudgetLaw"tookeffect. Itprohibited thecentralgovernmentfromborrowingfrom the centralbank and fromdeficit financing its current account, but the central government could have deficit financingin its capital account although it had to financethe deficit with governmentbonds. It also imposed more stringent restrictions on local governments: Local governmentsat all levels were required to have their budgets balanced (as before),and furthermore, the law strictly controlled their bond issuanceand restricted their borrowing in the financial market (a changefrom thepast). Toensureenforcement of the "BudgetLaw," an independent auditingsystemwas alsointroduced. For example,in 1996the StateAuditing Agency audited theMinistryof Finance's implementationof the statebudget for thefirst timesincethefoundingof thePeople's Republic in 1949 (Dong, 1997). Tax reform, together with the implementation of the "BudgetLaw," made local governments' budget constraintsmuch harder. Monetary centralization andjinancial reform. One of the mistakes in the first stageof reform was monetary decentralization, which was responsiblefor the inflationarypressureand softbudget constraintsof localgovernments(Qianand Roland, 1998). Before 1994,70percent of thecentralbank's loansto statebanks were made by the central bank's local branches, which were heavily influencedby the local governments. In 1993,thecentralbank centralizeditsoperationafterVicePremierZhu Rongjibecameitsgovernor. Sincethen, its local branches have been supervised only by the headquartersof the centralbank, not as before alsoby the local governmentof the region in which they reside. In 1995Chinapassed the "CentralBank Law" to givethe  centralbank themandatefor monetarypolicy independent of thelocalgovernment. Thesereforms substantially reduced the local government's influenceon monetary policy and credit allocationdecisions(Xie, 1996). This is one of the main reasons that the overallbudget constraints of local governments becamemuch harder in the 1990sthan in the 1980s, in fiscal channels because of the tax reform and in financial channels because of the monetary reform. In 1998, the central bank further replaced its 30 provincialbranches with 9 cross-province regional branches as in the U.S. Federal Reserve ~ystem.~This reform further minimized the local governments'influenceon monetary policies. Since 1994someprogresshas been madetocommercializefourmajor statebanks. Thesebanks began to adopt the international accounting standard for bank assets and risk management, and became more conscious of profitability and the quality of loans. They also started to compete with each other when their business dealings overlapped. Starting in 1998, the central bank abandoned the credit allocation ceilings imposed on these banks, replacing them with standard reserverequirements,assets-liabilitymanagement,and interest rate regulations. At the same time, foreign banks were allowed to open branches in China, initially restricted to special economic zones but later extended to all major cities. The Asian financial crisis demonstrated the importanceof prudential regulation. China has followed a U.S. model of banking regulationsalong the lines of the Glass-Steagall Act; not only is commercialbanking separated from investment banking, but also commercial banks cannot hold shares of stock in companies. Threedifferentgovernment agencies now separatelyregulatecommercialbanks, securityfirms, and insurance companies. Before 1998, the state always bailed out troubled financial institutions, but for the first time in 1998,severalhighprofilebanksandinvestmentcompanies, suchas HainanDevelopmentBankandGuangdong InternationalTrust Investment Company, closed down or went bankrupt. This signalled an important change on the part of the government: it was determined to discipline state financial institutions. Although the government might have incurred some short-run costs for doing that, it gained credibilitywhich is important in the long run. The nine regional branches are located in Shenyang,Tianjin,Jinan, Nanjing, Shanghai, Guangzhou,Wuhan, Chengdu,and Xi'an.  Downsizing of the government bureaucracy. Lessons from transition economies have told us that reforming the government is a critical part of institutional reforms and perhaps more fundamental than economic liberalization (Shleifer, 1997). Despite many early reforms, the basic government bureaucratic structurein China was stillkept intactfromtheplanning era,for instance,many industrialministriesremained for supervisingSOEs. In early 1998a major reformfor streamliningthe governmentbureaucracytook place. Most industrialministries, such as the textile and machineryindustries, were abolishedand replaced by much smaller correspondingbureaus, which were then absorbed into the StateEconomic and Trade Commission. Somenew ministries were created, such as the Ministry of Social Security. The number of ministries in the central government was trimmed from45 to 29 (a similar action will be taken at the local level in 1999),and the number of civil servants was cut by half, from 8 million to 4 million. To compensate for the losses, displacedcivil servants were sold apartmentsat discount prices according to their seniorityand were givenan option to study for undergraduateand graduatedegrees with tuition and stipendspaid by the government for three years. Chineseenterpriseshave had close ties with the government. Sometimes such a tie is an advantage, as in the case of TVEs, but in some other cases, the disadvantage clearly outweighs the benefits. This is particularlytrue with businessenterprisesowned and managedby the military,police, andjudiciary branches of the government. In the second half of 1998,the governmentseveredall the ties between these government agencies and their business enterprises. The military, police, andjudiciary branches of the government now solely rely on tax revenues to maintain their operations, not on business incomes. The earlier reforms of downsizing thegovernmentbureaucracy set good precedents for severingthe ties of the military with business enterprises. In the meantime, a major campaign of anti-corruption and anti-smugglingwas undertaken, and thereformofthejudiciary systemalsobegan. For instance,thefirstliveTV coverageof a civiltrial took place in the summer of 1998. Thesereforms of the military,police, andjudiciary systems represent a crucial initial step toward the rule of law. Privatization of state-owned enterprises and layoffs of state workers. China delayed privatization  of SOEs, and in fact, did not privatizeany state-owned enterprisesor lay off any stateworkersprior to 1992." While delays sometimes can be justified on the grounds of a lack of appropriatesocial security institutions supporting the unemployed, there are high costs associated with delays. Privatization of SOEs and layoffs of state workers began to emerge on a large scale in 1995 (Cao, Qian, and Weingast, 1999). This reform has made significant progress in two areas: privatization of small SOEs at the county level and mass layoffs of SOE workers at the city level. In these two areas of reform, local governments have been the driving force. Privatizationof SOEs started initiallyby local governmentsas experimentsin a few provinces, such as Shandong,Guangdong,and Sichuan. Later,thecentralgovernmentpromotedit with thesloganof "grasping the large and letting go the small" (zhuadafangxiao)." One interpretation of "grasping the large" is to keep about 1,000large enterprises as state owned. Privatization of small SOEs was very significant for China, because,in contrasttoEasternEuropeand the SovietUnion,China'sindustrialSOEs weredominatedby srnall- and medium-size enterprises. In 1993,they accounted for 95 percent in number, 57 percent in employment, and 43 percent in output of the state industrial sector. Most of these enterprises were under the supervision of county and city governments. By the end of 1996,up to 70 percent of small SOEs had been privatized in pioneering provinces and about half were privatized in many other provinces. Although in 1998,the process slowed down somewhatbecause of the Asian economic crisis, the trend already became irreversible. There are many SOEs which are either not viable or are overwhelmed with excess employment. For these firms, reallocation of labor is the main concern. About ten million workers from SOEs and urban collectiveswere laid off by the end of 1996,and an additional 11.5million workers were laid off in 1997. This layoff itself was a big achievementfor reform: never before were stateemployeeslaid off and state enterprises closed down. Twoinstitutionsaccompaniedthemass layoff:xiagang, or "steppingdownfromone'spost" and zaijiuye,or "reemploymentprogram." Cao, Qian, and Weingast (1999)arguethat these two institutions have important mechanisms for providing crediblemeans to compensatelaid off workers in the absenceof a social safetynet andtohelp them find newjobs. Whenthegovernmentusesxiagang to lay off workers,they continue loThe Chinese do not use the term "privatization," relying on several other terms, such as "transformation of ownership" (zhuanzhi)or "restructuring of ownership" (suoyouzhi gaizao). Similarly, the Chinese use "non-public ownership" as a substitute for "private ownership."  toreceivesomepayment fromthe enterprises, which reduces their resistance to reformex ante. Withzaijiuye, the government also creates an ex post environment in which workers, having new jobs, are less likely to demand more subsidies. Together, they not only buy the cooperationof SOE workers, but buy them out. C. The Political Economy of Reform and the Dynamics of Transition The political economy of reform concerns how reform can be initiated and pushed forward when it results in losers and winners. In analyzingthe political economy of reform in China, one needs to answer two questions. First, how was the oppositiontoreformby the old vested interestsovercome in order to initiate a reform? And second,how was thepossibleoppositiontoreformby new vested interests(whowerethe interim winners) overcome in order to move reform forward? Theinitializationof reformin China needed to overcomepolitical oppositionfrom theexisting vested interestsunder centralplanning. Motivatedby theChinesereformexperience,Dewatripontand Roland(1992) and Wei (1997) have shown that in the circumstance in which a comprehensivereform package is unable to win majority support, a sequenceof partial reforms may be able to win majority support each time. This is known as the "divide-and-rule"strategy. Indeed, the initialization of some of China's early reforms can be analyzed from this perspective. For example, special economic zones and regional experimentationcan be viewed aswaystoovercomeideologicalandpoliticalconstraints. Thepreferencesofparticularisticcontracting over universal rules can alsobe viewed as compromisesfor the samereason (Shirk, 1993). Therefore,some observedpatterns of incrementaland partial reformin China canbe attributedto this divide-and-rulestrategy. On the other hand, precisely because of these wise political compromises, China (prior to 1994) could undertakemuch moreradicalreformscomparedto the reformingcountries in EasternEurope(prior to 1990). By theend of 1993,China'seconomicsystemas a wholewas halfwaybetweena planned and a market economy. Would the incrementalreform continueor would partial reform block further reform? There are theoreticallytwo oppositeeffectsof partial reform. In the models of Dewatripontand Roland (1992)and Wei (1997), a sequentialreformstrategyhas an important advantageof buildingconstituenciesat the interim stage of reform. In addition, Dewatripont and Roland's model (1995) incorporates aggregate uncertainty and has  the featurethat a sequentialreform strategy can build momentumas well as constituenciesfor further reform. This is because when beginning with reforms that give a higher likelihood of a good outcome for a majority, the majority will obtain interim stakes and then may want to continuereforms when they are complementary to the previous ones. In China, the early agricultural reform created constituencies who were, with their increased wealth, interestedin developingrural industrial firms and liberalizingmarkets. In 1994because of the earlier massive entry of non-stateenterprises, in the industrial sector, the state's shareof output accountedfor only 40 percent of the nationaltotal, which clearlymadeprivatizationof SOEs much easier politically. Similaractionsin 1978 would be very differentpoliticalconsequences when the state's sharewas about 80percent. Also, as discussed in subsectionA above, thesupport generated by the momentumof earlierreform successin the 1980sprovided a political basis for the ideological change in the 1990s. On the other hand, there are also difficulties for pushing reform forward because the early partial reforms may have also created new vested interests which might be against further reform. Hellrnan (1998) emphasizedthis possibility based on the Eastern European transition experienceand provided some evidence showingthat it was the interim winners, not the losers, of partial reform who blocked further reform in some countries of Eastern Europe. Heconsideredthis situationoneof "winnerstakingall," whichpresents a serious political problem resulting from the incrementalreform strategy. But the evidenceprovided in subsection B above showsthat both theold and new vested interestshavenot blockedChina's furtherreforms in the past five years. Thus, China provides a case in which the winners of early reforms were not necessarily the eventual losers nor did these winners manage to "take all." Why hasn't the "partial reform trap" occurred in China as in some other transition countries? Three reasons seem relevant. The first reason is the nature of the early reforms. In some sense, all reforms are partial, but not all partial reforms are equal. Some partial reforms create huge rents for the concentrated winners but others do not. Many of China's early reforms seem to belong to the latter category. First, the agricultural reform in China can be viewed as a partial reform because it was almost the only sector that significant reform was undertaken in the late 1970s, but liberalizationin agriculture was quite thorough and  did not createmany rents. Second,regionaldecentralizationdiversified rent distributionaway from the central government, and inter-regional competition among local governments, however imperfect, also limited the amount of rent accruedtolocalgovernments. Third,fastentryandexpansionof non-statefirms,many of them local governmentfirms at the townshipand village levels, createda competitiveenvironment which eliminated many of the rent. Fourth,capitalcontrol was responsiblefor limitingthe amount of rents to be capitalizedand investedabroad. Fifth, theenforcementof theplan track under thedual-trackliberalizationnot only preserved old rents,but also limited new rents because a firm that received subsidized inputs was obligatedto deliver a quota output at a low price as well. Finally, a lack of natural resources and the omission of a mass privatizationprogram also helped reduce rent. As a result, during China's first stageof reform, the benefits were relatively evenly distributed,therewere not many losers, nor were thereconcentrated winners with huge gains. Thus, equity played an important political role in reformby avoiding many losers who could reverse it and huge winners who could block further reform. The second reason is the potential future gain from the increased market size and the efficiency resulting from further reform. The bigger these gains, the less important the loss of the current rent. This seems to be the case for the reformof the tax and fiscal systems in 1994. Although somelocal governments (such as Guangdong) benefitted tremendously from the earlier fiscal contracting system, they also rightly recognized that the ad hoc nature of the contracting systemcreated many uncertainties and that the political pressures from other provinces had also increased. Therefore, it was in their long-terminterest to move to a rule-based tax system rather than insist on the ad hoc contracting system. Thethird reason is that both the old and new vested interests were "bribed when furtherreforms were introduced. Of course,this was feasibleonly when therents werenot toolarge. For example,among the above mentioned reforms after 1994,such as unification of the foreign exchange rate, tax reform, downsizing the government bureaucracy, and layoffs of state workers, potential losers were all compensated to different extents. Compensationfor the interim winners was politically important for pushing reform forward, rather than leaving it in a "partialreform trap." Incremental reforms can both build up momentum and constituenciesfor further reform and create  obstacles to block it. Therefore, oneneeds to closelyexaminehow partial reforms arestructuredand how rents aredistributed. China's twenty years of reform experiencehave demonstrated that incrementalreform does not necessarily lead to a partial reform trap. Still,onecannot reach a more definite conclusion at the present time because China has not yet completed its transitiontomarkets. Indeed,China still faces some major challenges, the topic I turn to in the next section. 4. Completing China's Transition: ChallengesAhead and Priority Research Agenda By the end of 1998, much had been accomplished but there was still more to be done before China became a market economy and realized its full potential. In this section, I will highlight three major areas which may pose the most serious challenges for China: the financial system, state-owned enterprises and corporate governance, andtheruleof law. In each area, I willexaminethe major difficulties involvedinfurther reform, outline the required deeper institutional changes, suggest some ways to achieve them, and propose future research topics. The reforms in these three areas will be difficult but also crucial for China to complete its transition to markets, and therefore, their study should be a research priority. A. The Financial System As discussed in section 2, China's financial system served well, for an extended period of time, in mobilizing financial savings and providing the governmentwith quasi-fiscal revenue. At the present time, the previous fears of inflation and macroeconomic instability are largely gone, and in fact, deflation becomes a major worry. However, the institutions underlying China's financial system remain primitive and weak, and moreover. the banking system has become more and more fragile because of the increasing amount of accumulated non-performing loans in the state banks. Total non-performing loans were estimated in the range of 17-25 percent of GDP by 1993 (Lau and Qian, 1994), increasing to the range of 25-35 percent by 1997 (Lardy, 1998). These numbers are high by any standards. China's current financial systemis not sustainable in the long run. China has recognized its risks of a financial crisis and put financial stability as a top reform objective  amid the Asian, Russian, and Brazilian financialcrises and the Japanesefinancialtroubles. The main reason that China weatheredthe financialcrisisbetter than most of its Asian neighbors was its defensiveand cautions approachto financialliberalization:China maintained capitalcontroland restrictedthe entryof nonstatebanks and regulated interest rates. A financialcrisis might occur in the future in severalcircumstances. First, if the non-performing loans keep rising to dry out government budget for servicing its debt and to increase inflationary pressure. Second,if some severeshocks occur when reforms deepen in areas such as liberalizing the banking sector and loosening capitalcontrol. Third, if the depositors lose confidence in the state banks, which can be triggered by exchangerate or political instability. Someeconomistshave expressed a pessimistic view of a coming financial collapsein China similar to, or even worse than, those experienced in Asia and Russia. However, they have ignored some basic differences between China and those economies. These differences have reduced the likelihood of an occurrenceof the threecircumstancesdescribedabove,and thus, at thepresent time, a financialcrisis in China is not inevitable and the Chinese government still has some time to fix its financial systembefore it becomes really late. First, the banks in China are state-owned and thus their bad debts are simplygovernment, not private, debts. By the end of 1998,explicitgovernmentdebts were about 10percent of GDP. Assuming that onehalf of the non-performing loans are not recoverable,then total government debts, including the bad debts in state commercial banks, would still be less than 30 percent of GDP. This level of government debt compares favorably with the 70 percent in the U.S. and over 100percent in Japan currently, or the 60percent maximum requiredtojoin the European Monetary Union. Considering the fact that the taxation ability of the Chinese governmentis about one-half of that in the developedcountries, the burden of servicing the government debts as a shareof the governmentbudgetaryexpenditureis stillcomparableto other countriesandthus manageable. Second,thesebad debts aredomestic, not foreign,debts. As long as the statecontinues to control the internationalcapital flow and makerestrictionsondomesticinterestratesandtheentry of domesticand foreign banks, the government stillhas the instruments of financialrepression at its disposal. This will help reduce the government's costs of financingits domestic debt.  Third, exchange rate or political instability seems not to be an immediate concern for China now. Although a financial crisis in China is not imminent, a drastic financial reform is needed, the sooner the better. Two problems need to be distinguished, one concerning the "stock problem and another the "flow" problem. Lau and Qian (1994) argue that, although the two issues are related, the more important one is the latter, that is, to stop new bad loans from appearing now and in the future, rather than the former, that is, to clean up the balance sheet, The stock problem is largely a problem of the past. The money has already been lost, and it is an accounting exercise to determine where and how the losses should be recognized, which is mainly a problem of rents redistribution. Solving the flow problem is more important because it affects future expectations and behavior. Solving the flow problem requires a banking reform (but ultimately, an SOE reform, to be discussed in subsection B below). Since 1998, the Chinese state banks have been given the capacity to run on a ' commercial basis rather than on instructions from the government as in the past. There are signs that state banks reduced lending to large loss-making state enterprises and shifted their lending priorities to small and medium-sized non-state enterprises. Competition from foreign banks also emerged. These are encouraging signs. To solve the stock problem of cleaning up the banks' balance sheets, Lau and Qian (1994) proposed establishing a trust fund organization (called "Enterprise and Bank Reconstruction Fund"). This trust fund serves as an intermediary to issue bonds to the state banks, which would partially offset their losses created by the non-performing loans. They also proposed recapitalizing the state banks through possibly issuing preferred stock (with no voting rights) to the public. The non-performing loans would then be written down to zero on the banks' balance sheets but a 50 percent across-the-board interest in these loans would be transferred to the trust fund so that it would benefit if a portion of them wererecovered. The role of this trust fund is similar to that of the Resolution Trust Corporation (RTC) of the U.S. used in cleaning up the mess resulting from the Savings and Loans crisisin the 1980s. Along this line, the Construction Bank of China, one of its four major state commercial banks, was recently selectedby the central bank to experiment with ways of cleaning up its bad debts through a newly established "financial assets management company" (Singtao  Daily, March 6, 1999). The financial reform requires carefulresearch on both the flow and stock problems. To address the flowproblem in a fundamental way, China needs to introducea bankruptcy procedurewhich clearly specifies the rights and obligations of creditors (at present time mainly statebanks) in the event of bankruptcy of both liquidation and reorganization types. In particular, banks, as major creditors, should have the rights of receivership and the responsibility for reorganizationof the bankrupt firms. Because the current Chinese law does not allowbanks to hold any equity of firms,researchis needed to introducenew regulationswhich permit banks to temporarily hold equity during thereorganization period. On the issueof cleaning up the bad debts of statebanks, oneneeds to find a way to ensurethat sucha clean up will not result in a moralhazardproblem from the statebanks. To that end, the government must make a credible commitment to no more bailouts in the future. Research is also needed to identify methods to achievethis goal. Another research topic concerns appropriate sequencing of financial liberalization. In the case of Japan, Hoshi and Kashyap(1999)arguethat it is not theJapanesemainbank systemper sebut theproblematic sequencingof financialderegulationthat explainsits banking crisis. Deregulation allowed largecorporations to quickly switch to the capital market for direct financing, but at the same time, the banks' new lending primarily flowed to high risk smallbusinesses and becametied more strongly to thebubble economy. As the bubbleburst, a banking crisis emerged. China may face similar problems when its statebanks become more independent from the government and shift their lendingportfolios to smaller firms. To reduce financial risks at the time of financialliberalization,China needs to learn lessons from the recent Asian experiences. B. State-OwnedEnterprises and Corporate Governance Reforms of state-ownedenterpriseshavebeen disappointing. The managerial contract responsibility systempromoted in the 1980shad only limitedsuccessand SOEperformanceinthe 1990scontinuedto decline (Wu, 1995). For instance,there weremoreone-thirdof SOEsmaking losses,andon average,profits and taxes per unit of net capital stock and working capital in stateindustrialenterprisesfell from 24.2 percent in 1978 to 12.4 percent in 1990and further down to 6.5 percent in 1996(China Statistical Yearbook, 1997). Even  though new private firms are developing and small SOEs are being privatized, this is not a substitute for transforming large SOEs, sincethey still constitutethe backboneof the economy, arethe main revenue source and financialburden for the government, and are ultimately responsible for the financial sector problem. Although the excessive"socialburdens" of SOEs (i.e., workers welfareobligations)are oftenblamed fortheir poor performance,the main problems areinstitutional,concerningfinance(the softbudget constraint problem)andpersonnelappointments(theParty controlproblem). Thesoftbudgetconstraintproblemhasbeen discussed in sections 2 and 3, and in recent years the budget constraintsof SOEs have been hardening. But Party control overpersonnel has remained basically unchangedfor thepast 20 years. The Party has exercised control over the selection and dismissal of SOE managers through its Organization Departments at different levels. For example, the Central Party Organization Department has the authority over appointments of the top managers of very large SOEs (minister or deputy minister level), as does the Provincial (or Municipality) Party OrganizationDepartment for most largeand medium-sized SOEs (bureau level). This authorityapplies tojoint-stock companiesas long as the statehas the majority share, even if they are listed on the stock market or are located in the special economic zones. The appointment and dismissal process represents the most importantchannel of political influenceover enterprisesby the Party apparatus. Under the Party control personnel system, SOE managers, like mayors, ministers, and Politburo members, arepolitical appointeesof the Party. This politicalprocess of managerialappointmentshas several serious problems. First, the appointmentprocess is politicized, secretive,and complicated. When the Party selects both managers and politicians at the same time, it may not choose the right people as managers. Second,the selectionandevaluationmethodsarebased oninformationthrough bureaucraticrather than market channels (the latter includes the stock market, rating companies, and investment banks). Third, the Party bureaucrats have neither the ability nor the incentives to make the right decisions on managerial selection according to business criteria because they are mainly politically motivated." Through "expanding enterprise autonomy" and "increasing enterprise retained profits" (fangquan "It is interesting to compareSOEs with TVEs in this regard. Although TVE managersare appointedby township or village governments, they do not go through the higher level Party apparatus and thus they are not subject to the same political process as SOE managers. After all, most TVE managers are not "statecadres."  rangli),thepast reforms improvedmanagerial incentivessomewhatbut the effect was rather limitedand short- lived. Why? The main difficulty of reforming SOEs without privatizing them is reflected in the following institutional dilemma (Qian, 1996): On the one hand, delegating more effectivecontrol rights to managers provides them with incentives to increase current production but also enables them to plunder state assets, which results in high agency costs. On the other hand, maintaining Party control over the selection and dismissal of managers serves to check managerial asset stripping somewhat but is also the ultimate sourceof politicalinterference,resulting in high political costs. The SOEproblem in China is the intertwining problem of both high agency costs and political costs. Before being privatized, large SOEs (including state banks) should aim to reduce both agency and political costs, which can only be achieved by a combination of establishment of corporate governanceand depoliticization (Qian, 1996). Corporate governance is a set of institutional arrangements governing the relationshipsamonginvestors(shareholdersandcreditors),managers, and workers. Thestructureof corporate governanceconcerns (1) how control rights are allocated and exercised;(2) how boards of directors and top managers are selected and monitored; and (3) how incentives are designed and enforced. Corporatization,a process of establishing corporategovernance,is a useful step in enterprisereformeven without privatization, becauseithelpshold directorsresponsiblefortheassetsof thecompanyandprevent furtherassettheft;provide a mechanismfor informationexchange; set the stagefor sellingshares;and separatethe state fromenterprise. In Eastern Europe and in other developing countries,corporatization was carried out before privatization and improved enterpriseperformance. In developedeconomies,major issues of corporategovernanceconcernlegal rules limitingthe agency problems, protecting shareholders and creditors, and providing room for managerial initiatives. The same problems arise in China, but with a special concern about the role of the state as a large stakeholder. In addition to corporategovernance, depoliticizationis alsonecessary,whichmeansthattheParty's directcontrol over managers should be limited, if not eliminated. Unless the issueof the Party's role is addressed, the goal of "separation of government and enterprise" cannot be materialized, and unless the state, institutional investors, and individual investors are put on an equal footing,political intervention by the government will  continue to plague the performance of these large firms. Corporatization and depoliticization are difficult tasks for China because they necessitate some political reform. Future research needs to find a way to limit the Party's role in the appointment and dismissal process of SOE managers without eliminating its leadership role. There were suggestions about the creation of the State Assets Management Committee to oversee state assets in enterprises. In such a scheme, only the Committee representatives have authority, through the board of directors and depending on the number of shares held by the state, over the appointment and dismissal of top managers (World Bank, 1997). Many questions remain. For example, who will appoint the members of the State Assets Management Committee? The Party, a government agency, the People's Congress, or others? Will such a person or institution stop interferingthe appointment and dismissal process of the board of directors? More research is needed to make the scheme politically acceptable and economically sensible. C. The Rule of Law Thebiggest challengeforChina to completeits markettransition is theestablishment of therule of law. The recent Constitutional amendmenton the rule of law is a good start. The economic advantages of the rule of law over ad hoc arrangements are transparency, predictability, and uniformity, that reduce idiosyncratic risks, rent-seeking, and corruption, which in turn reduce transaction costs. But the rule of law is more than putting the government's words into public codes; it fundamentally concerns a relationship between the government and markets that is appropriate for making a credible commitment. There are two economic roles of the rule of law. The first is that the law should be applied to the government -- the government needs to be constrained by law vis-a-vis other economic agents in the market. Through the rule of law, the government binds itself and thus makes a credible commitment to the provision of private incentives, which are the ultimate force for economic development. This role of the rule of law provides a foundation for secureprivateproperty rights against governmentintrusion, and it reflects thecrucial difference between the "rule of law" and the "rule by law." Oneserious problem underminingprivate incentivesinChina has been insecureprivateproperty rights.  For example,privateenterprisesandfarmersarefrequentlyforcedtopay variety of "unauthorizedfees"tolocal governments, and their businesses are alsoharassed by local governments. Revenue hiding is a response to government predation, but is costly. Recently,private businessmen and farmersbegan to use legal means to protect themselves against government'sintrusion. For example, The Wall StreetJournal (March 25, 1999) reported a case of Peijiawan village in Shaaxi Province, where 12,000farmers in 1996 filed a class-action lawsuit against the local government for levying excess fees of $75,000. In the fall of 1998,the local court made an initial ruling in favor of the farmers, the local government appealed, and now the case is before the Shaaxi Provincial SupremeCourt. This is an unprecedented event in China. The second economic role of the rule of law is that the government needs to protect private property rights and enforcecontracts and to create a level field for market corrgetition. This will help achieve credible commitment among economic agents. To achievethis goal, the government needs to become a neutral third party,a regulatorratherthan amanager. Duringtherecent restructuringof thegovernmentbureaucracy,many government agencies were eliminatedand the role of the newly established agencies has been reoriented from management to regulation. Oneexampleis theMinistryof InformationIndustry. It used todirectly administer China Telecom, the telephone monopoly in China. Now, China Telecom is being broken up into three companies, whileforeign competitionis being introduced, and theMinistry becomesthe regulatoryagency for the entire telecommunicationsindustry (Singtao Daily, March 6, 1999). Topreservemarket competition,thenationalgovernmentneeds tofight against regionalprotectionism. In the past, market competition in China was largely an accident of regional decentralizationunder Mao, combinedwiththemore-or-lessspontaneousemergenceof small-scaleindustriesthroughoutthecountry. From time to time, there have been many reports that local governments erected trade barriers to block goods and factor movement in order to protect local interests. China needs a "Commerce Clause" as in the U.S. Constitutionand the central government shouldhave the responsibility to police the common market against regional market protectionism. Future research is needed to study specificways of implementing the rule of law. For example, an important topic concerns how to create a substantiallyindependentjudiciary system, starting at the grassroots  level,and then gradually moving upward. The rule of law requires an independent and uncorrupted judiciary system to function. A completely independentjudiciary system seems impossible under a one-Party system, but it may not be necessary for thetimebeing because a substantiallyindependentjudiciary systemcan achieve quite a lot economically for the rule of law to work. The latter can be done because China is such a large country and most of the economic decisions are made at the local level. Building a judiciary system that is independent of thelocalgovernment'sinfluence is feasibleat thepresent time, and the aboveexampleof 12,000 farmers in Peijiawan village suing the local government illustratesthis possibility. Two decades ago few economists predicted that China would go this far and accomplish so much. China has surprised the world. Although past performance is no guarantee of future results, there are good reasons for being optimistic. Today, the ideology against markets and private ownership has subsided, the goals of transitionhave been set, many market-supporting institutionsare being built, and the Chinesepeople are more willing than ever to integrate China's economy with the global one. For China to successfully completeits transition to markets, priority on the research agenda shouldbe given to the three areas outlined above. 5. Reflections on the Economicsof Reform and InstitutionalChange: Lessons from China Economistsoften offer advicetotransitioneconomiesbased on their knowledgeabouteconomics. But economics has as much to learn from the experiences of the transition economies as it has to teach them (Walder, 1995). This can be done in two ways: One is by using the data generated from the transition economies to test existing economic theories. Another is through inspiration from the experiences of the transition economies to extend the existing theories or even develop new ones. Studying China's reform is useful for both purposes. Much researchhas been doneusing data from China to test existing theories. But studying China's experience is even more useful for generating new theories, especially in the area of institutionalchanges. This is because China's transition path is so unusual that it casts doubt on much of the conventional thinking on fundamental issues concerning system changes and the process of reform (Chow,  A. Reflections on the Principles of System Change China differs from Eastern Europe and Russia in many important ways including their initial conditions. China had a large agriculture sector which was the spring board for its reform; China's more decentralizedplanning systemmade it natural topursue reform in a more decentralizedway based on regional experiments; and theten year turmoil of theCulturalRevolutiondiscreditedcentralplanning and substantially weakenedthegovernment(includingtheParty)bureaucracyanditsvested interests.l 2 Hence,Chinais unlikely toprovide a model forEasternEuropeor Russiato follow. However,becauseourprevious thinkingonreform and transition was almost exclusivelybased on the experiencesof Eastern Europe, the conventional wisdom is biased. It is therefore useful to incorporateChina -- the larger half of all transition economies -- into the analysis. It is commonplaceto comparetheChinesereformexperiencesince 1978(and often, up to 1994)with the transition experiences of Eastern Europeand Russia after 1990and to contrast the differencebetween the two as "gradualism"vs. "bigbang." This is an inappropriatecomparison. In EasternEurope,reforms started as early as 1968in Hungary, 1980in Poland, and 1985in the Soviet Union. China, Hungary,Poland, and the Soviet Union all went through a two-stageprocess: first reforming the plamed system and then building the market system. WhencoyaringChina with EasternEuropeat a comparablestage,I draw three conclusions. The first conclusion, based on China's achievements during the first fifteen years of reform, is that reforming a plamed economy, both as a singleevent and as a step along the longer path, can be successful. ThereformsinEasternEuropeprior to 1990were a failure. Kornai (1992)madea convincinganalysisof them and reached the followingconclusion: "In spiteof generating a whole series of favorable changes,reform is doomed to fail: the socialist system is unable to renew itself internally so as to prove viable in the long run." In retrospect, the reforms undertaken in China between 1978and 1993were much more comprehensive and l2Due to spacelimitation, this paper will not discusshow initial conditions affect the transitionpath. See Qian and Xu (1993), and Sachs and Woo (1994) for discussions.  radical than those in Eastern European prior to 1990,the latter having no serious reform of the government, no dynamic development of non-state enterprises,no financial deepening, and no real markets. That is why China's early reform was more successful than those in Eastern Europe. The evidence from China is compelling, demonstrating that the EasternEuropean experienceis not universal. The second conclusion,based on the Chineseexperienceof the last fiveyears, is that systemchange from a planned system to a market system can occur without a political revolution. The Eastern European reform in the 1970sand 1980sled to a dead end because "thesystem is incapableof stepping away fromits own shadow" (Kornai, 1992). It eventuallyresulted in a political revolution thatjump-started the transition in the 1990s. Although it is still too early to predict that China can successfully completeits transition to a market system, there is enough evidence to show that the goal is set, thejourney is well under way, and the chance for attaining the goal is good. Therefore, the previous conclusion based on the Eastern European experience that planned economies are unable to replace their systems with market systems needs to be reconsidered. If China completesits transition,it will be the first country under the Communist Party to do SO. The third conclusion,based on China's two decades of reform, is that there are diversepaths for a successfultransition. A good path of transition,especiallyconcerning institutionalchanges,has to consider country-specificconditions. China provides a caseof a feasibleand successful alternativepath of transition tomarkets,in which nopoliticalrevolutionpredatedthechangeof economicsystemsas was thecaseinEastern Europe. Hence, the assumptionthat all plamed economies were alike and that they should follow the same path of transition needs to be modified. China's case shows that reforming a socialist economy can be successful; the plamed system can evolvesmoothlytoa market system;andtherearediversepathsformaking agoodtransition. It may be argued that China is special because it was a poor agricultural country. It may also be argued that Hungary and Poland arespecialbecausetheir earlyreformswereconstrainedby not beingtruly independentfromthe Soviet Union, andtheir later transitionswerefacilitatedby their aspirationstojoin theEuropean Union. In any event, the principles of system changes are more complicatedthan one used to believe.  B. Reflections on the Process of Reform After twenty years of experience,China's reformcancontribute several lessons about the process of reforminparticularandinstitutionalchangeingeneral. Themain lessonisthatconsiderablegrowthispossible with sensiblebut not perfect institutions,and some "transitionalinstitutions"can be more effectivethan the "best practiceinstitutions"for a period of timebecauseof the second-bestprinciple: removing one distortion may be counter-productivein the presence of another distortion. In transition economies basic market-supporting institutions(suchas theruleof law) are lacking, as well as thepeople and humancapitalto operatethem (such as law enforcement). Both usually take years to develop, except in the case of East Germany, which was absorbed into West Germany immediately after unification. This often means that the internationalbest practice institutions,even if we know what they are, may not work well for the time being. It alsomeans that someexisting institutionscan be useful to rnarket- oriented reform even though they may eventuallyvanish. Fiscal contracting, TVEs, and anonymousbanking are all institutionalinnovations that worked quite well for a time period in the Chineseenvironment. All transition economies have great potential for improvement because of enormous allocative distortionsandthelackof incentivesoftheplanningsystem. Therefore,intheory,evenif institutionsarehighly imperfect, impressiveresults are potentially possible. However, many failures in the early reforms and the recent transition suggest that not all changes can produce good results. What kinds of changes can produce good results? China's experienceoffersthreespecificlessons,but they arebetter viewed as generalprinciples than a formula for transition. First, institutional changes that create incentives, impose hard budget constraints, and introduce competition should not only apply to firmsbut also to governments. Indeed, reforming government is an important component of economicreform. When the government is provided with positive incentives and is subjected to hard budget constraints and competition (such as the township and village gwement), the outcomeof thereformisproductive; if thegovernmentis subjectedto softerbudgetconstraints(such as higher level local governments were in the 1980s),the outcomewill be problematic. Second, successful reform relies on political support, which in turn depends on delivering tangible  benefits to a large majority of the population. Economists usually blame "stupid politics" when their beautifully designed reform programs are not implemented. But political scientist Barry Weingast has this to say: "An ironic aspect of the economists' position is that they want individuals to pursue self-interest in markets but not in politics." Compensatingpotential losers in thereform is both a political and economic issue, and a reform that does not create many or big losers can be politically acceptable ex ante and sustainable ex post. The dual-track approach to market liberalization, when appropriately implemented, is one example of good politics and economics. Third, successful institutional change requires appropriate, but not necessarily optimal, sequencing. Unlike macroeconomicstabilization policy, institutional change is an unavoidably long process. Judging from the outcome, the process of China'stransition to markets has been fairly fast overall. It took Hungary 30years and Poland 20 years to achieve their current results and will certainly take Russia even longer. The Chinese experience shows that whenever politically feasible, it is better to dismantle the existing institutions after the new ones are put in place, or allow the new ones to emerge from the old, to avoid an institutional vacuum. It also shows that the implementationof reform can becompatiblewith the institutional capacity of the economy. Examples of appropriate reform sequencingin China include: Empoweringlocal governmentsfor development of local government enterprises before privatization can be instrumental for growth; pursuing industrial liberalization first while delaying financial liberalization can compensate for fiscal decline, avoid financial crashes, and, at the same time, create better incentives; enforcing a plan track and phasing it out later can minimize the opposition to reform while it improves economic efficiency. On the other hand, theChinese experience shows that onedoes not need optimal sequencingto achieve an impressive performance, and what is most important is to avoid fatal mistakes rather than to make fine tuning. Indeed, many arguments can be made that China's reform is not optimal. Both in terms of reform sequencing and of any specific reform, arguably, China could have done a betterjob and achievedeven greater results if better alternative reforms had been done. The errors made with the "crossing the river by touching the stones" style can be detected. For example, as I have shown above, China's reform fell short in the areas of reforming the financial system and large state-owned ehterprise and establishing of the rule of law.  However, to this date, these errors have not undermined China's reform in a fatal way. C. Reflectionson the Theoryand Practice of Transition Transition from a planned to a rnqket economy is one of the most significanteconomic events of the twentieth century. The core of the transitionconcernsinstitutionaltransformation, which is complicatedand difficult. For most transition countries, with the exceptionof few, transition will take more time to complete. During the past decadethere were two big surprises. One big surprisewas the sharp initial decline in output followed by recovery in most countries of Eastern Europe and the former Soviet Union -- the phenomenon known as the U-shaped output response (Blanchard, 1997). Another big surprise was China's remarkable successon its different path of transition. The gap between conventional economic thinking and the realities of the transition shows that our knowledgeaboutinstitutionalchangeingeneraland transitioninparticularis quitelimited. This limitationhas two related components. First, our knowledge about how a capitalist market economy works is still limited. Although neoclassical economics is a powerful tool for explaining how price mechanisms work, it does not provide complete theories about the role of institutions, history, and political economy yet. Ronald Coase (1992),referringtotransitioneconomies,says, "withouttheappropriateinstitutionsno marketeconomyof any significanceis possible. If we knew more about our own economy, we would be in a better position to advise them." Unfortunately, we didn't. Douglass North (1997) agreed: "Whileneo-classical theory is focused on the operation of efficient factor and product markets, few western economists understand the institutional requirements essential to the creation of such markets since they simply take them for granted. A set of politicalandeconomicinstitutionsthat provides low-cost transacting and crediblecommitmentmakespossible theefficient factor andproduct markets underlyingeconomicgrowth." Tobuild a market systemfrom scratch, nothing can be taken for granted. Second,ourknowledgeaboutthetransitionprocess isevenmorelimited. Thereis a differencebetween thefinaldestinationand theprocess of transition, andeven if wehaveperfect knowledgeabout the destination, how to get there is a separateissue. As Robert Solow said, "Thereis not someglorious theoretical synthesis  of capitalism that you can write down in a book and follow. You have to grope your way" (The New York Times, September 29, 1992, p. El). Richard Freeman (1994) echoed that view, "economics does not have sufficiently compelling theory or empirical knowledge to answer questions about the institutional design of advanced capitalist economies, much less economies in transition." Because the transition from plan to market is unprecedented, the practice of transition is original and the theory of transition is in its infancy. Two excellent survey papers on the economics of transition (Dewartripont and Roland, 1996; McMillan, 1996) all recognized the limits of our knowledge on transition. More and more people, both inside and outside the transition economies,have realized this too. 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