China's Transition Experience, Reexamined

by Jeffrey Sachs and Wing Thye Woo

The most remarkable difference between reforms in China and in countries of Central and Eastern Europe and the former Soviet Union (CEEFSU) is that China succeeded in producing more than a decade of phenomenal growth, while countries of CEEFSU, no matter which reform strategy has been tried, have seen a sharp initial downturn in production, usually with a significant rise in unemployment. The undoubted Chinese success led many economists to urge CEEFSU to adopt the Chinese dual-track approach (see box next page). By 1996, however, the call for this dual-track approach has basically disappeared in the fast-reform countries of CEEFSU, since their sharp initial downturn has been followed by rapid growth. Poland's per capita GDP growth was around 6 percent in 1995, around the levels of the East Asian tigers. A similar rate of growth is expected in 1996.

Shifting from Wheat to Rice?

The differences in initial conditions and economic structures are so profound that it has been necessary for countries of CEEFSU to follow a fundamentally different kind of reform from Chinese gradualism. A simple transplantation of Chinese-style reforms to Russia or to other countries of CEEFSU would not be possible or desirable. Supporters of introducing Chinese gradualism in Russia might as well advise Russia to solve its agricultural problems by shifting from wheat to rice. We can summarize the structural differences, and their implications, as follows:

•1. In 1978, at the start of the reform period, China's heavily subsidized state sector employed a relatively small share, 18 percent, of the labor force while the agricultural sector—not subsidized by the state—accounted for 71 percent of the labor force. State-owned enterprises (SOEs) offered a generous package of wages and social protection, pensions, heavily subsidized housing, medical coverage, childcare, food, and recreational facilities. The peasants received none of these benefits and are still consuming roughly one-third of what urban residents consume. While most state enterprise workers have chosen to keep their privileged positions (at least during the first fifteen years of reforms), the peasants have been only too glad to shift out of low-income agricultural activities and into the new, higher-income jobs in the nonstate sector, notably in the township and village enterprises (TVEs) and in enterprises in special economic zones of the coastal provinces (see box on page 3). Thus, the nonstate sector grew despite the preservation of the state sector. It is important to note that China's rural reforms contributed directly to a one-time jump in productivity in agriculture between 1979 and 1985, but after that, agricultural productivity returned to its historical trend. Therefore, rapid growth in China has come mainly from the non-state, nonagricultural sectors.

Countries in the CEEFSU, by contrast, lacked a vast surplus-labor sector, and the (also heavily subsidized) state sector workers were eager to keep their privileges rather than risk the transition to the nonstate sector. In Russia, around three-fourths of the population are urban residents, and as of 1991, more than 90 percent of the population were employed in state-owned enterprises. Further, Russian farmers on state farms (sokhozes) and collective farms (kolk hozes) received approximately the same income and benefits as SOE workers, thanks to very large subsidies from the central government. Therefore, when the new, nonstate sector was progressively legalized during 1986-91, an SOE worker shifting into the nonstate sector could experience a drop in income and security. The flow of workers to the nonstate sector was insufficient to reinvigorate the economy.

•2. Market reforms in the CEEFSU countries necessarily involved an initial decline in industrial production. In these countries heavy industry was overdeveloped under the old regimes' bureaucratic directives while the service sector was correspondingly underdeve- loped. In China a decline of agriculture's contribution to the GNP itself generated growth, without a squeeze of the existing industry. Besides, industry was not as excessively built up, since it had endured a much shorter period under stable central planning than the industries in the CEEFSU. The experience of China and the CEEFSU countries suggests that the marketization of a planned economy inevitably shifts resources toward the service sector: from the agricultural sector in China, and from industry in the countries of the CEEFSU. Seen this way, much or all of the initial drop in industrial production in the CEEFSU countries after the start of reforms was a natural part of the needed reallocation of employment and resources.

•3. In both regions partial liberalization unleashed macoreconomic pressures, especially by allowing state enterprises to reduce actual and reported profits, so their tax payments decreased. These pressures were more manageable in China, partly because the state enterprise sector employed a smaller part of the labor force, partly because of rapid growth in other sectors, and partly because of adequate monetary policy. The pressures turned explosive in much of the CEEFSU, particularly Bulgaria, Poland, and the (former) Soviet Union, because of deeper structural problems as well as gross macroeconomic mismanagement during the communist reform period (and well into the postcommunist reform period in much of the former Soviet Union).

•4. One key macroeconomic burden is social expenditure. In China social spending from the central government covers a small fraction of the workforce, much less than 20 percent. In CEEFSU, by contrast, social spending from the central government covers nearly the entire population, and public demands for social guarantees outrun the fiscal capacity of the state.

No Such Thing as Free Subsidies

The usual argument for the superiority of China's two-track approach compared with a Polish-style "big bang" goes something like this. Economic reform involves substantial upheaval, so it is desirable to moderate the size of the shocks that will hit the economy during the transition. Therefore, it is useful to protect the old sectors of the economy at the same time that new economic opportunities are introduced by market liberalization. Since the old sectors are inefficient, they will lose out in competition with the new sectors, but this will happen gradually as workers voluntarily flow from the old state enterprises to the new and more efficient nonstate enterprises. A direct "assault" on the existing state enterprises—by cutting subsidies, raising input prices, privatizing ownership—is both unnecessary and traumatic. But in China the proportion of the labor force employed by state-owned units was 18 percent in 1978 and was still 18 percent in 1993. This means that there were actually 35 million more Chinese working in state-owned units in 1993 than in 1978. The state-owned sector is not "withering away."

Several studies have concluded that total factor productivity (TFP) growth of the Chinese SOE sector has been positive in the reform period. However, these calculations are based on questionable price deflators of intermediate and final outputs. Even calculating with these data, annual TFP growth of SOEs reached only about half of that achieved by the collectively owned enterprises (which include town and village enterprises).

Besides, overall profitability of the SOE sector has been declining. Many SOEs are still running losses, a decade after the start of enterprise reforms. In 1992, a boom year, output grew 13 percent, and yet two-thirds of Chinese SOEs were loss-makers. The heavy losses have continued to the present. Some blame the tough competition by nonstate enterprises. But decline in profits occurred across the board, even in heavy industries with negligible new entry by nonstate firms. Excessive wage increases throughout the SOE sector may have been a more relevant reason for the profitability decline. Managers have little incentive to resist wage demands because their future promotion to larger SOEs is determined in part by increases in worker welfare during their tenure.

The financial weakness of SOEs undermines macroeconomic stability; it reduces fiscal revenue, widens the budget deficit, and causes faster monetary growth; and it forces the central bank to cover the bulk of SOE losses through bank loans. The relatively small size of the SOE sector (compared with countries of the CEEFSU) enabled the government to help out the loss-makers without endangering macroeconomic stability, and to retain some control over the enterprises, especially over their fulfillment of production quotas at plan prices. With the state still being able to monitor the SOEs, there was less need to consider immediate privatization because widespread spontaneous privatization did not occur. But the fact remains that just as it did not succeed in producing the new socialist man during the Cultural Revolution, China, like Eastern Europe and Russia, has not succeeded in producing profitable SOEs.

Another Look at China's Success Story

In addition to the "advantages of backwardness" in economic structure, there are several other factors that have contributed to China's superior growth performance:

• China's reforms did not start at a time of high macroeconomic crisis and severe external debt requiring implementation of an austerity program.
• China's saving rate is unusually high even by East Asian standards. Household saving is about 23 percent of disposable income in China versus 21 percent in Japan, 18 percent for Taiwan, 16 percent for Belgium, 13 percent for West Germany, and 8 percent for the United States. The annual flow of household saving into the formal financial system (the state banks and rural credit cooperatives) rose steadily from 3.4 percent of GDP in 1980 to 11.7 percent in 1991.

The high household saving rate plays an important role in stabilizing the Chinese economy. It has enabled the government to rely on seignorage (money-financing of the budget deficit and off-budget SOE subsidies), since the house- holds are willing holders of the increased money supply. (Comparable subsidization of industry in Russia has so far produced very high inflation, because the increased money supply has not been willingly held by households and firms).

• The two disastrous leftist campaigns, the Great Leap Forward (1958-62) and the Cultural Revolution (1966-76), undermined belief in Marxist dogmas, weakened the state's administrative capacity, and discredited central planning. The Great Leap Forward program of crash industrialization starved around 30 million to death in the 1958-61 period, and the Cultural Revolution purged around 60 percent of party officials.

The legacy of these two disasters enabled Deng Xiaoping to quickly transfer a significant amount of formal and informal economic policymaking power and resources to the provinces when he returned to power in 1978. The central ministerial and party apparatus were too politically exhausted and too discredited to resist his decentralization. This ending of Beijing's stranglehold over political power has been fundamental to the continuation of economic reforms. (When the conservatives sought to reimpose a Stalinist central planning econ-omy in the immediate aftermath of the Tiananmen shootings in 1989, the provincial representatives were strong enough to repel the recidivist tendency toward central planning. Furthermore, it was the mobilization of this new decentralized political power by Deng Xiaoping after the collapse of the Soviet Union that forced the conservative faction to accept the new vision of a socialist market economy.)

•Central planning in China was always much shallower than in the CEEFSU. The Soviet central plan controlled 25 million commodities whereas the Chinese central plan controlled only 1,200 commodities, Furthermore, the breakdown of the national distribution system during the decade of the Cultural Revolution forced local authorities to promote small and medium-size industrial enterprises in order to meet local demand.

• Existence of family ties between the mainland Chinese and the overseas Chinese has facilitated the conduct of business. The explosive growth of the Special Economic Zones (SEZs) in southern China is a result of wholesale movement of labor-intensive industries from Hong Kong and Taiwan, which were losing their comparative advantage in these industries. China was closer, wages were lower, and language difficulties were nonexistent, compared with the alternative sites in Southeast Asia. Managers could commute daily from Hong Kong to supervise their factories in Shenzhen. The family connections greatly reduced the transaction costs of the investment by providing reliable local supervisors, inside information on the enforcement of regulations, and contacts with the local authorities.

Of all the factors identified as important causes of China's achievements in the 1978-92 period, only the high saving rate could be considered (in part) a policy lesson for economic reforms. The other factors are rather specific to China's circumstances.

Keeping the Bird Happy

Gradualism in China is as much the result of a political struggle between the Stalinists and the reformers, and of a general lack of consensus in the society at large, as it is the result of a particular theory of reform. The Stalinists subscribe to the "birdcage economy" doctrine. In the conception of its originator, Chen Yun, the central plan is the cage and the bird is the economy. The premise is that without central planning, the economy will be in chaos and production will be inefficient—that is, without the cage the bird will fly away. The amount of market activity that is to be tolerated to keep the economy working is analogous to the amount that the cage needs to be swung to create the illusion of greater space and keep the bird happy. The reformers, on the other hand, believe that only a market economy will promote long-term economic development.

"Muddling through" has not been a strategy, as claimed by some observers, so much as a result of the lack of political consensus. The reformers were able to convince the Chinese leadership in October 1992 to formally abandon "the planned commodity economy" in favor of "a socialist market economy with Chinese characteristics."

In November 1993, for the first time, the party identified ambiguous property rights as an important cause of the inefficiency of the state enterprise sector, and decided that large and medium-size state-owned enterprises should experiment with the corporate system, and that some small state-owned enterprises could be contracted out or leased; other SOEs shifted to the partnership system in the form of stock sharing, or were sold to collectives and individuals.

Since there is now more political consensus at the elite level, popular support at the mass level, and better knowledge generally of the steps required to establish a market economy, it is not surprising that China has accelerated its economic reforms since 1994. The new reform measures included unification of the exchange rate, making the currency convertible for current account transactions, a new tax system, the commercialization of the state-owned banks, and the corporatization of SOEs.

To sum up, the different results that we saw in China, Poland, and Russia immediately after the implementation of different economic reform programs arose more from differences in their economic structure than from the economic strategies implemented. China's reform problem is basically the classic development problem of promoting the movement of low-productivity, surplus agricultural labor into industry and services, while Central and Eastern Europe's and Russia's reform problem is the much more difficult and conflictual adjustment problem of inducing labor to move from uncompetitive, heavily subsidized industries to newly emerging, efficient industries.

This article is drawn from the articles and ongoing research of the authors.

Jeffrey Sachs is professor of International Trade at Harvard University and advises governments in several countries including Bolivia, Estonia, Mongolia, Poland, and Russia.

Wing Thye Woo is professor of Economics at the University of California, Davis.

What Is the Dual-Track Approach?

The basic Chinese strategy for moving from economic planning to a market system has been the gradual decentralization of economic decisionmaking, including the liberalization of the non-state-owned economy. The dual-track approach of establishing a market track, parallel to an existing plan track, pervades almost every area of economic policymaking: sectoral reform, price deregulation, enterprise restructuring, regional development, trade promotion, foreign exchange management, central-local fiscal arrangements, and domestic currency issuance. For example, the typical process of dual-price transition is as follows:

• Opening the free market while keeping state supply unchanged at the (lower) plan price.
• Adjusting the plan price incrementally over time to approach the market price. The supply offered at the plan prices is normally fixed by quota, if not reduced, over time. Generally, no "shock" is observed when convergence of the two prices occurs.

This approach was introduced at the end of 1978 with rapid and comprehensive liberalization of the agricultural sector while the industrial sector remained under traditional central planning management. The agriculture communes were disbanded over a two-year period by distributing the land with multiyear (usually fifteen-year) leases to the peasants, and allowing the leases to be relatively freely tradable. State procurement prices for agricultural products were raised, and free markets for some agricultural products were allowed. Farmers now enjoy wide-ranging production freedom: only 5 percent of their production in 1993 was set by the state plan.

In 1984 the dual-track arrangement was extended to industrial goods, with state procurement quotas for consumer goods much lower than for producer goods. The proportion of planned production of total industrial output value has been reduced from more than 90 percent in 1978 t0 5 percent in 1993.

SOE, COE, TVE, FFE, SEZ ...

In China, an SOE is a nationally owned enterprise; the central government is the ultimate authority for the enterprises' operations and the disposition its assets, even though the SOE in most cases has been assigned to the provincial or county government for supervision and management. The nonstate enterprises are those in which the central government lacks final authority over the disposition of assets. The nonstate sector consists of community-owned (collective-owned) enterprises (COEs), cooperatives, individual-owned enterprises, private corporations, and foreign joint ventures. COEs are owned by all the residents of the city, township, or village, and cooperatives by a small group of persons. The most prominent type of nonstate enterprise is the community -owned enterprises in the rural areas, known as township and village enterprises (TVEs). Foreign Funded Enterprises (FFEs) were predominantly established in the SEZs, Special Economic Zones.

Opening of the economy to foreign trade and investment has caused Chinese exports to boom, especially exports from the TVEs in recent years (see table).

China's Export Boom, 1987-94

National Peoples' Congress-Waits and Sees

China's economic targets imply a strategy of continued austerity. However, pressure from ailing state enterprises and inland provinces for a selective easing of credit is intense. All of the key reports to the March session of the National Peoples' Congress stressed that the government would continue its "appropriately" tight monetary policy through 1996 and for the next five years in order to control inflation. Prime Minister Li Peng acknowledged, in his report, the need for a "reasonable scale" of investment in fixed assets and in ongoing construction projects. There is debate among Chinese leaders over whether to relax credit. Some leading officials argue that any loosening now would risk a new bout of inflation. However, a large number of SOEs and less-developed inland provinces are pushing for a loosening-up. Nonetheless, economic targets are based on the continuation of the tight credit policy.

Economic Growth. Li predicted GDP growth of 8 percent this year and average annual growth of 8 percent thereafter up to 2000. This is down from average growth of 11.8 percent in 1991-95. On the basis of these and further projections, GDP is expected to rise from 5.8 trillion renminbi ($700 billion) to 8.5 trillion by 2000, and to double by 17 trillion by 2010. Actual GDP growth this year could be around 9 to 10 percent. Tight credit and strong demand have led to upward pressure on the exchange rate, which has eroded much of the gain in external competitiveness that resulted from the 1994 devaluation.

However, although a fall in net exports will tend to slow the economy—trade was in deficit in December and January after nineteen consecutive months of trade surpluses—this may be offset by strong consumption and capital investment. After growth in fixed assets investment came down to 18.8 percent last year, Li envisages a 32 percent expansion in 1996 and average annual growth of 30 percent to 2000. Total fixed asset investment in 1996 is expected to reach 2.1 trillion renminbi, with 1.4 trillion going to SOEs and institutions, and 660 billion to community-run and private organizations. Priority will apparently be given to key projects under construction in infrastructure, agriculture and industry, as well as to inland regions. The startup of new projects will continue to be controlled, especially high-grade real estate and urban construction projects.

Inflation. Beijing enjoyed considerable success in reducing inflation last year to less than 15 percent from 21.7 percent in 1994, albeit with the aid of price freezes, administrative measures, and subsidies. The government hopes that inflation will drop to 10 percent in 1996 and remain below 8 percent through the next five years.

Budget. The draft budget provides for a deficit of 61.4 billion renminbi in 1996, a slight improvement over last year's 62.1 billion renminbi. Total revenue will amount to an estimated 687.2 billion renminbi, an increase of 11.1 percent over 1995, with expenditures totaling 748.6 billion renminbi, up 9.9 percent. Tax reform, including improvements in collection and the new revenue-sharing agreements with the provinces, has helped to stabilize government finances.

State-owned Enterprises. To assist ailing state-owned enterprises (SOEs), which are burdened by excess workers, outdated equipment, and poor management, reformers last year proposed a two-tier strategy (see Transition, November-December 1995):

• One thousand key SOEs are to be singled out for special assistance, including low-interest loans, debt forgiveness, and technical aid, in order to transform them into modern corporate entities capable of operating independently from the state and assuming responsibility for their own profits and losses.

• A special fund is to be established to encourage other SOEs to merge, offset debts, and improve efficiency. It is also understood that many of these companies will declare bankruptcy. (Mergers, however, may create monopolies and can couple more efficient firms with less efficient ones.)

The parliament's recent session did not yet discuss these proposals.

Based on reports of Oxford Analytica, the Oxford (U.K.)-based international consulting firm. (Email: ra@oxford-analy tica.com).