Despite an improved political climate in the early to mid-1980s, the private economy lacked a defined legal position. However, in April 1988 the National People’s Congress adopted a constitutional amendment recognizing the legality of individually owned economic entities. It stated that they were a "complement" to the socialist public economy and would operate according to state guidance, supervision, and administrative regulation.

The growth of the private sector was further encouraged after Deng’s southern tour of China in 1992, in which he proclaimed the government’s commitment to deepening reforms and opening up to the outside world. In 1993 the Constitution was amended to indicate that the government’s goal was to establish a "socialist market economy" and that the private sector was a complement to it. This represented official recognition that the market system was not incompatible with socialism. The Constitution was further amended in 1999 to state that the private sector was an "important component of China’s socialist market economy."

The nonstate sector in Chinese government statistics consists of township and village enterprises, urban collectives, foreign-funded enterprises, and privately owned Chinese firms and small-scale entrepreneurs. The private sector is generally classified as consisting of domestic private enterprises and entrepreneurs (including self-employed individuals but excluding farmers). However, other nonstate categories might be classified broadly as part of the private economy. Many urban collectives and township and village enterprises, although they are usually owned and controlled by local governments, could be deemed private enterprises: they are generally run like private firms, operating according to market principles. Foreign-funded enterprises could also fall under the private sector category, since the parent company usually is a private business. Finally, many private companies prefer to register as township and village enterprises or state-owned enterprises simply to avoid harassment and interference from government officials.

Several studies indicate that nonstate firms are largely responsible for the rapid economic growth enjoyed since 1979, while the role of the state in industrial production has diminished markedly. It is largely because state-owned enterprises are less efficient and competitive than their nonstate counterparts. While state-owned enterprises accounted for 77.6 percent of gross industrial output in 1978, this share fell to 26.5 percent in 1998. The nonstate sector overtook the state sector in industrial output in 1995, accounting for 57.3 percent of total industrial output, rising to 73.5 percent in 1998. The nonstate sector is most involved in the consumer goods and export sectors, while the state sector dominates heavy and extractive industries, such as iron and steel, coal, and petroleum extraction and refining, as well as utilities, banking, and transportation.

According to official data, the private sector’s share of industrial output rose from 1.9 percent in 1985 to 5.4 percent in 1990 and about 16.0 percent in 1998. The number employed in the private sector (private firms or self-employed) rose from 4.5 million in 1985 to an estimated 81.3 million in 1999. Most private enterprises are small firms involved in production and services that are related closely to daily livelihood, such as light industry, manual trades, transport, construction, commerce, food services, and repair industries. While some large private firms exist (there are 40 private firms with capital of more than $12 million), the average enterprise in 1998 had a registered capital of about $60,000 and employed 14 people.

The growth of the private sector has to a large extent arisen from the government’s efforts to reform and restructure state-owned enterprises. At the Communist Party’s Fifteenth National Party Congress in 1997, President Jiang Zemin stated that the government planned to end support to and privatize the 307,000 state-owned enterprises and keep under state control, changing into globally competitive enterprises, about a 1,000 "flagship" enterprises.

Employment by state-owned enterprises has fallen from a peak of 112.6 million in 1996 to an estimated 81.2 million in 1999. Workers who have been laid off from state-owned enterprises have been encouraged by the government to find jobs in the private sector and start businesses. In 1999 an average of 4,000 laid-off state-owned enterprise workers a day are estimated to have re-entered the workforce in the private sector.

To date, the government has adopted a largely pragmatic approach to the private sector, although private firms are still barred from a variety of industries and services, unable to compete directly with state-owned enterprises. They often find it difficult to obtain bank loans, owing to policies that require state banks to give preferential treatment to state-owned enterprises (in 1996 state-owned enterprises absorbed 87 percent of total state bank loans). Entrepreneurs must seek financing elsewhere and at higher cost. Only a handful of private firms has been allowed to raise funds in the stock and bond markets.

Legal vacuums in the areas of property rights, legitimate business practices, and other basic features of a market economy have given officials huge discriminatory powers. Private firms must rely on connections (guanxi) with government officials to obtain licenses, bank loans, and raw materials. Even so, central and local government officials tend to give special treatment to enterprises they own or control and are often unwilling to establish business relations with private entrepreneurs.

Officials recognize that WTO membership will benefit China in the long run but could lead to short-term disruptions in many industries. As a result, the government has taken steps to promote the expansion of the private sector to help deal with expected layoffs resulting from increased foreign competition.

The government is aware that it must give domestic firms the same trade and investment opportunities that are afforded to foreign firms and investors under WTO commitments; otherwise, Chinese firms will be at a distinct disadvantage. It has therefore enacted laws and regulations that would give private firms trading rights (the right to import and export goods), create guidelines to facilitate borrowing from state banks by private firms, permit the establishment of four private banks, and lower the minimum capital needed to start a private business. In January 2000 the government pledged to scrap all obstacles to the development of the private sector, except in areas relating to national security and certain state monopolies.