11 Financial Growth and Macroeconomic Stability in China, 1978-92: Implications for Russia and Eastern Europe

Richard Bart, Chorng-Huey Wong, and Alan Roe
Published Date:
September 1994
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Ronald McKinnon

From 1978 to 1992, China’s liberalization was gradual, with a fairly stable price level and extraordinarily rapid output growth. Since 1989, rapid liberalizations in Eastern Europe and the former Soviet Union (FSU) attempted in the face of falling real output have generated much higher inflation. Yet both regions’ fiscal policies have been surprisingly similar. Like its socialist counterparts in Europe, the Chinese Government has seen its revenue share in GNP fall sharply; in 1991-92, its fiscal deficit approached 10 percent of GNP, as illustrated below. How did China manage to avoid inflation when its government was such a heavy borrower from the state banking system?

There are four ways in which China avoided resorting to the inflation tax:

  • It first liberalized in areas like agriculture, where subsequent productivity growth was rapid;

  • It imposed very hard budget constraints on, and gave little bank credit to, the newly liberalized “nonstate” sectors in industry and agriculture;

  • But it did retain intramarginal price controls on, and constrained financial support for, traditional soft-budget state enterprises; and

  • It set positive real interest rates on savings deposits.

The resulting enormous growth in saving and stocks of financial assets allowed the liberalized sector to finance not only itself but also the Chinese Government and the deficits of the slowly reforming state enterprises.

In this article, I analyze in statistical detail how the Chinese accomplished this remarkable financial feat. There are many similarities to the high financial growth policies followed by Japan in the 1950s and 1960s and Taiwan in the 1960s and 1970s (McKinnon 1993b, Chapter 3). Yet there is an important difference: the Chinese Government’s failure to gain control over public finances at the outset of liberalization (Blejer and others 1991). Nevertheless, I will argue that many important aspects of China’s dualistic banking and pricing policies could well be adopted by other transitional socialist economies in Europe and Asia. Indeed, China’s dualistic system of financial controls is consistent with, and nicely illustrates, the gradualist approach to the transition sometimes advocated for the FSU.

But China’s incredibly high real financial growth is not feasible in Russia and formerly socialist Europe. (Indeed, it may not be sustainable for much longer in China itself.) Thus, to prevent inflation and stem financial decline in the liberalizing European economies, fiscal reforms should come much earlier in the transitions than they did in China’s. Although China is an important, if temporary, exception on the fiscal side, its interest rate policies and step-by-step foreign trade reforms were fully consonant with the preferred order of economic liberalization, as we shall see (McKinnon 1993b, Chapter 1).

I conclude with a brief analysis of the inflationary explosion and sharp output decline in Russia in 1992, which arose out of the Yeltsin-Gaidar Government’s liberalizing reforms. Did the Russians get the order of economic liberalization wrong, or was this unfortunate event the result of adverse exogenous shocks beyond any government’s control?

Gradual Versus Rapid Liberalization in Socialist Economies

China is often cited as the leading example of a successful gradualist approach to economic liberalization.1 In 1978, the Chinese began to break up traditional agricultural communes into small farm leases (now of 10-15 years’ duration) under the so-called household responsibility system. From 1979 to 1983, with over three quarters of the population still in agriculture, farm output surged by 8-10 percent per year (D. Gale Johnson 1990). By 1984, the focus of rapid economic growth had shifted to rural light industry, which began to absorb much of the labor force released by productivity improvements in agriculture. Although small-scale private traders flourished, hundreds of thousands of the new manufacturing enterprises (township and village enterprises, or TVEs) were owned largely by townships and villages. In this so-called nonstate sector, the TVEs were market driven and outside the web of official price and output controls that still circumscribed activity in the old heavy-industry state sector.

In this traditional sector, the much larger state-owned enterprises (SOEs) remained under the ownership and control of the central government, and no attempt was made at some form of rapid privatization or price decontrol. Step by step, the pricing and financial arrangements facing the old SOEs were also rationalized, but at a more deliberate pace that lasted over a decade. Overall price stability in both the state and the nonstate sectors was surprisingly well maintained, with retail price inflation averaging 6-7 percent per year since 1978 (Table 1).

Table 1.China’s Main Economic Indicators
Real National IncomeReal GNPGeneral Retail Price IndexUrban Cost of Living IndexFree Market IndexMoney (M2)Exports/GNPForeign Reserves1
Percentage rate of growthPercentBillion $
Sources: Wong, Heady, and Woo 1993; Qian 1993. M2 data taken from IMF, International Financial Statistics, 1992 yearbook; other data from Statistical Yearbook of China, 1992, Chinese edition.

Foreign exchange reserves are those held by the central bank (The People’ Bank of China). Large reserves held by the foreign trade bank (The Bank of China) are excluded.

Sources: Wong, Heady, and Woo 1993; Qian 1993. M2 data taken from IMF, International Financial Statistics, 1992 yearbook; other data from Statistical Yearbook of China, 1992, Chinese edition.

Foreign exchange reserves are those held by the central bank (The People’ Bank of China). Large reserves held by the foreign trade bank (The Bank of China) are excluded.

The Chinese approach to freeing foreign trade was also gradualist Instead of a “big bang” that suddenly opened up the whole economy to international competition and world prices, special economic zones somewhat outside the control of the traditional state trading monopolies were started in Guangdong in connection with the Hong Kong trade. These then became progressively more numerous and broader in scope. Inside such a zone, exporters could retain all of their foreign exchange earnings while having freer access to imported materials and foreign capital or trading services; they also paid lower taxes on enterprise profits, particularly if they formed joint ventures with foreign companies.

By the end of the 1980s, an export (and import) boom had become China’s new engine of economic growth. Exports had risen from less than 8 percent of GNP in the early 1980s to around 20 percent in 1992. Real GNP growth itself averaged almost 9 percent per year from 1979 to 1992 (see Table 1). By the early 1990s, however, the distinction between special economic zones and the rest of the economy had eroded. Now, a wide range of SOEs, TVEs, and private enterprises participate. They have more equal access to foreign trade, and the domestic economy’s insulation from world markets has diminished.

Although this great economic transformation has been very rapid, it seems fair to characterize the Chinese Government’s economic policies as being gradualist—with the possible exception of the “minimum bang” necessary to get the ball rolling in agriculture in 1978–79.2 In 1985, these early Chinese successes encouraged Soviet President Mikhail Gorbachev to embark on perestroika, and in 1986 smaller Asian economies like Laos and Vietnam adopted their somewhat gradualist “new economic mechanisms,” which have been fairly successful.3 By 1989, the transition from central planning to more market-based economies had become a political imperative throughout Eastern Europe and the FSU.

But this fact poses a paradox. If gradualism in China and smaller Asian economies was successful early on, why did the East Europeans in general, and Russians in particular, later attempt more of a “big bang” approach to economic liberalization? Why were the East Europeans so enamored with more sweeping transfers of property rights (including elaborate voucher schemes for transferring state property) and sudden full-scale price and output decontrol in traditional enterprises? The “big bang” approach was often coupled with the intention—not always carried out in practice—to open the whole economy swiftly to unrestricted foreign trade with the hard-currency industrial economies.

At least in the initial stages of these rapid liberalizations, abrupt policy changes in Eastern Europe were associated with economic disorganization, sharp falls in output, and, in some cases, inflationary explosions (Aslund 1992). For the much briefer time series on the transition processes in Bulgaria, Czechoslovakia (before its dissolution), Hungary,4 Poland, Romania, and the Soviet Union (before its dissolution), Tables 2 and 3 depict the sharp decreases in output experienced by virtually all these economies from 1989 to 1992. This falling output has been accompanied by high, sometimes explosive, inflation that is nowhere more evident than in Russia and the Ukraine in 1992-93. In contrast, Chinese output rose sharply after 1978, and price inflation remained very low throughout the early 1980s (see Table 1).

Table 2.Gross Domestic Product (GDP) Growth Rates,1989–92(Percentage change in real CDP)
Soviet Union3.0–2.3–17.0
Sources: Aslund (1992); Calvo and others (1993).

Preliminary estimates

Sources: Aslund (1992); Calvo and others (1993).

Preliminary estimates

Table 3.Inflation, Unemployment, and Budget Balance,1990-92
Inflation (Percent change)Unemployment (Percent in December)General Government Balance (Percent of GDP)
Czechoslovakia1159101.06 60.1–2.2–4.4
Hungary3332221 78.50.4–3.3–10.6
Soviet Union61520.00.0–8.0–26.0
Sources: Aslund (1992); Calvo and others (1993).

Preliminary estimates.

Sources: Aslund (1992); Calvo and others (1993).

Preliminary estimates.

Were Circumstances in Eastern Europe (Including the FSU) Essentially Different?

To explain the output decline in Eastern Europe, I will list the exogenous political and economic circumstances that differed from those prevailing in China.

First, Eastern Europe was more industrialized and overly specialized in heavy industry. Because agrarian populations were proportionally smaller than in the Asian socialist economies, the possibility of returning to smallholder agriculture was more limited and the immediate gains less apparent.

Second, the collapse of the Council for Mutual Economic Assistance (CMEA) disrupted trade within the former Soviet bloc, and then trade among the FSU countries was disrupted.

Third, the precipitous decline in the power of the Communist party in most of Eastern Europe and the FSU was coupled with the weakening of both centralized political control over the economy at large and decentralized party monitoring of SOEs.

In contrast to China, the first point denies typical East European economies a substantial margin on which to liberalize to get immediate increase in output. So pervasive has been this pattern of falling output that many observers suggest that the transition from socialism must naturally follow a J-curve: output must fall before a long-term growth path more characteristic of a liberal economy can be established (e.g., Gomulka 1991; Murrell 1990). According to this J-curve view, liberalization must first largely destroy the old order before economic resources can be efficiently redeployed.

Countering this view, many argue that the trade shocks under the second point were so enormous that some decline in output was inevitable in any event, given the high degree of specialization in the old CMEA trading regime (e.g., Brada and King 1992). And in the 1980s, CMEA trade was about half the total foreign trade of Eastern Europe and the FSU. Then, in 1991, CMEA trade imploded, with 60 to 70 percent of member countries’ trade with each other suddenly drying up (Calvo and others 1993). Because this CMEA shock was so enormous, one could argue that a more rapid opening of trade with advanced industrial economies was imperative in Eastern Europe. This situation differed from the situation in the early stages of China’s liberalization.

Under the third point, the ability of the typical European reform government to establish central control of resources was so limited that rapid privatization and price decontrol in the industrial sector were more essential in socialist Europe than in socialist Asia. To put it more crudely, rip-offs of the assets of the SOEs had previously been prevented by the monitoring and oversight of the Communist party. Jeffrey Sachs (1992) has vehemently argued that with the decline in the party’s power, more rapid privatization of both industrial and financial enterprises is needed.

Without denying the great importance of the three points just given to what happened in Eastern Europe in general and Russia in particular, I hypothesize that China’s longer-running experience with the transition from a planned to a market economy still contains valuable lessons for the East Europeans. But rather than trying to cover the whole liberalization landscape at the microeconomic level, I focus on the problem of macro-economic control. Using China as a benchmark, what are the fiscal and monetary problems that a reform socialist government typically faces, and how can they best be resolved in ways that encourage output growth yet maintain price-level stability in the liberalizing economy?

A Chinese Puzzle: Price-Level Stability in the Face of Fiscal Decline

In the early 1980s, how stable was the “true” Chinese price level in an environment where most prices were still controlled? Chart 1 shows that as late as 1981, only about 10 percent of retail sales were free of price controls. By the early 1990s, more than 70 percent of the retail prices and 85 percent of the output prices of the collectively owned enterprises (COEs) had become market determined. (Even the output and input prices of SOEs were 70 percent decontrolled by 1991.) Consequently, three different consumer prices are presented in Table 1. From 1979 to 1991, an urban employee’s cost of living index rose the most, averaging 6.9 percent per year, while the more general retail price index averaged 6.2 percent and the “free market” index, made up only of commodities whose prices were decontrolled, rose by 6.5 percent.

Chart 1.China: Price and Market Reform

Sources: (Top) Share of COEs and SOEs at market prices are estimated by Zou (1992) from a sample of 253 enterprises. Share of retail sales at fixed prices from Schmidt-Hebbel (1992). (Bottom) Ratio of free prices to plan prices estimated by Zou (1992) from a sample of 253 enterprises; also Gelb, Jefferson, and Singh (1993).

1Collectively owned enterprises.

2State-owned enterprises.

Because of this relatively modest growth in the free market and other price indexes, it appears that China began its liberalization in 1979-81 without significantly repressed inflation. At the outset, no major macroeconomic adjustment was needed to work off a monetary overhang by a one-time inflation, as was planned in Poland in 1990 and in Russia in 1992, or possibly by a currency reform that canceled outstanding cash balances, as happened in West Germany in June 1948. Thus, for many years after 1978, official price controls on trade among the old state enterprises could be effectively enforced with centrally determined deliveries at those prices.

But price liberalization occurred at the margin. The SOEs could sell their output, beyond what the state contracted for, in the newly burgeoning “nonstate” sector at market prices; the lower panel of Chart 1 shows the 20–40 percent premium in prices charged in this free market. Fortunately, the absence of a monetary overhang limited this price gap and thus limited (but did not eliminate) the tendency for supply diversion—illicit transfers of scarce goods from the state sector to higher-price nonstate uses.5 As general liberalization proceeded through rapid industrial growth in the nonstate sector, the number of price-controlled goods in the state sector was continually reduced. But even these pegged prices were rationalized as prices of raw materials were increased in stages and prices of finished goods were sometimes scaled down.

China does not calculate a general producer price index (PPI). Because a PPI excludes services, it would show lower rates of price inflation, once the effects of price decontrol are removed, than do the retail price indexes of Table 1. Measured productivity growth in services is typically much less than it is in agricultural and industrial goods, particularly in a rapidly growing economy like China’s. The upshot is that since 1979, China has had a very stable price level in comparison with the often explosive price inflation in Eastern Europe.

Even without a monetary overhang at the outset, how was macroeconomic control in China subsequently sustained through 1992? One cannot look to Chinese fiscal policy for an answer. On the contrary, like all communist countries, China depended on price controls and ownership of state enterprises to generate and then collect huge surpluses from the industrial sector. By world standards, the domestic prices of industrial raw materials and agricultural wage goods were kept down compared with the prices of finished industrial goods. The resulting financial surpluses in most SOEs were then deposited in the state bank in blocked accounts as de facto government revenue.

But in all socialist countries, this implicit revenue system starts to unravel naturally as liberalization begins (McKinnon 1991). First, the government-owned share of industrial assets begins to fall. Second, price decontrol and industrial competition from both domestic and foreign sources tend to shrink the profit margins in all industrial enterprises, whether owned by the government or not. Indeed, many once (artificially) profitable SOEs become lossmakers. This tendency toward fiscal deterioration was qualitatively the same in China as in Eastern Europe or the FSU.

Table 4 shows the very sharp decline in the revenue of the Chinese (consolidated) Government from about 34.8 percent of GNP in 1978 to only 18.5 percent in 1991. To be sure, the government also sharply curbed expenditures, but the ambiguous financial position of lossmaking SOEs makes the net deficit hard to calculate. By including “policy loans”—that is, “forced” lending to the SOEs by the People’s Bank of China (the central bank), Christine Wong, Christopher Heady, and W. T. Woo (1993) calculate that the true consolidated fiscal deficit may have reached 10 percent of China’ GNP in 1991, as shown in Table 5.

Table 4.China’s Fiscal Situation in the Reform Period(Percentage of GNP)
RevenueExpenditureBudget Deficit
Chinese Definition“Standard” DefinitionChinese Definition“Standard”1 DefinitionChinese DefinitionGovernment Borrowing Requirement Definition2Stock Definition3
Source: Wong, Heady, and Woo (1993).

The “standard” definition of revenue subtracts the borrowing included in the Chinese definition and adds the subsidies that were counted as negative revenue. The “standard” definition of expenditure adds to the Chinese definition subsidies that were considered negative subsidies.

The government borrowing requirement definition of the deficit is “standard” expenditure minus “standard” revenue.

The “stock” definition of deficit is the government borrowing requirement definition minus principal repayments.

Source: Wong, Heady, and Woo (1993).

The “standard” definition of revenue subtracts the borrowing included in the Chinese definition and adds the subsidies that were counted as negative revenue. The “standard” definition of expenditure adds to the Chinese definition subsidies that were considered negative subsidies.

The government borrowing requirement definition of the deficit is “standard” expenditure minus “standard” revenue.

The “stock” definition of deficit is the government borrowing requirement definition minus principal repayments.

Table 5.Consolidated Deficit of Chinese Government and State-Owned Enterprises, 1988-91(Percentage of GNP)
Open Deficit1Hidden Deficit2Consolidated Deficit (1) + (2)A Conservative Reestimate3
Source: Wong, Heady, and Woo (1993).

Government borrowing requirement as in Table 4.

Central bank financing for the deficits of State-owned enterprises.

Assuming that the hidden deficit is 70 percent of the estimate in column (2).

Source: Wong, Heady, and Woo (1993).

Government borrowing requirement as in Table 4.

Central bank financing for the deficits of State-owned enterprises.

Assuming that the hidden deficit is 70 percent of the estimate in column (2).

In summary, there was ongoing fiscal deterioration in China from 1978 into the early 1990s. Growing open and hidden deficits have largely been covered by borrowing from the state banking system. And broad money growth in China has been very high, averaging about 23 percent per year for more than a decade. Whence our puzzle: how did China succeed in containing this inflationary pressure better than the socialist countries in Eastern Europe, which faced similar revenue declines? To be sure, China suffered significant price increases in 1985 and again in 1988–89 but successfully recovered by disinflating.

Self-Finance and Hard Budget Constraints for Chinese Farmers

After 1978, China swiftly moved to dissolve the communes in favor of smallholder agriculture—a change in incentive structures that immediately raised farm productivity. Equally important but less well appreciated, state marketing agencies sharply raised procurement prices farmers were paid for compulsory quotas of grains and other foodstuffs toward world market levels (Wong 1992). The remaining surpluses could then be freely sold in private markets. Together with the increase in output, this big improvement in the newly independent farmers’ terms of trade greatly increased the farmers’ cash flows. In the early 1980s, their improved cash position meant that farmers could finance their own on-farm investments, including residential construction, without significant borrowing from the state banking system or officially controlled rural credit cooperatives. In effect, very hard budget constraints but improved terms of trade were imposed on farmers as they entered the market economy.

As long as the price level remained relatively stable, as it did in the early 1980s (see Table 1), the newly independent farmers viewed themselves as undermonetized for purposes of financing on-farm investments. In part because farmers did not have access to bank credit, their desired stock of liquid assets was too small relative to their current income flow. They began building up their cash and savings deposits relative to their rising incomes. More by accident than by design, farmers, who made up over three quarters of the population in the early 1980s, became big net lenders to the government through the state banking system.

For statistical purposes, the financial position of farmers cannot easily be separated from that of the rest of the population. Table 6 shows that compared to urban household deposits, rural household savings deposits—that is, those accruing in rural credit cooperatives—initially grew proportionately faster than other deposits, rising from about 1.5 percent of GNP in 1978 to 6.3 percent in 1984. Nevertheless, the most important type of farm financial asset in the undermonetized state was probably hand-to-hand currency. Table 7 shows currency holdings also rising sharply in the early 1980s, from about 6 percent to 11 percent of GNP, and one suspects that currency is more heavily utilized than savings deposits in agricultural pursuits. (A currency buildup amounts to a loan to the government through the central bank.) Finally, some unknown fraction of the urban household savings deposits shown in Table 6—that is, those held in regular banks rather than rural credit cooperatives—is undoubtedly owned by farm households and smaller-scale ru-ral enterprises. The rapid rate of growth of rural income, combined with the buildup of farmers’ financial assets relative to their income, greatly augmented the lending resources of the state banking system.

Table 6.China: Household Bank Savings Deposits, 1978-91(In billions of yuan)
Total Household DepositsIncrease Over Previous Year (Percent)Urban Household Deposits1Increase Over Previous Year (Percent)Rural Household Deposits2Increase Over Previous Year (Percent)Total Household Deposits/GNP (Percent)
Sources: Statistical Yearbook of China, 1992; Qian 1993.

Deposits held by households in the state banking system.

Deposits held by households in rural credit cooperatives only.

Sources: Statistical Yearbook of China, 1992; Qian 1993.

Deposits held by households in the state banking system.

Deposits held by households in rural credit cooperatives only.

Table 7.China: Monetary Aggregates as Share of GNP(In percent)


Source: Almanac of China’s finance and Banking, 1990.

M1 = currency + enterprise and institution demand deposits.

M2 = M1 + household savings deposits (demand and time) + enterprise and institution time deposits. In China, household demand deposits are not checkable, but enterprise and institution demand deposits are.

Preliminary estimate.

Source: Almanac of China’s finance and Banking, 1990.

M1 = currency + enterprise and institution demand deposits.

M2 = M1 + household savings deposits (demand and time) + enterprise and institution time deposits. In China, household demand deposits are not checkable, but enterprise and institution demand deposits are.

Preliminary estimate.

Also critically important for China’s macroeconomic stability at this early stage was the relative absence of direct lending to the newly independent farmers. Table 8, courtesy of Qian (1993), shows that the total loans the rural credit cooperatives made to farm households, to TVEs, and to collective agriculture remained about one third to one half of total deposits from 1979 to 1984. (Even by 1991, these loans were still only two thirds of total deposits.) And farm households borrowed less than half of this reduced total of loans outstanding from the rural credit cooperatives. What was not lent out was kept on deposit as an informal reserve requirement with the Agricultural Bank of China (ABC). Because the ABC was a division of the state banking system, these funds were lent back to the government or its designees—an example of an “optimum” reserve tax (see McKinnon 1993b, Chapter 5). Also, taking their unrequited currency buildup into account, farmers were big net lenders to the rest of the economy at the critically important outset of liberalization in 1979-84.

Table 8.China: Rural Credit Cooperative Activities(In billions of yuan)

Loans to

Loans to

Loans to


Total Loans/

Total Deposits

Source: Qian 1993. Data taken from Statistical Yearbook of China, 1992.

Township and village enterprises.

Source: Qian 1993. Data taken from Statistical Yearbook of China, 1992.

Township and village enterprises.

Financial Deepening and Macroeconomic Balance: The Importance of Positive Real Interest Rates

From the mid-1980s through 1992, this dramatic and voluntary buildup of savings by rural households was replicated throughout the rest of the economy as industry succeeded agriculture as China’s leading growth sector. Table 7 shows the enormous increase in broad money holdings (M2) from about 28 percent of GNP in 1978 to about 97 percent in 1991. Because of the central government’s continued ownership and control of the state banking system, it could offset its deteriorating fiscal position by borrowing back the rapidly rising financial surpluses of urban and rural households or of the nonstate sector generally.

This government borrowing was noninflationary only because the relatively liberalized nonstate sector, which included the TVEs, was itself not a major claimant on the state banking system. In Table 9, Qian (1993) shows that in the late 1980s, loans to this nonstate sector—whether urban or rural—were generally only about 20 percent of the total outstanding loans of consolidated banking-type financial intermediaries. (And this 20 percent “limit” appears to be holding into the 1990s; industrial output in the nonstate sector now exceeds that of the traditional SOEs.) Without the government’s having to resort to a substantial inflation tax, the remaining 80 percent was sufficient to cover the financing needs of the old SOEs and the central government. This noninflation-ary mobilization of large-scale finance to cover the government’s fiscal deficits, both open and hidden, was the precarious keystone of macroeconomic stability in China in the 1980s, and it remains so today (1993) in the absence of major revenue-raising tax reforms.

Table 9.China: Bank Lending to the Nonstate Sector as a Proportion of Total Bank Loans Outstanding(In percent)




Sources: Almanac of China’s Finance and Banking, 1990; Qian 1993.

Township and village enterprises.

Sources: Almanac of China’s Finance and Banking, 1990; Qian 1993.

Township and village enterprises.

But why was the Chinese propensity to save in financial form so remarkably high? Price stability in China was, and still is, imperfect. Table 1 shows inflationary episodes in 1985 and 1988–89, and 1993 itself could be a year of a substantial cyclical upturn in the inflation rate. So China’s interest rate policy—particularly on savings deposits—remains very important in preserving the incentives of households and enterprises to build up their financial asset positions. Table 10 shows that the authorities have been relatively successful at keeping savings deposit rates positive in real terms, using the annual inflation rates in the national retail price index as the benchmark. (As discussed above, these real rates might look even higher if one used a decontrolled producer price index as the deflator.) A major problem arose in 1988–89, when inflation soared to 17-18 percent per year, turning the standard fixed interest rates on deposits and loans sharply negative (Table 10). But the government responded by fully indexing some interest rates. Nominal rates on three-year household time deposits were increased to between 20 percent and 26 percent in 1988–89 and so remained strongly positive in real terms (Table 11). Once inflation fell back to a very low level in 1990-91, however, this indexing was discontinued.

Table 10.China: Selected Interest Rates, 1980-911
Nominal Interest RatesReal Interest Rates


Price Index






Loan to

Loan to









per yearIn percent per year
Sources: Statistical Yearbook of China, 1992; Almanac of China’s Finance and Banking, 1990, 1992; Qian, 1993.

Year-end figures.

For circulation capital (one year).

For equipment.

Cost-of-living adfuslment allowance not included. See Table 11.

Sources: Statistical Yearbook of China, 1992; Almanac of China’s Finance and Banking, 1990, 1992; Qian, 1993.

Year-end figures.

For circulation capital (one year).

For equipment.

Cost-of-living adfuslment allowance not included. See Table 11.

Table 11.China: Deposit Interest Rates with Cost of Living Adjustment Allowance, 1988:IV-1991:IV(In percent)
Household 3-Year

Time Deposit

Annual Rate of




Household 3-Year

Time Deposit

1989:II1 1.1412.5925.73
Sources: Almanac of China’s Finance and Banking, 1990; Qian 1993.
Sources: Almanac of China’s Finance and Banking, 1990; Qian 1993.

Thus did China preserve the incentives for the nonstate sector in general, and households in particular, to accumulate monetary assets—including, in more recent years, government and industrial bonds. Because potential excess household purchasing power was soaked up, the supply and demand of hard money in the nonstate sector remained more or less in balance.

What about productivity growth in the nonstate sector? Although new industry in the nonstate sector did not receive much in the way of bank loans, financial deepening through higher deposit rates could still contribute to the nonstate sector’s high productivity growth, as has been observed by Gelb, Jefferson, and Singh (1993). Having access to attractive liquid financial assets inhibits bad physical investments with low or negative yields; at the same time, such access encourages intertemporal arbitrage for making good investments (McKinnon 1973; Burkett and Vogel 1991). In effect, attractive financial assets and productive physical capital are complementary.6

Industrial and Financial Dualism in China: The Macroeconomic Role of Price Controls in the State Sector

If there was no hard money overhang in Chinese households in 1978-79, why, then, did the Chinese Government retain (or only slowly remove) price controls in the old state sector after 1978? Unlike Eastern Europe, China did not attempt any sudden “big bang” liberalization or privatization of the state-owned industry that had been built up with distorted prices under the umbrella of central planning. Traditional heavy industry—whether in manufacturing, public utilities, or natural resources—remained firmly the responsibility of the central government.

The Chinese Government recognized that parts of the old heavy industrial sector would inevitably become unprofitable as prices were decontrolled or rationalized. Unprofitable state enterprises with, typically, thousands of workers could not be allowed to collapse just because of a change in economic regime. The social consequences would be too dire and the economic costs too great. While slowly raising the prices of raw materials relative to finished manufactured goods into better alignment with world market prices, the central government continued to prop up much of state-owned industry with low-cost bank loans and other subsidies. Because this practice perpetuated the syndrome of the soft budget constraint, state enterprises remained on a tight financial leash.

For example, at the outset of liberalization in the early 1980s, the SOEs were not permitted to bid freely with one another for scarce domestic resources or to bid unrestrictedly in an open market for foreign exchange. Producer prices in transactions among state-owned enterprises remained under centralized control and were only gradually phased out as the decade progressed. However, the government did allow a two-part pricing system to develop. Once state enterprises had satisfied their delivery commitments to one another at centrally controlled prices, they could sell any excess production at the margin to rapidly growing nonstate enterprises at market determined and usually somewhat higher prices, as Chart 1 shows. Similarly, the central government initially allocated all foreign exchange at the official exchange rate and then gradually allowed an interenterprise swap market to develop at a variable but modest premium over the official rate. Only by the early 1990s did this open swap market become the dominant method of allocating foreign exchange among enterprises.

Contrast this cautious approach with the “big bang” price decontrol in Russia on January 1, 1992. Suddenly, state-owned enterprises (with very soft budget constraints) could bid and negotiate prices freely for all goods, services, and foreign exchange the enterprises purchased from one another. Russian households, however, remained somewhat wage and cash constrained. The result in 1992 was a price explosion at the producer level, as shown in Chart 2. This explosion was led by a tremendous increase in the ruble price of foreign exchange, from about 5 rubles to the dollar at the beginning of the year to about 500 rubles at the end. (Because of multiple rates in 1991, the “true” ruble-dollar rate at the beginning of 1992 is ambiguous.)

Chart 2.Russia: Wage and Wholesale and Consumer Price Indexes, January 1992-January 1993

(December 1991=100)

Unlike in Russia, the Chinese authorities correctly recognized that price controls are necessary to anchor the producer price level when (i) enterprise budget constraints are still very soft, and (ii) there is not yet sufficient competition in the provision of individual raw materials or more complex producer goods from a hard-budget nonstate sector. Even if the government succeeded in controlling both wages in SOEs and the stock of “hard” household cash in circulation among households and the nonstate sector, this initiative by itself would be insufficient to peg the producer price level. Although the Chinese authorities slowly adjusted relative producer prices, they still anchored the producer price level by pegging most nominal prices of the goods and services traded among state enterprises in the early years of liberalization.

In positing an optimal order of economic liberalization, a dualistic set of financial, fiscal, and price controls should apply differentially to the traditional and liberalized sectors in the early years of the transition (McKinnon 1993b, Chapter 11). This industrial and financial dualism corresponds loosely to China’s distinction between its state and nonstate sectors. A more elaborate “model” dualistic control mechanism—taking the Chinese experience through 1992 into account—is displayed in Table 12.

Table 12.Alternative Financial Arrangements for Enterprises In a Model Transitional Economy


(State Sector)1
Liberalized Enterprises (Nonstate sector)
TaxationExpropriation of surpluses5Uniform value-added taxUniform value-added tax
Deposit Money: Domestic commodity convertibility3RestrictedUnrestricted interest-bearingUnrestricted interest-bearing
Credit eligibilityState bankNonbank capital marketNonbank capital market
WagesGovernment determinedCollectively determinedMarket determined
Residual profitsAccrue to governmentDividends to collective: retained earnings for reinvestmentDividends to owners,4 retained earnings for reinvestment, or lending to other private enterprises
Foreign exchange convertibilityRestrictedCurrent account only (swap market)Current account only (swap market)
Producer pricesPegged with intramarginal delivery quotas6Market determinedMarket determined

“Traditional” enterprises are those whose output and pricing decisions are still largely determined by a central government authority or planning bureau with centrally allocated inputs and credits from the state bank to cover (possible) negative cash flows. In China, traditional enterprises would be in the so-called “state” sector, while new entities outside these traditional controls would be in the “nonstate” sector.

“Collective” can refer to any level of government ownership or sponsorship, as with Chinese TVEs—township and village enterprises. For example, the value-added tax (VAT) administered by the central government would apply equally to liberalized enterprises owned or registered in different local jurisdictions.

Although residual profits revert to the state, they could include a “shadow” VAT levy in order to better express the “true” profitability of traditional enterprises.

“Commodity convertibility” here means the freedom to spend for domestic goods and services or to buy and hold domestic coin and currency—but need not imply convertibility into foreign exchange.

Dividends would be subject to the personal income tax when paid out to private owners, but retained earnings would not be taxed.

After satisfying delivery commitments to other traditional enterprises, marginal output can be sold at free market prices.

“Traditional” enterprises are those whose output and pricing decisions are still largely determined by a central government authority or planning bureau with centrally allocated inputs and credits from the state bank to cover (possible) negative cash flows. In China, traditional enterprises would be in the so-called “state” sector, while new entities outside these traditional controls would be in the “nonstate” sector.

“Collective” can refer to any level of government ownership or sponsorship, as with Chinese TVEs—township and village enterprises. For example, the value-added tax (VAT) administered by the central government would apply equally to liberalized enterprises owned or registered in different local jurisdictions.

Although residual profits revert to the state, they could include a “shadow” VAT levy in order to better express the “true” profitability of traditional enterprises.

“Commodity convertibility” here means the freedom to spend for domestic goods and services or to buy and hold domestic coin and currency—but need not imply convertibility into foreign exchange.

Dividends would be subject to the personal income tax when paid out to private owners, but retained earnings would not be taxed.

After satisfying delivery commitments to other traditional enterprises, marginal output can be sold at free market prices.

However, once the cash-constrained nonstate sector becomes big enough to compete vigorously with the old state sector in product markets, the government can relax price controls in the state sector. Together, the TVEs and private industries in the nonstate sector, broadly defined, now rival in size the aggregate industrial output of the old state sector. In 1978, collective or private industry in China was officially tabulated to be 22 percent of total output, but, mainly because of the growth of the TVEs, by 1991 this figure had risen to 53.7 percent (Perkins 1992). Because these new enterprises, operating with hard budget constraints, now compete vigorously with the old state sector, in the early 1990s price controls within the latter could be almost entirely eliminated without upsetting the producer price level—providing the amount of hard cash in circulation in the nonstate sector remained under control. Even into the 1990s, however, the old SOEs have still needed to be financially constrained from bidding for scarce resources like foreign exchange, insofar as they are also recipients of soft loans from the state banking system.

Tax Reform and the Optimal Pace of Financial Liberalization: China and Eastern Europe Compared

To be soundly financed, and for the state banking system to stay profitable, a reform government’s high interest rate strategy for household deposits requires even higher average interest rates on loans. China did not always manage to maintain the needed levels. Occasionally, an inversion made some loan rates lower than the equivalent deposit rates, particularly during the 1988-89 period, when nominal deposit rates were indexed. Such an inversion adds to the banking system’s and the government’s “hidden” deficit, beyond simply the deficit associated with the nonrepayment of bad loans to the SOEs.

Even without this inversion, this method of high-interest noninflationary financing implies that the Chinese Government’s open and hidden debt—through the state banking system to the non-bank public—is building up fast. But measuring the size of this official debt is complicated and cannot be undertaken here.

Moreover, as long as the government is leaning on the state banking system as a crutch to cover its own fiscal deficits, the scope for liberalizing—let alone for privatizing—the banks is limited. At this stage, the government cannot afford a parallel system of independent banks with unrestricted deposit and lending privileges to serve the TVEs or the private sector. Such banks would compete away the deposit-taking capabilities of the state banking system. (This may already be happening. To escape the direct credit controls imposed by the People’s Bank of China, the state banks themselves may be transferring some of their activities to less highly regulated and taxed finance and trust companies [Qian 1993].) If the Chinese Government threw away its financial crutch by, say, permitting unrestricted wildcat banking in the mode of the FSU, an inflationary explosion would ensue.

Like East European governments, the Chinese central government has failed to set up an effective internal revenue service for collecting revenue in a decentralized market economy. Unlike Eastern Europe, however, China has resorted more effectively to various “second-best” schemes for revenue collection. After 1978, by retaining control over traditionally profitable industrial enterprises, the central government was able to continue collecting revenue—turnover taxes and residual profits—directly for itself. Then, by the mid-1980s, as revenue from state-owned enterprises fell, the central government began an elaborate system of tax contracting with local governments to remit revenue to the center (Wong, Heady, and Woo 1993).

Still, this system left the government with a serious revenue shortfall for financing infrastructure investments; subsidizing lossmaking, old-line industrial enterprises; providing higher agricultural procurement prices; and so on. The salaries of high-level civil servants and educators have declined sharply relative to those in the nonstate sector. This decline in the fiscal position of the central government is clearly neither sustainable nor in the best long-run interests of Chinese economic development; among other problems, officials are more easily corrupted when their salaries are low.

The Chinese Government cannot rely indefinitely on such heavy borrowing, because households are no longer undermonetized and the M2-GNP ratio will not rise to infinity. When the ratio of household liquid assets to income peaks out, or even before, there will be a financial crisis if state-sector borrowing continues. The great economic accomplishments of the last 13 years will then be at risk, and an East European-style inflation cannot be ruled out.

The solution is obvious economically but difficult politically. The Chinese central government must quickly institute an internal revenue service capable of directly taxing all industries—central government, local government, and private—as well as the agricultural sector. Domestic and foreign trade should be covered uniformly so that the rate of business taxation can be kept moderate, as with a uniform value-added tax (VAT). At a somewhat later stage, households could systematically be brought under a personal income tax, but that approach is feasible only as people become wealthier. Aspects of how to implement this new tax regime are analyzed in McKinnon (1993, Chapter 11) and in Wong et al (1993).

In the transition in Eastern Europe and the FSU, by contrast, the need for fiscal reform is more immediate than it was in China. The initial decreases in output (see Table 2) and unfavorable inflationary expectations (see Table 3) have made it much more difficult for these governments to obtain noninflationary finance by borrowing from their banking systems in the Chinese mode. The growth in the real size of their financial systems is too small and could even be negative. Therefore, if further inflationary explosions are to be avoided, effective fiscal reforms must come much earlier in their transitions.

Russia’s Economic Dilemma Before the Big Bang, January 1992: Partial Price Liberalization and Supply Diversion

It was a major mistake for the Russian Federation, in January 1992, to suddenly place controls on virtually all prices within the state sector and to stop trying to enforce normal patterns of delivery within that sector. This “big bang” approach was very different from Chinese gradualism. On the other hand, some conditions in Russia in 1992 were very different from those prevailing in China in 1979. Moreover, the Yeltsin-Gaidar reform government in Moscow was acting in good faith and seemed to be following the advice of international agencies like the IMF and the World Bank and of most Western economists. So a careful review of some of the arguments that were presented prior to that fateful January in favor of the “big bang” approach seems worthwhile.

Two related arguments in favor of sudden liberalization in Russia can be adduced. The first was mainly macroeconomic and, following the Polish precedent of January 1990, was directed toward eliminating a monetary overhang at previously controlled prices by a one-time inflation. In the last section of this article, I take up this influential monetary overhang argument.

The second argument was more microeconomic in nature and was concerned with the sieve-like character of the previous system of price controls. In 1991, a substantial fringe of unregulated activities had developed in Russia’s nonstate sector, where prices were free and hard monies circulated. Unlike China, there was more small-scale trade, both legal and illegal, and relatively little production in this nonstate sector, if only because Russia had made little progress in liberalizing agriculture. Black market activities were rampant. This second influential argument emphasizes “supply diversion.”

A recent article, “The Transition to a Market Economy: Pitfalls of Partial Reform” (Murphy, Shleifer, and Vishny 1992), argues that partial reform, where prices are decontrolled in the nonstate sector but not in the state sector, is a mistake. (The authors had been to Russia and written their paper before January 1992.) If controlled prices in the state sector are set below those in the free market dominated by the nonstate sector, scarce inputs may be diverted from high-value to low-value uses, including to foreign trade. Such massive supply diversion from partial price liberalization, the authors argue, provoked the fall in output in 1991 in the FSU in general and in Russia in particular.

These authors illustrate their important and influential argument with several examples, one of which is worth repeating. Suppose an important industrial input, say timber, can be used for the production of railway boxcars in the state sector or for the production of family homes in the nonstate sector. The demand for timber for boxcars is relatively inelastic, reflecting a high producer surplus within the railway industry for providing general transportation. In contrast, the demand for timber in the housing industry is relatively elastic, and consumer surplus is relatively low. Like most raw materials in socialist economies, timber traditionally has been underpriced in terms of finished manufactures. Suppose such price controls are retained in the state sector, so that users of boxcars cannot bid beyond a set price, say P*, for timber.

In a partial liberalization, suppose now that a nonstate housing industry can bid for timber from forestry enterprises in the state sector at free market prices. By bidding slightly above P*, the nonstate housing industry could expand very rapidly at the margin. Unrestricted entry by small construction firms could rapidly absorb this key raw material and cause a collapse of the output of vital railway cars in the transportation network. (The same output collapse of railway cars could also happen if the nonstate sector bid away timber products for export.) When output fell in Russia in 1991, there were price controls on what state firms could pay for various inputs in terms of quasi-blocked enterprise money, while nonstate firms in the “cash” economy sometimes had a much freer hand in the bidding process and could even bid with more attractive household money.

This provocative article does not refer to the different financial circumstances, including the different monetary circuits, of state and nonstate enterprises. It focuses only on the anomalies of the two-part pricing system. In this narrower context, the authors identify two solutions to the problem of supply diversion:

  • First, keep the two-part pricing system in place but strengthen the old system of state orders for enforcing minimal deliveries of price-controlled inputs in critical industries within the old state sector; or

  • Second, abandon two-part pricing within the state sector, and thus eliminate both price controls and bidding restraints on state firms competing with nonstate firms for scarce inputs.

In assessing the first point, the authors note that the Chinese Government started off its liberalization with an extensive two-part pricing system in the traditional state sector. However, Christine Wong (1992) notes that relative prices within the state sector were also realigned to push them closer to those prevailing internationally:

During the first period in 1979–84, in agriculture state procurement prices were raised substantially across the board .... In industry, the prices of 29 producers’ goods were raised during 1979–81, including those for coal, pig iron, coking coal, cement, plate glass, and some steel products. Other prices were reduced: those for machinery, instruments, and tools. The prices of many consumer goods were also reduced from their initially very high levels, including wrist watches, televisions, tape recorders, radios, synthetic fabrics, etc.

At the same time more prices were freed to market determination through two devices. The first was to reduce the scope of planned allocation. In agriculture, the number of products was reduced from 46 to 22 in 1982, and further to 12 in 1984. In industry, the number of producers’ goods under plan allocation was reduced from 256 in 1979 to 30 in 1984. By 1984, virtually all “minor” consumer prices had been freed.

The second device was to allow some of the goods in the key sectors that remained under state control to enter into market channels, a development that gave rise to the “dual” price system that emerged in the mid-1980s … whereby the proportion of output under state plans would continue to be traded at plan prices, while extra-plan output would be traded at (higher) “extra-plan” prices … to provide better (profit) incentives at the margin. (Wong 1992, p. 72)

However, for the Russian case, Murphy, Schleifer, and Vishny (1992) reject the Chinese solution of partial liberalization with dual pricing. They claim that the different political circumstances in China, where the Communist party has retained centralized power, could force state firms to deliver their assigned quotas at below-market prices, so that private buyers would be able to buy only surplus production at the higher prices. Because of the decline of the Communist party in Russia, however, the authors claim that delivery quotas for state enterprises have already been relaxed, and it would now be impossible to enforce such delivery quotas even if the Russian Government wanted to. Therefore, the authors conclude that the gradualist approach based on partial price reform—the first point above—should be scrapped in favor of full price liberalization—the second point above: “The most natural implication of the analysis in this paper is that price reform should take the form of a big bang, with all prices being freed at once … Fortunately, the Russian Government moved to an almost complete price liberalization in 1992” (Murphy, Shleifer, and Vishny 1992, p. 906).

Unfortunately, unrestrained bidding for scarce inputs by Russian state enterprises from January 1992 onward led to an even bigger inflationary explosion and sharper fall in real output than under the partial price reforms of 1990-91:

The Russian economic depression deepened dramatically in 1992 with GDP falling 19% and NMP (net material product) produced down 20%. Since reaching a peak in 1989, the level of NMP produced has fallen by nearly 32%, with GDP falling slightly less. The major change in 1992 compared to 1990–91 is that consumption had to bear the brunt of the decline in aggregate output—it fell by 15–16% compared to less than 3% drop in 1991. The level of net investment … in 1992 fell to less than one third (!) of its peak 1988 level.

Russia made no headway in controlling inflation last year. The end-December level of consumer prices was up by a factor of 26.3 relative to December 1991 while the industrial wholesale price index was up a staggering 62.2 times for the same period. These figures imply average monthly inflation rates of 31.3% and 41.1%, respectively. (PlanEcon Report, March 1993, p. 1)

What went wrong? Was there some major flaw in the three authors’ persuasive argument for a “big bang” price reform jointly encompassing both the state and nonstate (household) sectors? Or did Russian reformers again simply not go far enough—a line of thought to which many influential outsiders still adhere?7

Indeterminacy in the Producer Price Level with Unconstrained Bidding by State Enterprises

The “big bang” argument for total price decontrol is flawed if some of the important actors bidding for scarce resources have soft budget constraints. If Russia’s state enterprises are not financially constrained, no meaningful equilibrium in producer prices exists. Until their budget constraints are hardened, unconstrained bidding by state enterprises will cause the producer (wholesale) price level to increase indefinitely—and thus also increase relative to the retail prices cash-constrained households face. After presenting evidence on this point, I discuss the underlying financial mechanisms.

Taking December 1991 as the base month just prior to the massive price increases of January 1992 and using data from the Russian Ministry of the Economy, Mikhail Bernstam of Stanford University’s Hoover Institution plotted Chart 2: the course of Russian wholesale and consumer prices and wages on a monthly basis from January 1992 through January 1993. The key point is the explosive growth in wholesale prices relative to consumer prices or wages in the initial months after price decontrol. All the increases are astronomical, but by October 1992, wholesale prices had risen almost 2.5 times as much as consumer prices. And from the fragmentary data, by the end of the year consumer prices had risen twice as much as wages, so that wholesale or producer prices had actually risen five times as much as wages.

However, in such a financially volatile context, data sources are hard to reconcile. Because of the more or less complete decontrol of prices (but not wages) in January 1992, rates of growth in monthly time series data in 1992 were particularly difficult to interpret. For example, in December 1991, the general retail price index stood at 282.6 (1990 being 100) and then jumped to 941.0 in January 1992, an increase of 230 percent in just one month. But this one-time outburst of extraordinary inflation was designed to work off the large cash overhang that had been rapidly building in 1991, when retail prices were still partially controlled. (Although difficult to measure, the overhang component of household cash holdings might have been as high as 50 percent of total wage and salary income in 1991.) But nominal wages remained controlled and rose only about 31 percent in January 1992. So real wages fell very sharply in January 1992, a fall not recouped by subsequent substantial but controlled increases in nominal wages relative to retail prices.

Because the Russian Government’s power to tax the household sector is very limited, these imperfect wage controls are the principle means by which the Russian Government can restrict the supply of new money—including savings deposits—in the household monetary circuit. And indeed, household saving deposits as a share of retail sales turnover fell dramatically—from 60 percent in 1991 to about 25 percent in mid-1992—and had virtually vanished by the end of 1992. Similarly, in this world of imperfect statistics, the (ruble) currency-to-GNP ratio was about 10 percent at the beginning of 1992 and had fallen to about 3 percent by the end of the year. This decrease is one reflection of the 1992 “cash shortage” in Russia and other former Soviet republics.

In great contrast to the financial deepening in China, with M2-GNP near 100 percent by the end of 1992, the purchasing power of money (in rubles) held by the nonbank public in Russia had become very small—probably around 3 percent of GNP, with the household deposit base of the banking system wiped out.

Another data source showing the extraordinary pattern of price changes in the Russian economy in early 1992 is in various parts of the PlanEcon Report that are collated and rearranged in Table 13. From December 1991 through June 1992, ruble wages increased about 4 times, retail prices between 6 and 7 times, wholesale prices between 18 and 19 times, and the ruble price of dollars about 33 times.

Table 13.Key Russian Inflation Indicators, 1985-June 1992(Annual change, in percent)
1985198619871988198919901991Jan.-June 1992/

Jan.-June 1991
June 1992/

Dec. 1991
Wholesale industrial prices1.23.9138.11,3601,850
Consolidated retail prices0.
Food (excluding alcohol)
Alcoholic beverages6.224.715.
Nonfood products–0.9–
Prices for paid services70.6480510
Retail prices in: State and cooperative trade0.
Cooperative trade1.
Collective farms5.
Nominal wages71.6397
Commercial exchange rate3,290
Sources: Russian Goskomstat and PlanEcon Report September 3, 1992.
Sources: Russian Goskomstat and PlanEcon Report September 3, 1992.

To help interpret this incredible increase in the price of foreign exchange, the PlanEcon Report (September 1992) estimated that the purchasing power parity (PPP) exchange rate (using CPI comparisons) was 6 rubles to the dollar when the commercial rate was pegged at 55 rubles to the dollar in June 1992. Subsequently, this commercial rate was further freed to be determined by market forces in the Moscow interbank currency exchange (opened in 1991) and rose to 143 rubles to the dollar in July 1992 and to 241 on September 22, 1992. “At the end of trading, [the ruble] had sunk to 241 against the dollar—a loss of 35.5 rubles on last week’s level of Rbs 205.5 to the dollar. The volume of dollars traded was also a record, at $68.8m—a sign of the willingness of Russian enterprises to use Rbsl5bn to buy the US currency as a hedge against inflation.” (Financial Times, September 23, 1992, p. 4; italics mine).

What is going on here? As in the classic centrally planned socialist economy, Russian enterprises were still on a soft-money circuit—deposits with, and credits from, the state banks. In contrast, households and the emerging nonstate commercial sector were on the relatively hard-money or cash circuit. This softness of financial constraints on the old state enterprises has two related aspects, as follows:

First, central government enterprises in Russia have traditionally had access to low (nominal) interest rate credits from the state banking system and from other state enterprises. In the face of rapid price inflation, which results in almost complete debt forgiveness in real terms (as happened in 1992), these bank credits become a massive subsidy. In addition, by simply not repaying their trade credits, state enterprises also borrow heavily from one another. Although ostensibly commercial in nature, this credit, which is not subject to ordinary commercial restraints, became a prime cause of softness in enterprise budget constraints in 1992.

Second, enterprises had no hard deposit money or interest-bearing assets denominated in rubles that they could hold either for short-term liquidity or as a longer-term store of value. Indeed, in the traditional Soviet monetary system, enterprises were, and still are, enjoined from holding household cash balances and have had to hold noninterest (or trivially low-interest) deposits with the state bank in several categories of quasi-blocked accounts. Not only are these ruble accounts not liquid, but in the past they have been subject to arbitrary seizure and confiscation by the government as an informal method of tax collection. (Residual profits of state enterprises traditionally accrue to the central government anyway.) From the existing explosive inflation, the low nominal rates of interest, and the threat of confiscation, enterprises see very negative real deposit rates on any of the ruble monetary assets they cannot avoid accumulating.

In these circumstances, if state enterprises are given the option of bidding (with their soft money) for foreign exchange assets in virtually any form, they will grossly overbid. Although imported producer and consumer goods are in heavy demand, enterprises are even more desperate to find a nondepreciating liquid financial asset they can legally hold through time. Apart from excess physical inventories of inputs and outputs, foreign bank accounts or other foreign exchange assets are very attractive inflation hedges at this unfortunate juncture in Russia’s financial affairs. Thus, in a market for foreign exchange dominated by state enterprises, the ruble price of dollars is bid up beyond any conceivable level warranted by purchasing power parity.

The Role of Price Controls on State Sector Enterprises in the Transition

Before liberalization occurs, price and wage controls in a typical socialist economy have a dual economic function.

First, government revenue depends implicitly on the structure of relative prices. The government “distorts” relative prices in order to generate surplus profits within the state-owned industrial sector (McKinnon 1993b, Chapter 11). In comparison with world markets, domestic prices of primary products, industrial materials, and money wages are deliberately kept low relative to the domestic prices of finished manufactures. As described above, the resulting surpluses in enterprise cash flows are then deposited in blocked accounts with the state bank (the government’s operative tax revenue.)

Second, price controls are also necessary to peg the absolute producer price level—that is, to provide a nominal anchor for prices charged in trade among state enterprises with soft budget constraints. Otherwise, if any open bidding were allowed, producer prices would be indeterminate, as with the 1992 Russian price explosion. (If excess money issue and price inflation existed at the consumer level, continual movement indexing of wholesale prices to ever higher official pegs would become necessary.)

In an optimal order of liberalization for the economy as a whole, both situations just described constrain the pace at which prices in the state sector can be safely decontrolled. When liberalization begins, the government’s revenue position is undermined if competitive pressure undercuts monopoly profits in the industrial sector and finished goods prices fall relative to material inputs and wages. This fall in tax revenue can result in both excessive hard money creation in the household sector and inflationary pressure that is first manifest at the consumer level.

Consequently, without a satisfactory internal revenue service for collecting income and commodity taxes on a general basis, liberalizing socialist governments must retain wage controls as a second-best way of taxing personal income. These wage controls maintain the profit position of the state enterprises, on the one hand, and prevent too much soft enterprise money from being converted into hard household cash—hand-to-hand currency and savings deposits—on the other. For example, to maintain the government’s revenue position and a modicum of monetary control, Poland’s otherwise “big bang” price liberalization at the beginning of 1990 was accompanied by stringent wage controls. Initially, money wages in Poland rose more slowly than the final output prices consumers had to pay. Similarly, in Russia’s “big bang” liberalization at the beginning of 1992, wage controls led to a sharp fall in real wages as inflation accelerated.

This draconian, albeit informal, system of personal income taxation may initially succeed in curbing inflation at the retail and household level. Hard cash in circulation may be effectively limited, as was initially true in Russia in 1992. But by themselves, wage controls are not enough to prevent an inflationary explosion in the prices prevailing in trade among state enterprises, including the price of foreign exchange—whence the dramatically unbalanced inflation process observed in Russia in 1992.

Consequently, price and credit controls may have to be retained in the old state sector, even after a proper system of general taxation is put in place and the revenue position of the central government appears to be balanced. As long as the money and credit positions of the old state enterprises remain soft, direct price controls in this sector will remain necessary until a cash-constrained nonstate sector becomes large enough to be an effective competitor.

Choosing the Right Model of Inflation in Order to Disinflate Efficiently: A Simple Taxonomy

In designing an efficient program for ending price inflation in any economy, it is important to choose the right model of the inflationary process itself. Three possibilities can be considered.

Open inflation in market economies

The traditional textbook analysis of open inflation starts with a unified monetary system and market-determined prices. Excessive lending by the central bank to the government or its designees causes cash or “high-powered” money in circulation to rise sharply. With a lag, prices then begin moving upward and eventually catch up with the increased amount of nominal money outstanding. But the money supply is the proximate causal variable for the increase in prices, as in most Latin American inflations.

Repressed inflation with a cash overhang

In the now-standard analysis of repressed inflation with general price and wage controls, economists envisage a single well-defined monetary overhang interchangeably owned by households and enterprises in an essentially unified monetary system (see Barro and Grossman [1976] generally, or Lipton and Sachs [1990] for Poland in particular). If the economy is to begin functioning properly, however, the overhang must be eliminated by canceling much of the outstanding nominal money in circulation, as happened in West Germany in 1948, or by open inflation. By removing price controls and devaluing the currency in the foreign exchanges in January 1990, the Polish Government planned to inflate away the purchasing power of its monetary overhang and was fairly successful in doing so. In principle, if new sources of cash injections into the economy are limited, inflation should come to a halt after a one-time increase in the price level. (Because Poland’s fiscal policy remains weak, however, the Poles may not fully succeed in reasserting monetary control.)

These two highly simplified models of either open or repressed inflation assume a unified monetary system where households and enterprises are on essentially the same monetary circuit and have fairly hard budget constraints. Was this a reasonable assumption for Poland on January 1, 1990? In the 1980s, Poland had a history of attempted financial liberalizations and banking reforms—with a lot of missteps—that tended to obliterate the sharp distinction between household cash and savings accounts and the deposit or credit money owned by firms. Both could traffic with cash and were subject to restraint in bidding for scarce resources by their cash positions if the government limited new credits or other subsidies. Then, if the Polish Government could get control over the cash base within this unified monetary system, that situation would be sufficient to bring inflation under control.

Producer price inflation in enterprises with soft budget constraints

Russia’s financial-monetary system—and that of other countries in the Commonwealth of Independent States (CIS)—in 1991–93 would seem to be qualitatively different from Poland’s at the beginning of 1990. Russia had essentially retained the old socialist distinction between enterprises—which were not cash constrained in their ability to bid for scarce resources—and cash-constrained households. Even so, Russia went ahead and suddenly decontrolled all producer prices, with disastrous consequences. Although this Russian model of inflation is not yet in any textbook, it soon will be.

How does Russia get the inflation genie back into the bottle? In the short run, successful macroeconomic stabilization requires a major recentralization of the government’s control over money and credit and a reassertion of the primacy of the state-controlled banking system, including the elimination of independent “wild-cat” banks. Because of the special characteristics of socialist industry, price setting at the producer level (including of the exchange rate) may also have to be recentralized as part of the stabilization package. So there is an unfortunate policy dilemma: to secure macroeconomic stabilization in the near term, important banking and commodity pricing policies may have to move counter to what most economists would like to see for the long-run liberalization of the Russian economy.

But this dilemma between short and long run is less acute for fiscal policy. A drastic improvement in the Russian Government’s ability to collect tax revenue is necessary for macroeconomic stabilization, on the one hand, and for sustaining the longer-term market-oriented and institutional reforms, on the other.


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Donald Mathieson

Ronald McKinnon has presented an insightful and well-reasoned analysis of the Chinese reform experience, illustrating the strengths and weaknesses that are associated with a relatively gradual transition from a centrally planned to a market-based economy. His paper raises important questions about the implications of the Chinese experience for the stabilization and structural reform programs in the other transition economies. I would first like to comment on Mr. McKinnon’s analysis of the Chinese reforms and then turn to the implications of the Chinese experience for other transition economies.

Mr. McKinnon has identified two major problems associated with the Chinese reform program. One is the chronic fiscal control problem arising from both difficulties in curtailing expenditures and raising revenues. The Chinese Government will undoubtedly address this problem, but it will not be an easy one to resolve. A second problem associated with China’s current financial policies that is likely to make future reforms more difficult is the heavy government involvement in the banking system. Indeed, a large proportion of bank lending in China takes place at the government’s behest and is directed either to state-owned enterprises or to the government itself.

In addition to the usual problems such government-directed lending can create (nonviable loans) there is another major problem: it inhibits the reorienting and retraining of staff to enable them to deal with the decentralized and more market-oriented banking system that will ultimately have to come into existence. The training process will involve familiarizing bank personnel with the techniques for evaluating creditworthiness and for creating a prudent supervision system. These concepts are difficult to introduce into a banking system whose lending activities have traditionally been directed by the government.

Moreover, a significant moral hazard problem can also arise during the transition from a state-owned to a more market-oriented financial system. Market discipline is difficult to establish if depositors implicitly assume that the government is going to guarantee their liabilities to the banking system.

One aspect of financial intermediation in China has not yet been mentioned. I have always regarded the role of foreign direct investment—which generally is not considered a financial intermediation activity—as a fairly important source of financial intermediation services for the Chinese economy. Since the mid-1980s, foreign investment has taken place on a large scale in China and recently has been expanding. The scale of this activity, especially in the most productive regions, is such that it can be treated as an intermediation process between external savers and domestic investors. In a sense, it has allowed China to operate with a relatively narrow banking system and has significantly reduced the cost of not having a fully functioning financial intermediary system.

I would just like to touch on how Mr. McKinnon’s reform proposals differ from some of the other plans and proposals that are currently in place or under discussion. I am not going to talk about all the elements of reform but will merely touch on the similarities and differences that have surfaced in a few of what are, to my mind, the key areas.

On the question of fiscal reform, the various proposals largely agree. The general advice is to initiate fiscal reform early on, for all the reasons that Mr. McKinnon stressed. However, the Chinese undertook their fiscal reforms much later in their reform process than Mr. McKinnon would recommend.

Mr. McKinnon’s plan begins to differ both from the experience with ongoing reforms and from other proposals in relation to what I call price reform (broadly defined as including both goods and asset prices). Mr. McKinnon criticizes the price liberalization that took place in Russia and argues that when it was combined with soft budget constraints on state-owned enterprises, the results were an overshooting of goods prices and a depreciation of the real exchange rate. He would argue, I am sure, that the same thing will happen in other states of the former Soviet Union if they use the same reform sequence. Similarly, in his other work, Mr. McKinnon has been reluctant to allow for a freeing of asset prices. Although an advocate of what I would call modest positive real interest rates, he has been reluctant to endorse full interest rate liberalization.

Given Mr. McKinnon’s earlier work on financial liberalization, one relevant issue might be why this stance on interest rate policy seems at odds with his earlier views that interest rates should be liberalized fairly early in the reform process. The question is a complex one and requires that interest rate liberalization be analyzed on two levels. Interest rate liberalization has consequences not only for the assets and liabilities of the banking system but also for the process that the central bank uses to inject credit into the banking system. For example, the Federal Reserve injects base money into the U.S. financial system primarily through a series of open market operations; in a sense, it auctions off the credit to the banking system. A variety of similar proposals that have been made for the Russian stabilization program involve setting a target path for central bank credit to the banking system and then auctioning off that credit. This approach has many attractive features. It is used in many countries and has been an element of numerous IMF programs. However, as I understand Mr. McKinnon’s analysis, it could lead to serious difficulties in China and elsewhere.

Why would there potentially be problems? Mr. McKinnon’s view is basically that Russia, China, and other transition economies have institutional structures incompatible with auction markets. In order for auction markets to function appropriately, the participants must either be wealth constrained or creditworthy and able to borrow at a fixed interest rate. As I understand Mr. McKinnon’s arguments, participants in the auction market are unlikely to meet either condition under the current circumstances in China and Russia.

Auctioning credit or freeing deposit rates does two things, in Mr. McKinnon’s analysis. First, it can produce high real interest rates, as the insolvent players have a strong incentive to bid high because they either do not expect to have to repay the credit or assume that the government will bail them out. Second, these auctions also tend to ration credit away from the solvent players. The individuals and companies who really do have something to lose will not be willing to pay the same high real rates as the insolvent players.

Is there a way around this problem? Mr. McKinnon’s analysis involves a solution that harks back to the use of credit controls in both industrial and developing countries. With these controls, credit is allocated on the basis of what the Japanese would call “window guidance policy.” In other words, credit is allowed to expand proportionally to the deposit base or total assets. This technique acts as a means, albeit imperfect, of limiting the ability of insolvent institutions to expand their activities at the expense of solvent institutions. Thus, the main reason why Mr. McKinnon’s earlier and later analyses differ in terms of goods and asset prices relates to the presence or absence of solvent participants in auction markets. This factor must be taken into account in the early stages of the design of stabilization and structural reform programs. In turn, it bears on the question of whether the FSU countries are unique. As I understand the gist of Mr. McKinnon’s message, it is that they do differ from other economies, not in the sense that the way in which their markets work is somehow unique but rather in the sense that the nature of the participants in the market is different.

Just one final remark about this analysis. How can the solvency problem be dealt with? Mr. McKinnon has stressed an approach that is essentially based on reestablishing central control—that is, on bringing decision making on asset and goods prices back under some form of centralized control. This path is not one that most other proposals have outlined. The proposals put forward by Jeffrey Sachs and others stress the importance of trying to introduce solvency in a number of ways, including through the rapid privatization of state enterprises. These proposals also stress the importance of current account convertibility, because convertibility imposes a form of discipline on the relative price structure.

Omotunde Johnson

At the outset, I will state what I see as the crux of Ronald McKinnon’s argument, and then I will make a few additional points. Mr. McKinnon argues that it was a major mistake for the Russian authorities to attempt the “big bang” approach to economic reform and, in particular, to suddenly decontrol state sector prices and simultaneously end the old socialist pattern of delivery in January 1992. In his view, the “big bang” argument is flawed if the major economic entities bidding for scarce resources are operating with soft budget constraints. He notes that since Russia’s state enterprises were not financially constrained, producer prices had no meaningful equilibrium level and certainly could not serve as nominal anchors, as they would in a typical market economy.

It was also a mistake, in Mr. McKinnon’s view, to give up the implicit revenue yielded by price and wage controls in the state sector before a satisfactory mechanism had been put in place to collect general income and commodity taxes. Removing price controls and retaining only wage controls could also not do the job, according to this view, and in fact resulted in the unbalanced inflationary process observed in Russia in 1992. If the directed subsidized credit in the system and the interenterprise arrears (which were later monetized) are also taken into account, these policies had a further consequence. As many have pointed out, the inflation tax in Russia has been borne primarily by households and a few unsubsidized productive sectors, including services and distribution.

In relation to foreign exchange operations, Mr. McKinnon’s argument is that when an exchange rate is market determined in a situation such as Russia’s, where state enterprises are free to bid as they choose but operate with only soft budget constraints, the ruble price for dollars will be bid up beyond the level that would typically be derived from a purchasing power parity analysis. Mr. McKinnon argues that part of the problem is that the wrong model of inflation was used as the basis for designing Russia’s policy. More specifically, the appropriate model for Russia was not one of either open or repressed inflation within a unified monetary system, with households and enterprises operating on the same monetary circuit and both sectors adhering to hard budget constraints. Rather, the model should have involved an explicit distinction between enterprises that are not cash constrained in their ability to bid for scarce resources and cash-constrained households. This alternative model, Mr. McKinnon argues, would have shown how unwise it was to decontrol producer prices in the manner the authorities chose.

In Russia, inflationary pressures were aggravated by the fact that, unlike China, Russia did not and probably could not have enjoyed any immediate positive output effects from the liberalization policies. Instead, liberalization coincided with the major dislocations in both trade and production that resulted from the breakup of the Soviet Union and the collapse of the Council for Mutual Economic Assistance (CMEA) trading system.

In my view, Mr. McKinnon’s analysis in this area is correct, but I would like to point out three additional aspects of the situation. First, many people—including some within the IMF—pointed out to the Russian authorities before January 1992 that Russia did not have the macroeconomic framework necessary to support the price liberalization initiative the Russian authorities were about to launch. IMF staff made representations to the Russian authorities stating exactly this point before the policy was implemented.

Second, it was apparent by late 1991, and especially after Mikhail Gorbachev left office, that Russia would attempt the “big bang” approach to economic policy reform early in 1992, in view of the sort of political economic atmosphere that existed in Russia at the time. If the Tianamen Square freedom fighters had won and had succeeded in installing a democratic regime, I would not have been surprised if they too had attempted the “big bang” approach in their economic reform program.

There are at least two reasons for this type of behavior. The first is that the “big bang” approach is the economic policy analog of the reformer’s impatience to achieve the complete destruction of the old political regime. It would have been easy for Mr. Gorbachev to pursue gradualist economic policy reform, but it was not possible for Boris Yeltsin. In brief, Western advisers preaching the “big bang” approach were sought by a regime that wanted it.

The second reason is the one that struck me most forcefully when I first started paying attention to the debate over the Russian reforms—namely, the naivete of those who favored the “big bang” approach. These people held quite unrealistic views about how quickly reforms in Russia would begin to bear fruit in the form of real output increases and about how short-lived any adverse output effects would be. Others who were not quite so naive realized both that the short-term costs could be serious and that a J-curve effect was inevitable. However, many of these realists also felt that the combination of a government determined to stay the course, an understanding population that appreciated the potential long-term benefits, and massive foreign assistance to help maintain consumption and provide the investment resources needed to rehabilitate some of the productive sectors would enable the economy to turn around quickly after any initial drop in output.

My third point is that it is not altogether clear what those who favor the “big bang” approach should be accused of at the macroeconomic level. It is difficult to argue that the proponents of this approach did not realize the nature of the most important macroeconomic preconditions for its success. Assuming that the enterprises were free from official price controls, these conditions would have included, at a minimum, (i) hard budget constraints on enterprises; and (ii) an effective government budgetary policy able to adapt to a decrease in revenues from traditional sources, either by finding alternative revenue sources or by cutting back on expenditures. As mentioned before, many proponents of this type of reform would have included at least one further condition—massive external assistance. Should the criticism then be that the supporters of the “big bang” approach should have realized that the conditions for macroeconomic stability could not be met, both because of domestic political factors and because external assistance on the scale required was simply unlikely to materialize? This perhaps would be the most legitimate criticism.

The big question now is where Russia can go from here. Mr. McKinnon suggests that to achieve macroeconomic stabilization in the near term, it may be necessary to return to some form of centralized government control over money and credit. It may also be necessary, in his view, to return to centralized price setting at the producer level, including of the exchange rate. In my opinion, this move would be an unfortunate one. It would only increase uncertainty in the economic environment and adversely affect expectations. These developments would, in turn, be bad for incentives. To roll back the clock, as it were, does not seem wise.

A better course to follow, in my view, has already been started with the program supported by the IMF’s systemic transformation facility (STF). This program involves hardening the budget constraint on enterprises; strengthening fiscal policy, including maintaining tight control over the nominal budget deficit (which could then become one of the nominal anchors in the system); improving the banking and payment systems; and finally, continuing a flexible exchange rate regime. If a government wants to subsidize enterprises, it would be advisable to do so using lump sum transfers that are, in turn, explicitly and fully accounted for in the budget.

To conclude, I would like to make a general point about the focus and structure of the debates on economic reform programs. Undoubtedly, one of the great advances made in these discussions has been the realization that social safety nets are a matter of real concern and that it is necessary to search for measures and policies that can incorporate them. I also believe that progress was made when the focus shifted from the speed and pace of reforms to their nature and sequencing. In my view, once the nature of the needed reforms has been determined—typically, by a political process—economists have greater control over the sequencing than over the speed. To put it bluntly, one can attempt ex ante any speed one likes. The actual speed one achieves ex post will depend on a complex web of political, social, and economic factors over which economists as such may have little control.

Summary of Discussion

Three main issues were raised during the general discussion. First, discussants commented on Ronald McKinnon’s statement that the counterpart to the rapid growth of household claims on China’s banking sector is the large state sector deficit. This deficit, broadly defined, includes the deficit in the administrative budget, the cash deficits of the state enterprises, and infrastructural investments by both state and provincial governments. Mr. McKinnon emphasized that, in practice, the liberalized nonstate sector needs to save enough to finance both itself and the state sector deficit.

Links were drawn between this point and fiscal federalism in other developing countries, such as China and Brazil. It was noted that a common problem in federal systems is that provincial governments are allowed to run deficits and subsequently must turn to the state banking system for loans to finance these deficits. Mr. McKinnon noted that China’s “village industries,” which have proliferated in the last 12 years and are all owned by local governments, are another source of revenue for local administrations. For example, if a local authority is able to exploit some monopoly position in setting the output prices of a new factory, the local administration is able to add to its own revenues. Mr. McKinnon argued that although the central government could use the money from these industries, they have instead become an important source of finance for local governments throughout China.

The positive side of this development is that these enterprises have tended to be relatively competitive, achieving reasonable levels of operational efficiency. Thus, they have promoted not only more efficient provision of certain goods and services but also greater financial independence for local governments. This last fact is a somewhat ironic and uncomfortable one for the Chinese Government, because this independence has come about through enterprises owned by the state, albeit at the local level. The contrast is all too obvious between this aspect of China’s economy and the advice frequently given to transition economies to separate the ownership and management of private enterprises from government operations.

Discussants then addressed a second, more general point concerning the risks and benefits of market-based reforms for foreign exchange allocation and domestic financial market operations. One participant noted that the primary risk involved in implementing these reforms is that if they fail, the resulting macroeconomic environment can be more unstable than it would have been had the controls been left in place. China’s present situation was cited as an example of this phenomenon. The benefits of successful reform, on the other hand, take the form of greatly improved efficiency in the allocation of resources.

Asked how the IMF and donor agencies view this trade-off in light of their active encouragement of market-oriented reforms, IMF speakers responded by referring again to the conditions under which auction markets can be expected to work more efficiently than systems based on administrative allocations. It was noted that when a system with solvent participants is in place, auctions seem to be the preferred method of allocating resources. However, in the countries of the former Soviet Union (FSU) and other transition economies, which have large numbers of insolvent participants, the move toward greater reliance on market forces involves much greater risks. IMF speakers maintained that these risks relate primarily to the potentially unmanageable public sector obligations that can result from unsuccessful reforms, including the need to bail out an increasing number of banks that may fail if interest rate liberalization increases the costs of production for enterprises too much. However, in most cases the potential danger should not cause governments to reject auction markets but only to be cautious when using them.

It was also noted that most auctions operate according to the established rules for access and collateral. Following these regulations reduces the risk of nonpayment that arises when not enough information is available about market participants. Mr. McKinnon noted that the auctions China uses in its swap market for foreign exchange have been very effective during a time when arbitrage with the outside world has remained limited. But as China becomes more and more open in this regard—in part as a result of U.S. pressure—these auctions will become increasingly difficult to operate unless the official and swap exchange rates are unified.

The third and final issue involved the ways in which reform programs in China and the FSU differ from the programs in Latin America and Africa with which the IMF has had considerable experience. The main difference seems to be the extremely high incidence of technically insolvent economic agents in the transition economies. It was argued that this widespread insolvency can be expected to affect the sequencing of reforms and that action needs to be taken to increase the solvency of key agents before auction markets are implemented. Another important difference that was pointed out is the widespread problem of moral hazard in transition economies, the result of explicit or implicit government guarantees covering everything from bank deposits to job security. The extent of these guarantees seems certain to reduce discipline within a market system and to slow down the pace at which true market mechanisms can be relied on to allocate resources and perform other economic functions.

This article first appeared as Chapter 13 of Ronald I. McKinnon, The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy (Baltimore and London: Johns Hopkins University Press, 1991, 1993). It is reprinted with permission of the publisher.

Two highly readable overviews of the gradualist Chinese approach are provided by Dwight Perkins (1992) and John McMillan and Barry Naughton (1992).

Terminology used by John Williamson (1991).

See recent studies done for the Asian Development Bank by Fforde and Vylder (1993) on Vietnam and by Vokes and Fabella (1993) on Laos.

Because Hungary has gradually been liberalizing for some time, one could plausibly argue that Hungary does not belong in this group of rapidly liberalizing transitional economies.

This problem of supply diversion bedeviled the old Soviet economy in 1990/91, when price controls were in the state sector with very high price premiums in the marginal free or “black” economy (Murphy, Shleifer, and Vishny 1992).

In the early 1990s, important new empirical research for the World Bank over a huge 80-country, 30-year (1960–89) sample pooled in cross-section and time series provides further strong empirical support for the link between financial depth and high productivity growth. See particularly Levine (1992) and King and Levine (1993).

See the comment “If He Goes” in The Economist (326: March 13, 1993), pp. 17–18, which argues for even more sweeping price decontrol in Russia.

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