Chapter

II Initial Conditions and Special Characteristics of Chinese Reform

Author(s):
Michael Bell, Kalpana Kochhar, and Hoe Khor
Published Date:
June 1993
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This section reviews some of the economic conditions at the start of the reform era and certain characteristics of the economic environment during the period. It highlights a number of special features of the Chinese reform process that may be germane to understanding its impact and compares China’s experience with those of other former centrally planned economies in transition.

Initial Conditions and Reform Environment

Macroeconomic and Structural Conditions

The Soviet-style “command” economy model was first chosen to guide the development strategy following the establishment of the People’s Republic of China in 1949, but in time Chinese leaders became increasingly disenchanted with some aspects of this model, particularly the high degree of centralization. The central planning apparatus was overhauled in 1957; the central government retained control over important large- and medium-scale industrial enterprises but for other enterprises, particularly those engaged in light manufacturing, control was transferred to local authorities. Although there were periods before 1978 when central control was tightened and then loosened again, China never returned to being centrally planned to the same degree as the former Soviet Union or some Central and East European countries.

What was the economic legacy of the development strategy pursued in the two and a half decades up to 1978? Despite the depression and famine following the Great Leap Forward (1958–59) and the political upheavals of the Cultural Revolution, China had achieved growth rates averaging 6 percent a year between 1952 and 1978 (Table 1), albeit with significant variability. Measured inflation was for the most part low, and government budget deficits and external imbalances were rarely large. Measured in terms of the production of electric power, cement, and steel, China’s industrial base in the late 1970s was comparable to that of Japan and the Soviet Union in the 1960s, and its record on income distribution and on social indicators compared favorably with those of middle-income countries. Reflecting an aversion to foreign borrowing in the three decades up to 1978, China entered the reform period with virtually no external debt.9 This stood in contrast to other developing countries in Eastern Europe and elsewhere where relatively heavy external borrowing was used primarily to finance consumption and inefficient investment (Table 2). In short, the Chinese economy, unlike those of other former centrally planned economies in transition, was not in a deep crisis of macroeconomic instability just before reforms were implemented. Thus, the question arises as to the factors that provided the impetus for economic reforms and their scope.

Table 1.Selected Macroeconomic Indicators(Annual percent change, unless otherwise specified)
Real Net

Material

Product1
General

Retail

Prices
Government

Budget

Balance2
Exports3Imports3Trade

Balance3
19521.30.81.1-0.3
195314.03.40.41.01.4-0.4
19545.82.32.21.11.3-0.2
19556.41.00.31.41.7-0.3
195614.1-0.21.61.6
19574.51.50.71.61.50.1
195822.00.2-1.92.01.90.1
19598.20.9-5.32.32.10.2
1960-1.43.1-6.71.92.0-0.1
1961-29.716.2-1.11.51.5
1962-6.53.80.91.51.20.3
196310.7-5.90.31.61.30.3
196416.5-3.71.91.50.4
196516.9-2.70.52.22.00.2
196617.0-0.31.02.42.20.2
1967-7.2-0.7-1.52.12.00.1
1968-6.50.10.12.12.00.1
196919.3-1.12.21.80.4
197023.3-0.20.72.32.3
19717.0-0.80.62.62.20.4
19722.9-0.23.42.90.5
19738.30.65.85.20.6
19741.10.5-0.36.97.6-0.7
19758.30.2-0.27.37.5-0.2
1976-2.70.3-1.26.96.60.3
19777.82.01.17.67.20.4
197811.70.70.39.810.9-1.1
19797.62.0-5.113.715.7-2.0
19807.96.0-3.518.120.0-1.9
19814.42.4-0.622.022.0
19828.81.9-0.722.319.33.0
198310.41.5-0.922.221.40.8
198414.72.8-0.826.127.4-1.3
198512.88.80.327.442.2-14.8
19868.16.0-0.930.942.9-12.0
198710.97.3-0.939.443.2-3.8
198811.318.6-0.747.555.2-7.7
19894.417.8-0.752.559.1-6.6
19904.12.1-1.062.153.48.7
19917.72.7-0.871.963.88.1
199213.05.3-1.085.080.64.4
Source: China Statistical Yearbook, 1992.

From 1978, the series is gross national product.

Revenue minus expenditure on the basis of the authorities’ definitions in percent of net material product or gross national product.

In billions of U.S. dollars, on a customs basis.

Source: China Statistical Yearbook, 1992.

From 1978, the series is gross national product.

Revenue minus expenditure on the basis of the authorities’ definitions in percent of net material product or gross national product.

In billions of U.S. dollars, on a customs basis.

Table 2.Selected Countries: Debt and Debt-Service Indicators
1980198619871988198919901991
External debt as a ratio to GNP
China1.58.511.611.310.714.216.4
Argentina48.470.576.466.5119.162.349.2
Brazil31.243.742.334.325.625.228.8
Former Czechoslovakia12.012.814.415.718.629.5
Hungary44.874.077.969.573.767.677.0
India11.921.322.021.723.923.729.2
Indonesia28.052.269.064.359.766.166.4
Korea48.745.531.021.115.614.414.4
Malaysia28.086.580.461.650.544.647.6
Mexico30.582.582.161.448.541.736.9
Poland51.569.963.954.682.061.4
Thailand26.045.442.437.034.435.039.1
Debt-service ratios
China4.49.69.59.711.411.412.0
Argentina37.376.274.344.536.239.448.1
Brazil63.147.041.948.234.622.630.8
Former Czechoslovakia8.07.98.89.610.011.5
Hungary18.941.033.531.129.734.332.5
India9.332.029.430.327.628.330.6
Indonesia13.937.437.140.435.531.133.0
Korea19.726.732.314.811.810.7
Malaysia6.322.221.124.715.611.28.4
Mexico49.554.240.148.037.927.830.9
Poland12.814.210.69.44.95.4
Thailand18.930.122.020.216.317.013.1
Source: World Bank, World Debt Tables, 1992–93.
Source: World Bank, World Debt Tables, 1992–93.

Although no crisis was apparent at the macroeconomic level, there was growing discontent with the system, especially in the rural areas. The recorded economic growth prior to 1978 was achieved largely by increasing the amounts of labor and capital employed, with little or no growth in total factor productivity. Moreover, there were sharp swings in output growth associated primarily with the waves of centralization and decentralization. The economy faced chronic and fundamental economic difficulties, many similar to those encountered by other centrally planned economies, including a distorted pricing system, inefficient resource allocation, concentration of investment in heavy industry at the expense of basic infrastructure and the resultant bottlenecks, stagnation in agricultural production with shortages of nongrain products, isolation from foreign competition, a pervasive emphasis on quantity rather than on quality, and slow growth in per capita consumption with acute shortages of many consumer goods and housing.

China’s economic growth during the 1960s and the first half of the 1970s was much lower than several of its East Asian neighbors (Table 3). Moreover, owing to the essentially autarkic regime of the previous three decades, China had made little technological progress in many critical areas. Chinese leaders increasingly recognized that unless the technological disparity between China and her neighbors was effectively addressed, these output gaps would only widen.

Table 3.Selected Economies: Growth Rates of GNP and GNP Per Capita, 1960–76(Annual percent change)
GNPGNP

Per Capita
Korea9.67.3
Singapore9.57.5
Japan9.18.0
Taiwan Province of China9.06.2
Hong Kong8.76.4
Thailand7.74.6
Malaysia6.73.9
Pakistan6.13.2
China5.73.6
Philippines5.42.4
Indonesia5.23.1
India3.51.2
Myanmar2.90.7
Sources: World Bank, World Bank Atlas, 1978; and China Statistical Yearbook, 1991.
Sources: World Bank, World Bank Atlas, 1978; and China Statistical Yearbook, 1991.

Domestic Saving

A key factor in the successful transformation of economies is the availability of resources for noninflationary financing of adjustment and growth. Since the inception of reforms, China has enjoyed high rates of domestic savings—estimated at 30–35 percent.10 These rates are considerably higher than in most developing countries and even industrial countries, and are only slightly lower than in countries like Japan and Singapore. In addition to an increase in the saving rate, the most notable trend since the early 1980s has been a shift in the composition of total saving from the state sector to households. In particular, the share of household saving in total saving as well as in total household income has risen sharply since 1979. Household saving is estimated to have accounted for about 40 percent of domestic savings in 1991. Further, rural households accounted for an estimated 75 percent of total household saving. There can be no doubt that the high savings rate contributed to China’s success in maintaining macroeconomic balance during the reform period.

From a policy perspective, the issue of interest is whether the high saving rate reflects a behavioral characteristic of Chinese households or is merely a monetary phenomenon, that is, “involuntary or forced saving” as a result of repressed inflation. Clearly, the two have very different policy implications. If the magnitude of repressed inflation is small, the danger of a sharp rise in inflation following price liberalization should be limited.

Several arguments can be made in favor of each side of this issue. For example, it can be argued that, until recently, significant price controls existed in the economy. This, together with the rapid monetary expansion that has taken place, has led to an increased degree of forced savings in the economy. Furthermore, as the state continues to provide for retirement, education, housing, and health care, most of the theoretical reasons underlying the choice to save are not relevant in China.

On the other hand, it could also be argued that with the emergence of the two-track pricing system in China—under which individuals and enterprises are free to buy goods at market-related prices at the margin—money holdings or savings cannot be considered “involuntary.” Moreover, unlike urban households for which enterprises provide housing, medical care, and pensions, rural households have to rely on their own savings to procure these services. Another reason for high rural saving is their access to lucrative investment opportunities, particularly since the introduction of the household responsibility system and the easing of restrictions on nonagricultural activities. Urban households in contrast have had little portfolio choice (until very recently) outside bank saving deposits.

Empirical studies11 on the nature of households’ decision making with respect to saving in China have been far from conclusive on whether and to what extent saving is “involuntary.” Some studies, such as Dessi (1991) based on sample survey responses, have concluded that forced saving is significant among urban households and could account for as much as 15–25 percent of urban household saving. On the other hand, there appears to be much less evidence that rural saving is involuntary.

Access to External Financing

Even with greater willingness to turn to foreign sources to finance its modernization and development process, China’s policy toward external borrowing has been relatively conservative. Borrowing has remained predominantly medium and long term from official sources, and a substantial proportion of it has been on concessional terms. In absolute terms, China’s external debt did increase dramatically, rising tenfold in the 1980s. In particular, the rapid economic growth and import liberalization of the mid-1980s was accompanied by a surge in external indebtedness, with the share of short-term commercial debt rising sharply.

However, prudent debt management and an improved monitoring capability have served to limit the ratio of total debt outstanding to GNP to about 16 percent in 1992, with about 20 percent of total debt being on concessional terms. Throughout the reform period, China’s debt-service ratio has remained much lower than in most other developing countries. Although in the immediate wake of the events of June 1989 China’s access to the market for medium- and long-term funds became tight, there appears to have been no enduring impact on creditworthiness as the external accounts strengthened and reform reappeared on the agenda.

In addition, China has had considerable success in attracting foreign direct investment, which increased from less than $400 million in 1982 to over $11 billion in 1992. In this regard, the special roles played by Hong Kong and, more recently, Taiwan Province of China are noteworthy. Between 1988 and 1992, Hong Kong alone accounted for more than two-thirds of foreign direct investment inflows to China, the major part being absorbed by the coastal province of Guangdong. Since 1990, investment from Taiwan Province of China has also been increasing, particularly in Fujian. These trends are no doubt largely attributable to the cultural and geographic proximity of these territories to China.

Openness of the Economy

In the pre-reform period, the overriding preoccupation with self-sufficiency resulted in the development of domestic oil production, which in turn served to insulate the Chinese economy from the effects of two oil shocks in the 1970s. Also, through much of the pre-reform period and even the early reform years, China remained a relatively closed economy, with imports and exports as a ratio to GNP being less than 10 percent in 1978 and remaining below 20 percent until 1984. As a result, the economy was less vulnerable to external disturbances such as recessions in world markets and fluctuations in interest rates. Moreover, the absence of bilateral payments arrangements, such as the Council for Mutual Economic Assistance (CMEA), helped prevent the emergence of further distortions and rigidities in the trade system in addition to those generated by the pricing system and the strict administrative control of external trade and payments, and served to expose Chinese exporters to some competition.

Special Characteristics of Reform

Regional Policy

China has adopted a selective approach under which certain provinces or regions were chosen to play a leading role in the reform process. This approach partly reflected a strong predilection for experimentation arising from the authorities’ perception of the complexity of simultaneous nationwide reform in such a large country, and their concern with avoiding instability. A persistent theme of the reforms was a gradually increasing outward orientation (“opening to the outside world”), under which China attempted to increase its foreign exchange earning capacity. A further characteristic of the early reforms was their focus in regions with a relatively low proportion of large state-owned enterprises subject to mandatory planning.

These features led to the emergence of the coastal provinces as the focal point of many aspects of the reform effort to the extent that they proved a driving force behind the reform process. It might also be argued that the reform process merely removed the impediments to the coastal provinces’ exploiting their comparative advantages. The first step was to establish the special economic zones (SEZs),12 giving them more financial and administrative powers, including the right to approve large-scale investment projects, to grant tax concessions and other incentives to foreign-funded enterprises, and, until recently, to retain a higher proportion of foreign exchange. As the positive results of these experiments became evident, the approach was extended to a number of other “coastal open cities,” each of which acquired the right to offer incentives to potential investors, allowing a degree of competition among localities and potential for divergence in economic performance among provinces or regions. Indeed, it might be observed that in a number of instances the localities, “given an inch, have taken a mile.”

Two by-products of these developments were a growing disparity in economic growth among provinces and pressure from the provinces for greater autonomy in their economic relations with the central government, particularly in matters affecting resource allocation. Net transfers between the provinces and the center have been governed by contracts of three to four years’ duration, and a perception remains that these transfers are not equitable. Moreover, since the major part of the state’s revenue is retained in the provinces, the center’s ability to undertake macroeconomic management through fiscal policy is diminished. This is exacerbated by the difficulty faced by the People’s Bank of China to contain credit expansion because of local political pressure on provincial branches of banks.

Decentralization and its Effects

The Chinese reform process has been characterized by the progressive decentralization of economic decision-making power. Nowhere is the process of devolution of decision-making powers and control from the center to the provinces more apparent than in the change that has taken place in the system of state investment and allocation of raw materials through the material supply system. Before reforms were initiated, these systems were at the heart of Chinese central planning. Central government control over both the level and composition of investment has declined significantly. Furthermore, state control over the allocation of key raw materials has steadily been eroded with the progressive reduction in the scope of mandatory planning.

Under these circumstances, China’s policymakers are faced with two major issues (dealt with in greater detail in Section V below). First, with the decline in the central government’s direct authority over investment decisions, the need for effective indirect macroeconomic policy levers with which to regulate the overall level of investment demand has become critical. Second, the potential for conflict between central and local investment priorities now exists, largely owing to (1) the distortions in the price system, which make investments in priority sectors such as energy and transportation infrastructure unattractive to provincial and local authorities; and (2) underdeveloped capital markets that blunt financial intermediation, with investible surpluses tending to be reinvested in the areas from which they originate irrespective of rates of return in other provinces. The latter has led to the wasteful duplication of investments across provinces and investments that are less than optimal.13

The share of investment in China’s GDP has always been high, underscoring the reliance placed by the authorities on “accumulation” for growth. In the pre-reform period, most fixed asset investment was under central control. Total fixed asset investment consisted of investment by state-owned enterprises, collectives, and individuals.14 These investments were financed primarily through the budget or under the credit plan through policy loans from the specialized banks. The central government could therefore closely regulate the level of investment and its composition. Although most investment decisions continue to be made by some level of government after the initiation of reforms,15 the share of total investment financed through direct budgetary appropriations has declined dramatically (Table 4). To some extent, this reduction is not surprising given the rapid growth of the nonstate sector in China over the past few years. However, similar trends are discernible even when the share of funds from the budget in investment by state-owned units is examined (Table 5).

Table 4.Total Fixed Asset Investment(In percent of total, unless otherwise specified)
1981198519871988198919901991
Total fixed asset investment100.0100.0100.0100.0100.0100.0100.0
By ownership
State-owned units66.166.163.161.461.365.665.9
Collectively owned units16.812.915.015.813.811.912.7
Individual17.121.021.922.724.922.521.5
By source of finance
State budget28.416.013.19.18.38.76.8
Domestic loans20.123.020.617.319.623.5
Foreign investment3.64.85.86.66.25.7
Self-raised funds71.6160.347.964.556.952.352.3
Others11.210.913.111.8
Source: China Statistical Yearbook, 1991.

Includes all other forms of financing outside the state budget.

Source: China Statistical Yearbook, 1991.

Includes all other forms of financing outside the state budget.

Table 5.Fixed Asset Investment of State-Owned Enterprises(In percent of total, unless otherwise specified)
198519871988198919901991
Total investment100.0100.0100.0100.0100.0100.0
By source of finance
State budget24.020.514.713.413.210.2
Domestic loans23.024.524.220.923.628.1
Foreign investment5.37.39.010.19.18.4
Self-raised funds47.747.652.255.654.153.4
By sector
Agriculture2.72.42.32.42.72.8
Industry54.461.262.563.062.058.2
o/w: Energy21.823.623.327.929.026.4
Transportation and communications13.512.311.510.711.913.4
Source: China Statistical Yearbook, 1991.
Source: China Statistical Yearbook, 1991.

The principal factor accounting for the decline in the share of investment financed through the budget is the sharp decrease in budgetary revenues, from the equivalent of 27 percent of GNP in 1979 to 16 percent in 1992. The fall in revenues is, in turn, attributable to the structural weaknesses in a transitional revenue system marked by ad hoc contracts between the state and the enterprises, and between central and local governments (see Section V for a more detailed discussion of these arrangements). With these decentralized arrangements, local authorities have the incentive to collect fewer taxes that must be shared with or turned over to the center. Resources are thus kept in the hands of enterprises through generous local tax exemptions. “Voluntary” contributions from enterprises have left growing amounts of surplus funds in the hands of local governments—”extrabudgetary funds”—which have been used to finance local investment initiatives. As will be discussed below in Section VI, each phase of China’s reforms has been accompanied by a surge in aggregate demand—primarily investment demand. This fact, together with the diminution of central authorities’ influence over the level and composition of investment, has had important implications for the stability of the macroeconomic situation during the phases of reform, and indeed for the pace of the reform itself.

Enterprise Ownership

A key question that has faced economic reformers in China, as elsewhere, is whether the continuation of public ownership represents an insuperable barrier to the functioning of markets and efficient resource allocation. China has consistently maintained its preference for public ownership as a means of achieving its vision of a socialist market economy. As envisaged by China’s policymakers, such a system would be characterized by increased competition and the elimination of mandatory planning, but not necessarily by the replacement of state ownership with “private” ownership, as in a capitalist system. The objective is to retain the predominance of public ownership supplemented by nonstate and private ownership, while achieving an effective separation between state ownership and control of enterprises. Although the development of a socialist market economy is a recent goal—marking an important change in the ideology of economic reform in China—throughout the reform process ownership structures have been modified in a number of important respects that had major implications for enterprise management. In particular, these modifications might be viewed as an attempt to simulate market conditions by encouraging profit-maximizing behavior.

First, there was a substantial degree of decentralization in control from the central government to provincial and municipal governments, notably in foreign trade. In some respects, the size and complexity of the structure of the Chinese Government may have facilitated the effective decentralization of control. The significance of this change is that although government interference has not been eliminated, lower levels of government view enterprises under their jurisdiction as a source of revenue and have therefore been willing to allow relatively free rein to profit-maximizing behavior.

Second, the introduction of the household responsibility system and the lifting of restrictions on non-farm activities in rural areas led to the rapid growth of various forms of enterprises—notably the TVEs—that fall almost entirely outside the jurisdiction of state or provincial authorities. They are not subject to state planning norms, price setting, or other forms of state intervention; conversely, they do not have preferential access to credit or material supplies, nor do they benefit from investment from the central government or from guaranteed sales to the state. That is, these enterprises operate largely in a market-oriented manner, facing a highly competitive environment and hard budget constraints. See Box 1 for further details on China’s nonstate industrial sector.

Third, the initiatives to open up parts of the economy to foreign trade and investment led to the emergence of various forms of private and quasi-private ownership, both domestic and foreign, through the establishment of foreign-funded enterprises (FFEs). In addition, the Government has encouraged private entrepreneurship in some areas of the economy, particularly in the service and commerce sectors. Even in the industrial sector, the share of privately owned enterprises in industrial output tripled to over 5 percent in the five years through 1990. Private share ownership is still limited in scope, although with recent moves to open securities exchanges, private shareholding of state-owned companies can be expected to increase.

Fourth, even among the enterprises that remain under state control, the scope for direct intervention has gradually eroded as mandatory planning has been reduced, price setting powers devolved, more autonomy in investment decisions allowed, and higher profit retention permitted. Also, in the mid-1980s, the authorities initiated experiments in which enterprises were allowed to issue shares. These shareholding arrangements are described in Box 2.

Rural Land Tenure

Even more than with enterprise ownership, the formal ownership of land has changed little and remains almost exclusively under some form of public ownership. However, a fundamental change occurred in land management systems. From 1949 through 1977, collectivization of land management prevailed under a three-level system in which households were organized into production teams, which in turn were organized into brigades and ultimately into communes of, on average, 4,000–5,000 households. Private plots were tolerated on a limited scale. Under this system, land was collectively owned, and the basic production unit was the team (of, say, 20–30 households).

Box 1.China’s Nonstate Industrial Sector

Over the last decade the role of the nonstate industrial sector has acquired increasing importance in the Chinese economy. Nonstate-owned enterprises have been growing rapidly, and in 1992, they accounted for a larger share of the gross value of industrial output (GVIO) than did state-owned enterprises (SOEs).

The definition of the nonstate-owned sector in the Chinese context needs to be clarified. The contours of the private sector, as commonly understood in market-based economies, are not as clear-cut in China. There are six tiers of government: central, provincial, prefecture or municipal, county or district, township, and village. Enterprises that are under the direct authority of the central government or of provincial governments are considered state owned, and all others are considered to comprise the nonstate sector. In China’s official statistics, there are three main categories of nonstate enterprises: collectives, individual businesses, and “other enterprises.”

Collectives can be urban or rural, depending on their affiliation. Enterprises affiliated with a district government under a municipality or a county are regarded as large urban collectives. Those affiliated with a neighborhood are labeled small collectives. In addition, urban cooperatives are included in the category of urban collectives. Rural collectives include township and village enterprises (TVEs) and rural cooperatives. What distinguishes collectives from state-owned enterprises is that they are not managed by, nor do they report to, the industrial ministries/bureaus or any representatives thereof. They operate largely in a market-based environment. From the point of view of ownership, collectives are regarded as publicly owned, because in principle their ownership is shared by the community. However, many are in effect private enterprises, because they are merely partnerships hiring several employees from the local community—which is particularly true of cooperatives. The line dividing collectives from private enterprises is thus becoming increasingly blurred.

The remaining categories of the nonstate sector together comprise what is officially regarded as the private sector. An individual business is defined as one that is owned by a household or an individual and employs no more than seven people. The category of “other enterprises” consists of private enterprises owned by a household or an individual and employing more than seven workers; foreign enterprises; and joint ventures.

The principal factors accounting for the dynamism of the nonstate sector are

  • Much of the growth of the nonstate-owned sector has been in the light and service industries. These industries were severely neglected in China’s industrialization strategy, which focused primarily on the development of heavy industry. Thus, one explanation for the rapid rise of collective and private enterprises was their ability to exploit successfully gaps in China’s industrial structure and respond to substantial unsatisfied demand in sectors previously repressed.

  • The degree of administrative centralization in China has been much less marked than in other former centrally planned economies. Each layer of government functions as a semiautonomous operating unit and controls its enterprises along functional lines. Local governments have thus had a strong incentive to set up their own sources of finance and to keep the resources so generated within their own administrative jurisdiction. The reforms of the last decade and a half have exploited and further accentuated the decentralized nature of administration in China, which has had profound implications for the development of the nonstate sector.

  • The weak bargaining position of lower levels of government has meant that, unlike the central and provincial or city level counterparts, they have been unable to provide their affiliated enterprises with the cushion of a soft budget constraint. As a result, nonstate enterprises, unlike the SOEs, have had to operate through the discipline of hard budget constraints. It is not surprising, therefore, that the nonstate enterprises have emerged as the more efficient.

If the current trends continue, the nonstate sector would account for over two-thirds of China’s total GVIO, and 30–40 percent of the country’s GDP by the year 2000. Such an expansion of the nonstate sector is likely to have important consequences for the entire economy, and for SOEs in particular, for which competitive pressures will rise substantially. This competition in turn is likely to constitute the single most important impetus to the reform of the SOE sector.

In assessing the future of the nonstate sector, several points should be borne in mind. First, despite considerable progress, uncertainties have persisted regarding individual ownership rights and the legal position of various forms of nonstate ownership. Second, action to improve market competition is needed. Interprovincial and even interlocality trade barriers and transport bottlenecks hamper market integration. Third, nonstate-owned enterprises have so far done well in penetrating export markets, a feat accomplished in large part through activity in processing and in partnership with the marketing skills of counterparts in Hong Kong. For the most part, they have been constrained to use foreign trade corporations as intermediaries and have not enjoyed direct trading rights. This institutional constraint lessens the ability of Chinese enterprises to learn, and it has also served to restrict the access of nonstate enterprises to foreign trade credit. Finally, a constraint that bears heavily on all industrial enterprises, and especially on those in the nonstate sector, relates to inadequate physical infrastructure. This problem will require immediate attention if the momentum behind China’s nonstate sector is not to be undermined.

Box 2.Shareholding Arrangements in China’s State-Owned Enterprises

Since the mid-1980s, SOEs, on an experimental basis, have begun to transform themselves into shareholding companies. These are defined as enterprises with “legal person” status that raise capital through the issue of shares. Those that issue shares to the general public are known as “joint-stock” companies. The financial liability of the shareholders is limited to the value of their shareholdings in the company. Joint-stock companies can list their shares on one of the two stock exchanges in Shanghai and Shenzhen. For others, the shares are not listed publicly but are sold through securities companies, brokerage houses, or simply to the employees of the enterprises.

The emergence of joint-stock companies and equity markets—although still of limited significance from an economic standpoint—represents a major change in the ideological framework of reforms in China: they are no longer seen as being at odds with the institutional underpinnings of a “socialist” economy. To understand the apparent paradox between the issuance of shares and the continued characterization of the ownership structure as “public,” it is necessary to define the concept of “ownership.” It can be defined as the right to (1) determine how enterprise assets are used; (2) receive the surplus produced by the enterprise; and (3) sell, trade, or transfer enterprise assets. This characterization of the concept of ownership in the Chinese context is attributable to the World Bank (1988). For SOEs that have been turned into shareholding companies, it is not solely the state that exercises these rights, but all shareholders, including individuals and other state and nonstate entities. In this way, shareholding is seen as being compatible with social or public ownership of the enterprises. Clearly, the potential for contradictions and conflicting objectives exists in this system. The continued preference of the authorities to maintain the predominance of public ownership presumably reflects their conviction that such a system is more equitable. However, with shareholding arrangements, ownership may become concentrated in the hands of a few individuals, thus contravening this basic objective of “social” ownership.

At first, the shares of the companies listed on the stock exchanges were issued only to domestic residents (“A” shares). Since 1991, however, some companies have been permitted to issue “B” shares, denominated in local currency, but purchased by foreigners with payment in foreign exchange. The foreign exchange is converted using the swap market exchange rate, and foreign investors are guaranteed convertibility of their investment and earnings into foreign exchange at the swap market rate. These stock markets have grown rapidly during the past two years, and the number of companies listed has risen from 15 to 60. In addition, plans are under consideration to list stocks of some companies on stock exchanges abroad. Indeed, one former SOE was listed on the New York Stock Exchange in 1992, and in 1993 some 9 enterprises have listed their stocks on the Hong Kong Stock Exchange.

The authorities see the main advantages from adopting the shareholding system as facilitating (1) the separation of government ownership from management; (2) the mobilization and rational allocation of financial resources; and (3) the provision of greater financial and decision making autonomy so that enterprises can become more efficient and respond dynamically to changing market opportunities.

With regard to the extent of state participation in shareholding companies, four levels of government ownership are envisaged. In certain priority sectors, defined as those characterized by market failures or that produced goods deemed to be of national strategic importance, enterprises will remain wholly owned by the Government. The second level will consist of enterprises with majority government ownership. The third level will comprise enterprises with minority shareholding by the Government. Finally, some small enterprises engaged primarily in commercial activities will be auctioned or leased to individuals, with the state not being represented in the ownership structure.

After an enterprise has been turned into a shareholding company, the state’s position as the sole owner will disappear. As one among many owners of equity rights, the state will only participate in the decision making to the extent of its representation. The authorities envisage that, even in enterprises in which the state is the majority shareholder, the effective separation of ownership from management will be achieved by requiring that the Government act according to the statutes of the new company law that is being drafted and is expected to be promulgated during the course of 1993. Problems arising from conflicts of interest between the state as a shareholder and as the collector of tax revenues are not expected as long as the state behaves in accordance with both company law and tax laws.

In addition, state agencies will be responsible for approving the applications of state-owned enterprises to restructure themselves as shareholding companies, reviewing and approving the valuation of their assets (which would be conducted by independent appraisers), reviewing the pricing of shares, determining which state agency will actually hold the “state’s” shares, and so on.

Several problems remain to be resolved with respect to these experiments. The first concerns the establishment of a strong legal framework governing the issuance and trading of shares. Second, asset valuation and accounting practices need to be standardized across enterprises. Third, the pace of reform of the social security system needs to be quickened to enable fundamental restructuring of the SOE sector. Fourth, financial sector reforms need to be accelerated so that, inter alia, banks can no longer be prevailed upon by central and local authorities to grant loans to uncreditworthy enterprises, which, in turn, has important implications for “hardening” enterprise budget constraints. Finally, some question remains on whether a true separation of the state’s role as an owner and as a manager can be achieved as long as the majority or even the largest minority of shareholders are agents of the state.

Three key features of the reforms of 1978 are noteworthy: first, collective ownership was retained as a fundamental precept; second, arable land was distributed among farm households based on family size and the availability of labor; and third, production decisions became the responsibility of the household governed by contracts with the relevant rural collective economic organization. Although the old system of communes, brigades, and production teams was abolished, these entities were reconstituted as townships or villages, the government of which was charged with the responsibility for land management and the negotiation of contracts with the households.

The slowdown in agricultural growth in the mid-1980s gave rise to the view that the reforms might have induced too much fragmentation of land holding and the loss of the economies of scale that had been available under the former system. This concern has induced some adaptation of the system in the past three-five years, originating at the local level—apparently without any initiative from the center—which has led to the emergence of two types of plot in each village: one type is allocated equally to each household in the village for its private use; the other is allocated to households under contracts that are open for bidding.

In addition, shareholding cooperative systems have emerged in various parts of the country on an experimental basis by which property under the direct control of the collective is valued and divided into equal shares. Some shares are reserved for collective ownership and the rest are distributed among the village households. These shares cannot be traded but earn dividends. The administrative powers of the cooperative are vested in a board of directors, elected through a system in which each member has one vote, irrespective of the number of shares held, and decisions are made by majority vote. As a result of these experiments, farmers no longer cultivate small pieces of land but give their contracted land to the cooperative in return for shares upon which they earn dividends. The cooperative may cultivate the land or use it as a factory site, hiring labor from the households involved in the cooperative arrangement. This approach has helped solve some of the problems associated with small, fragmented land holdings.

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